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Pilots are in the driver's seat and can wreak a merger deal
Vaughn Cordle, CFA / February 22, 2008
The biggest risk to a big airline merger will be seniority list integration with the pilots. Given the right
information, most pilot groups will make the best decision. However, it is the small percentage of
union leaders that may kill any deal because they insist on protecting junior pilots, or they ask for too
much.
As an example, to restore UAL pilots to pre-9/11 wage levels will take around $450m, but they should
accept perhaps $250 (20% or so) if given an equity stake of say 5%. The key success factor is
whether or not the pilot population understands that no merger equals years of no pay raises, no
growth, and no new aircraft. The pilots that control the union may not allow the UAL pilots to vote on the
deal.
In the case of DAL/NW, we are assuming costs and revenue synergies, with a net of higher labor
costs, of around $800m. Labor costs would increase approximately $1.2 if wages are brought up to
industry average, which would offset $990 in revenue synergies and around $950m in cost synergies.
Higher labor costs will dominate any cost synergies, but the net synergies should increase the new
airline's market value by over $6b (in addition to the current $10 billion combined value) or
approximately $9 per share. Of course, these numbers are only estimates that provide insight into how
the deal should be structured.
The details of DAL's expected synergies will provide the guidance required to fine-tune estimated
earnings and post-merger value. The deal can create substantial value if the pilots and other labor
groups take a certain percentage of equity in the merged airline instead of much higher wages.
Rumors are that the company will give labor 7% of the new equity in exchange for lower wage
increases, and 4% for the pilots. If true, this increases the post merger market value towards $20
billion and values labors' stake at $1.4 billion, leaving $800m for the pilots. Delta's high market value
[post-merger] will fall over time as labor eventually demands leading industry wages and work rules.
To argue that mergers cannot create value for labor, consumers, and the shareholders reflects a
misunderstanding of what drives value and why mergers should happen. Looking backward and
saying past airline mergers were failures is misguided because the success or failure of a merger
has to be measured against a status quo scenario. In other words, what appears to be a failure can,
in reality, be successful because the alternatives may have created less value or destroyed value.
Value in this sense is firm or enterprise value. The reality check for those who think mergers should
not happen will be what happens next at DAL/NW, and most likely UAL/CAL.
Pilots are in the driver’s seat and can wreak any deals if they ask for too much, or if seniority issues
bog down negotiations. However, it is in the best interests of the union members to sign off on the
deals because it will result in a stronger airline that can afford higher labor costs and new aircraft. The
alternative for labor to a merger will be no pay raises, no growth, and no new aircraft. Management has
every incentive to drag out negotiations for years.
With a merger, pilots and other labor groups will get an immediate pay raise – (15%-20% is a good
guess) and the new airline will have the scale and scope economies that reduce risk and improve
returns. AirFrance/KLM has incentive to invest equity in a combined DAL/NW and this, too, will reduce
the risk profile of the airline and increase market value via expanded valuation multiples.
Pilot pay raises of around 15%-20%, with a 5% or so equity stake, is doable given what we believe
(and what most analysts believe) is a reasonable estimate of cost and revenue synergies. With the
equity kicker, pilots have the potential to recapture lost compensation and receive a nice bonus. If our
estimates are correct, the equity component per pilot will be double that of the annual pay hike. It's only
a one shot bonus, but it can be quite substantial.
The biggest risk to DAL/NW or UAL/CAL mergers is seniority list integration. If one pilot group insists
that its junior members are not placed below the more senior pilots at the other airline, this could kill
the deal, or at the very least result in a lengthy delay. One more point: political opposition will fall by the
wayside once labor fully supports mergers and consolidation.
Vaughn Cordle, CFA / February 22, 2008
The biggest risk to a big airline merger will be seniority list integration with the pilots. Given the right
information, most pilot groups will make the best decision. However, it is the small percentage of
union leaders that may kill any deal because they insist on protecting junior pilots, or they ask for too
much.
As an example, to restore UAL pilots to pre-9/11 wage levels will take around $450m, but they should
accept perhaps $250 (20% or so) if given an equity stake of say 5%. The key success factor is
whether or not the pilot population understands that no merger equals years of no pay raises, no
growth, and no new aircraft. The pilots that control the union may not allow the UAL pilots to vote on the
deal.
In the case of DAL/NW, we are assuming costs and revenue synergies, with a net of higher labor
costs, of around $800m. Labor costs would increase approximately $1.2 if wages are brought up to
industry average, which would offset $990 in revenue synergies and around $950m in cost synergies.
Higher labor costs will dominate any cost synergies, but the net synergies should increase the new
airline's market value by over $6b (in addition to the current $10 billion combined value) or
approximately $9 per share. Of course, these numbers are only estimates that provide insight into how
the deal should be structured.
The details of DAL's expected synergies will provide the guidance required to fine-tune estimated
earnings and post-merger value. The deal can create substantial value if the pilots and other labor
groups take a certain percentage of equity in the merged airline instead of much higher wages.
Rumors are that the company will give labor 7% of the new equity in exchange for lower wage
increases, and 4% for the pilots. If true, this increases the post merger market value towards $20
billion and values labors' stake at $1.4 billion, leaving $800m for the pilots. Delta's high market value
[post-merger] will fall over time as labor eventually demands leading industry wages and work rules.
To argue that mergers cannot create value for labor, consumers, and the shareholders reflects a
misunderstanding of what drives value and why mergers should happen. Looking backward and
saying past airline mergers were failures is misguided because the success or failure of a merger
has to be measured against a status quo scenario. In other words, what appears to be a failure can,
in reality, be successful because the alternatives may have created less value or destroyed value.
Value in this sense is firm or enterprise value. The reality check for those who think mergers should
not happen will be what happens next at DAL/NW, and most likely UAL/CAL.
Pilots are in the driver’s seat and can wreak any deals if they ask for too much, or if seniority issues
bog down negotiations. However, it is in the best interests of the union members to sign off on the
deals because it will result in a stronger airline that can afford higher labor costs and new aircraft. The
alternative for labor to a merger will be no pay raises, no growth, and no new aircraft. Management has
every incentive to drag out negotiations for years.
With a merger, pilots and other labor groups will get an immediate pay raise – (15%-20% is a good
guess) and the new airline will have the scale and scope economies that reduce risk and improve
returns. AirFrance/KLM has incentive to invest equity in a combined DAL/NW and this, too, will reduce
the risk profile of the airline and increase market value via expanded valuation multiples.
Pilot pay raises of around 15%-20%, with a 5% or so equity stake, is doable given what we believe
(and what most analysts believe) is a reasonable estimate of cost and revenue synergies. With the
equity kicker, pilots have the potential to recapture lost compensation and receive a nice bonus. If our
estimates are correct, the equity component per pilot will be double that of the annual pay hike. It's only
a one shot bonus, but it can be quite substantial.
The biggest risk to DAL/NW or UAL/CAL mergers is seniority list integration. If one pilot group insists
that its junior members are not placed below the more senior pilots at the other airline, this could kill
the deal, or at the very least result in a lengthy delay. One more point: political opposition will fall by the
wayside once labor fully supports mergers and consolidation.
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