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Scenarios for an Industry in Decline
By Vaughn Cordle, CFA / June 2006
A critical question is: what happens next in terms of industry structure? Several scenarios or
combinations of scenarios make sense:
1) High fuel prices and capital market discipline force capacity constraints and higher fares.
2) Industry continues to lose money and more firms fail or merge, but this only provides temporary
pricing relief as capacity is taken out of the system.
3) Foreign ownership rules change, Open Skies is realized, and consolidation takes place in
Europe and the U.S.
Given current assumptions of fuel costs and economic growth—and we think the industry will lose
$2 to $2.5 billion this year—the most likely scenario is what I would describe as muddle
through/slow liquidation. The other two possibilities are robust recovery and consolidation.
I don't think capacity discipline will be sufficient to return the industry to long-term health. There is
simply too much "dumb money" in the system. The institutional money may be the dumbest of all,
with a long history of under performing in the airline investment space.
A perceptive analyst could surmise—given high fuel costs, new and relaxed foreign ownership
rules and Open Skies—that consolidation in Europe and the U.S. would be a natural and
necessary byproduct of an industry that is too fragmented and inefficient. With an Open Skies
agreement in place, AirFrance (which took over KLM in 2004) may want to invest in Delta, or
perhaps in Northwest; British Airways in American, and Lufthansa in United Airlines. Airlines in
the various alliances, for example Air Canada and United, should consider cross-border
investments to strengthen the larger global network.
Continental, AirTran, Frontier, Midwest, and others are odd men out in the alliance game, which
suggests that they make good merger candidates. Frontier and Canada's Westjet are particularly
attractive acquisitions, in my view.
The longer fuel costs remain high, the greater the probability of mergers, divestitures, and
consolidation. I am not as certain about Open Skies as I am about the relaxation of the foreign
ownership rule, because politics has a nasty habit of trumping rational decision-making. It may be
the best way to rationalize an inefficient global network of fragmented airlines, many of which
simply do not make economic sense as stand-alone businesses.
The dollar’s decline—it will continue to decline, given the negative 6.121 percent current account
deficit—and new accounting rules that encourage mergers suggest that if current foreign
ownership rules are relaxed, U.S. airlines will become attractive investment candidates.
The European Union and other countries around the world adopted IFRS rules last year, which are
similar to GAAP/SFAS rules pertaining to writing off goodwill, or the control premium paid to take
over another company. Basically, this encourages mergers because earnings per share (EPS)
are accretive after the merger. Prior rules required spreading the control premium over future
years, which reduced EPS and the stock price. This is just an accounting issue that allows
acquiring firms to take goodwill writeoffs, but it does influence managers to use mergers as a way
to increase EPS growth, and their option values. EPS is not the best way to measure economic
performance, but this is what investors and managers tend to focus on.
Given the increased pitch of squealing from ALPA and Continental, which are against changing the
foreign ownership rule, it would seem that the ownership and Open Skies issues are very hot
topics. If the rule is modified or changed—and it should be changed—it could be significant in
terms of how the industry shakes out. Further declines in the dollar suggests that the real price of
oil will continue to stay high and U.S. companies will become even more attractive investments,
given some rationalization in capacity.
Continental and the big unions are on the wrong side of the argument on the foreign ownership
rule change. A case can be made that it is in the nation's best interest, and this includes labor and
investors, to allow cross-border investments.
By Vaughn Cordle, CFA / June 2006
A critical question is: what happens next in terms of industry structure? Several scenarios or
combinations of scenarios make sense:
1) High fuel prices and capital market discipline force capacity constraints and higher fares.
2) Industry continues to lose money and more firms fail or merge, but this only provides temporary
pricing relief as capacity is taken out of the system.
3) Foreign ownership rules change, Open Skies is realized, and consolidation takes place in
Europe and the U.S.
Given current assumptions of fuel costs and economic growth—and we think the industry will lose
$2 to $2.5 billion this year—the most likely scenario is what I would describe as muddle
through/slow liquidation. The other two possibilities are robust recovery and consolidation.
I don't think capacity discipline will be sufficient to return the industry to long-term health. There is
simply too much "dumb money" in the system. The institutional money may be the dumbest of all,
with a long history of under performing in the airline investment space.
A perceptive analyst could surmise—given high fuel costs, new and relaxed foreign ownership
rules and Open Skies—that consolidation in Europe and the U.S. would be a natural and
necessary byproduct of an industry that is too fragmented and inefficient. With an Open Skies
agreement in place, AirFrance (which took over KLM in 2004) may want to invest in Delta, or
perhaps in Northwest; British Airways in American, and Lufthansa in United Airlines. Airlines in
the various alliances, for example Air Canada and United, should consider cross-border
investments to strengthen the larger global network.
Continental, AirTran, Frontier, Midwest, and others are odd men out in the alliance game, which
suggests that they make good merger candidates. Frontier and Canada's Westjet are particularly
attractive acquisitions, in my view.
The longer fuel costs remain high, the greater the probability of mergers, divestitures, and
consolidation. I am not as certain about Open Skies as I am about the relaxation of the foreign
ownership rule, because politics has a nasty habit of trumping rational decision-making. It may be
the best way to rationalize an inefficient global network of fragmented airlines, many of which
simply do not make economic sense as stand-alone businesses.
The dollar’s decline—it will continue to decline, given the negative 6.121 percent current account
deficit—and new accounting rules that encourage mergers suggest that if current foreign
ownership rules are relaxed, U.S. airlines will become attractive investment candidates.
The European Union and other countries around the world adopted IFRS rules last year, which are
similar to GAAP/SFAS rules pertaining to writing off goodwill, or the control premium paid to take
over another company. Basically, this encourages mergers because earnings per share (EPS)
are accretive after the merger. Prior rules required spreading the control premium over future
years, which reduced EPS and the stock price. This is just an accounting issue that allows
acquiring firms to take goodwill writeoffs, but it does influence managers to use mergers as a way
to increase EPS growth, and their option values. EPS is not the best way to measure economic
performance, but this is what investors and managers tend to focus on.
Given the increased pitch of squealing from ALPA and Continental, which are against changing the
foreign ownership rule, it would seem that the ownership and Open Skies issues are very hot
topics. If the rule is modified or changed—and it should be changed—it could be significant in
terms of how the industry shakes out. Further declines in the dollar suggests that the real price of
oil will continue to stay high and U.S. companies will become even more attractive investments,
given some rationalization in capacity.
Continental and the big unions are on the wrong side of the argument on the foreign ownership
rule change. A case can be made that it is in the nation's best interest, and this includes labor and
investors, to allow cross-border investments.
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