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War of Attrition & Potential for Consolidation
April 1, 2005 / Vaughn Cordle, CFA
Many of the big network airlines and low-cost airlines are not viable given the industry's current
environment of excess capacity, low fares, and ever-higher fuel costs.
Increasing seating density and aircraft utilization (i.e, TED and Song) is a great way to spread fixed
costs over more seat miles and lower costs. The flip side of lowering average unit costs in this
manner is that more traffic can be carried with the same number of aircraft. Hence, the means to
enhance revenue. However, it does not increase revenue in proportion to the reduction in unit costs.
Unfortunately, most US domestic markets have too much capacity already and it takes ever-lower
fares to generate those extra passengers. When extra capacity is added to competitive markets,
regardless of method, fares are driven below existing levels because the intensity of rivalry with
competitors increase. This is why rosy revenue projections never materialize when high cost airlines
start low-cost subsidiaries.
Unless capacity is reduced significantly in the domestic market, pricing will not improve to the level
required to cover current costs for the majority of airlines. The price elasticity of demand is inelastic
at the industry level. In other words, traffic goes up less than one percent when yields fall one
percent. It's a mature industry in decline and one in desperate need of consolidation.
The potential for viability is most likely a function of a major industry restructuring. Viability can only
be defined in risk and return terms and a business strategy must be articulated in language that
insiders and outsiders can understand. It has to be qualified and quantified in competitive
advantage terms and it must pass the strategic tests of consistency.
With oil prices above $55 and climbing the probability of some type of consolidation increases. It
may not be possible for several of the US airlines to return to viability - in terms of earning the cost of
capital over a full business cycle - as standalone companies or in their current form.
One way for the weaker airlines to survive would be to combine operations with one or more other
airlines. Redundant functions and overlapping capacities can be rationalized and synergistic
savings used to offset higher fuel costs. Pricing power and the business case for investment would
be greatly enhanced.
Past combinations have not succeeded because the acquiring company paid an excessive control
premium, which typically should not be greater than 30% to 35%. United was willing to pay a
premium for US Airways that was 10 times greater than the medium control premium in the United
States. The union board members (ALPA and IAM) running United apparently didn't know how to
properly value a company. This became apparent when the employees paid a similar 300% control
premium to gain control of the airline during the union-led (ESOP) leverage buyout.
Large pools of capital are looking for a place to invest. Equity investors in the airline sector will want
a proper return on investment and they will want a solid business case they can understand. What
really matters to potential investors is the present value of the discounted future cash flows. Hence
the need to articulate viability in risk and return terms.
It appears that the best bet for several of the airlines is one that involves a merger. The key is to
quickly put together a business plan that makes sense and is finance able while there is still a cash
cushion. And, the best solution would be for these airlines to raise equity, not more debt. Hedge
funds have large pools of capital and are a likely source of capital.
The advantage goes to the team that pulls together a combination and operational plan that makes
the most sense in terms of providing opportunity-cost returns to the equity providers. This requires a
proper valuation of the combination and it will require a strong and motivated management team to
pull it off.
However, It appears that the likely outcome will be the war of attrition. The airlines with the deeper
pockets, i.e, stronger balance sheets, simply outlast the airlines who finally run out of cash.
Operational problems are the natural byproduct of a company in financial distress and it appears
that US Airways is finally running out of time and money. Things could deteriorate to a point where
they are forced to shut down.
US Airways and Independence Air may be the first casualties in the war of attrition. Delta and NWAC
could follow with a bankruptcy filing within 12 months.
April 1, 2005 / Vaughn Cordle, CFA
Many of the big network airlines and low-cost airlines are not viable given the industry's current
environment of excess capacity, low fares, and ever-higher fuel costs.
Increasing seating density and aircraft utilization (i.e, TED and Song) is a great way to spread fixed
costs over more seat miles and lower costs. The flip side of lowering average unit costs in this
manner is that more traffic can be carried with the same number of aircraft. Hence, the means to
enhance revenue. However, it does not increase revenue in proportion to the reduction in unit costs.
Unfortunately, most US domestic markets have too much capacity already and it takes ever-lower
fares to generate those extra passengers. When extra capacity is added to competitive markets,
regardless of method, fares are driven below existing levels because the intensity of rivalry with
competitors increase. This is why rosy revenue projections never materialize when high cost airlines
start low-cost subsidiaries.
Unless capacity is reduced significantly in the domestic market, pricing will not improve to the level
required to cover current costs for the majority of airlines. The price elasticity of demand is inelastic
at the industry level. In other words, traffic goes up less than one percent when yields fall one
percent. It's a mature industry in decline and one in desperate need of consolidation.
The potential for viability is most likely a function of a major industry restructuring. Viability can only
be defined in risk and return terms and a business strategy must be articulated in language that
insiders and outsiders can understand. It has to be qualified and quantified in competitive
advantage terms and it must pass the strategic tests of consistency.
With oil prices above $55 and climbing the probability of some type of consolidation increases. It
may not be possible for several of the US airlines to return to viability - in terms of earning the cost of
capital over a full business cycle - as standalone companies or in their current form.
One way for the weaker airlines to survive would be to combine operations with one or more other
airlines. Redundant functions and overlapping capacities can be rationalized and synergistic
savings used to offset higher fuel costs. Pricing power and the business case for investment would
be greatly enhanced.
Past combinations have not succeeded because the acquiring company paid an excessive control
premium, which typically should not be greater than 30% to 35%. United was willing to pay a
premium for US Airways that was 10 times greater than the medium control premium in the United
States. The union board members (ALPA and IAM) running United apparently didn't know how to
properly value a company. This became apparent when the employees paid a similar 300% control
premium to gain control of the airline during the union-led (ESOP) leverage buyout.
Large pools of capital are looking for a place to invest. Equity investors in the airline sector will want
a proper return on investment and they will want a solid business case they can understand. What
really matters to potential investors is the present value of the discounted future cash flows. Hence
the need to articulate viability in risk and return terms.
It appears that the best bet for several of the airlines is one that involves a merger. The key is to
quickly put together a business plan that makes sense and is finance able while there is still a cash
cushion. And, the best solution would be for these airlines to raise equity, not more debt. Hedge
funds have large pools of capital and are a likely source of capital.
The advantage goes to the team that pulls together a combination and operational plan that makes
the most sense in terms of providing opportunity-cost returns to the equity providers. This requires a
proper valuation of the combination and it will require a strong and motivated management team to
pull it off.
However, It appears that the likely outcome will be the war of attrition. The airlines with the deeper
pockets, i.e, stronger balance sheets, simply outlast the airlines who finally run out of cash.
Operational problems are the natural byproduct of a company in financial distress and it appears
that US Airways is finally running out of time and money. Things could deteriorate to a point where
they are forced to shut down.
US Airways and Independence Air may be the first casualties in the war of attrition. Delta and NWAC
could follow with a bankruptcy filing within 12 months.
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