 |  |  |  |  |
Why An Open Skies Agreement Is Good For U.S. Airlines
By Vaughn Cordle, CFA / May 2006
Foreign ownership rules in the airline industry should be changed because they are a key barrier to
Open Skies, which would likely lead to consolidation in Europe and the U.S., and cross-border
investments.
Both regions of the world have too many airlines and too much wealth-destroying capacity. It’s true
that the airlines never seem to lack capital sources—as long as they restructure and make a case
that they can survive. The distinction is in the nature of the capital. Recall that capital equals total
assets (paid for by equity and debt), and assets can be aircraft, tugs, computers, or any number of
supplies the airlines require to operate. Most suppliers are willing to extend credit or leases to
secure a stream of value for themselves, and this results in a mis-specification of risk. In other
words, capital costs are too low, given the inherent riskiness of the airline industry. The upshot is
that too much capital is invested. Excess capital can and does lead to excess capacity in the airline
industry.
Foreign investment would come in the form of equity capital, which would be less expensive than
hedge fund capital. It's less expensive because it is long term and "strategic" capital; also because
the dollar has weakened in world markets. Revenue and cost synergies would result from better
coordination of activities between a U.S. carrier and its foreign partner.
Rationalizing the airlines on a global basis would expand industry valuation multiples, which in turn
would drive down the cost of capital—equity and debt. Bottom line: Cross border synergies and
consolidation would contribute to the top and bottom line, and increase market values. The big U.S.
network airlines do not have enough equity on the balance sheet, and they are at risk of being
marginalized by better financed and profitable foreign competitors in the non-U.S. markets.
The fact that labor has more leverage with bigger airlines is a major risk, which is why many don't like
the idea of consolidation. I agree. However, consolidation can come in many forms, and one form
is to have a global portfolio of airlines. More airlines add a competitive dynamic that lowers the labor
risk, and a portfolio of airlines can dominate a big piece of the world's market share. Several large
portfolios makes sense in terms of carving up the world's markets and rationalizing global networks.
The other reason most mergers don't work is because the acquirer pays too much for the control
premium, which typically is 30 percent. UAL would have paid closer to 300 percent for US Airways,
which is the primary reason it did not make economic sense. America West and US Airways
consolidated in a way that did not result in a large control premium. The cost and revenue synergies
have been greater than most believed, but the key success factors are: 1) significantly lower labor
costs, and 2) the elimination of excess capacity. The combined entity is 11 percent smaller than the
sum of the two independent airlines prior to the merger. Consolidation eliminates excess capacity
and produces revenue and cost synergies.
Airlines should have the ability to make cross-border investments. Currently they do not and this
limits the U.S. airlines’ ability to invest in other parts of the world. There is no good reason airlines
should be treated differently in this regard. Open Skies will most likely lead to consolidation in
Europe and the U.S., and this can be good for consumers, labor, and suppliers. The quality of the
product is improved because airlines can afford the cost if they can earn a sufficient profit.
By Vaughn Cordle, CFA / May 2006
Foreign ownership rules in the airline industry should be changed because they are a key barrier to
Open Skies, which would likely lead to consolidation in Europe and the U.S., and cross-border
investments.
Both regions of the world have too many airlines and too much wealth-destroying capacity. It’s true
that the airlines never seem to lack capital sources—as long as they restructure and make a case
that they can survive. The distinction is in the nature of the capital. Recall that capital equals total
assets (paid for by equity and debt), and assets can be aircraft, tugs, computers, or any number of
supplies the airlines require to operate. Most suppliers are willing to extend credit or leases to
secure a stream of value for themselves, and this results in a mis-specification of risk. In other
words, capital costs are too low, given the inherent riskiness of the airline industry. The upshot is
that too much capital is invested. Excess capital can and does lead to excess capacity in the airline
industry.
Foreign investment would come in the form of equity capital, which would be less expensive than
hedge fund capital. It's less expensive because it is long term and "strategic" capital; also because
the dollar has weakened in world markets. Revenue and cost synergies would result from better
coordination of activities between a U.S. carrier and its foreign partner.
Rationalizing the airlines on a global basis would expand industry valuation multiples, which in turn
would drive down the cost of capital—equity and debt. Bottom line: Cross border synergies and
consolidation would contribute to the top and bottom line, and increase market values. The big U.S.
network airlines do not have enough equity on the balance sheet, and they are at risk of being
marginalized by better financed and profitable foreign competitors in the non-U.S. markets.
The fact that labor has more leverage with bigger airlines is a major risk, which is why many don't like
the idea of consolidation. I agree. However, consolidation can come in many forms, and one form
is to have a global portfolio of airlines. More airlines add a competitive dynamic that lowers the labor
risk, and a portfolio of airlines can dominate a big piece of the world's market share. Several large
portfolios makes sense in terms of carving up the world's markets and rationalizing global networks.
The other reason most mergers don't work is because the acquirer pays too much for the control
premium, which typically is 30 percent. UAL would have paid closer to 300 percent for US Airways,
which is the primary reason it did not make economic sense. America West and US Airways
consolidated in a way that did not result in a large control premium. The cost and revenue synergies
have been greater than most believed, but the key success factors are: 1) significantly lower labor
costs, and 2) the elimination of excess capacity. The combined entity is 11 percent smaller than the
sum of the two independent airlines prior to the merger. Consolidation eliminates excess capacity
and produces revenue and cost synergies.
Airlines should have the ability to make cross-border investments. Currently they do not and this
limits the U.S. airlines’ ability to invest in other parts of the world. There is no good reason airlines
should be treated differently in this regard. Open Skies will most likely lead to consolidation in
Europe and the U.S., and this can be good for consumers, labor, and suppliers. The quality of the
product is improved because airlines can afford the cost if they can earn a sufficient profit.
©Copyright 2006 AirlineForecasts, LLC All Rights Reserved