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Are Joint Ventures Sustainable?
By Vaughn Cordle, CFA / October 2010
A metal neutrality requirement in airline joint venture (JV)
agreements appears to be a core requirement for DOT approval. This
requirement allows alliance partners to work around the legal
restrictions against merging and cross-investing in international
markets, but the arrangement may not be sustainable in the long run if
one or more of the partners are disadvantaged in terms of returns and
growth. Moreover, the DOT requires an update every 18 months, and
there are no guarantees that the JVs will be immunized after the
government reviews.
I estimate that AMR's return on investment (ROI) will be only 5%
[$300-$400m in net losses] this year compared to British Airway's 10%
and Iberia's 12%. What’s more, when balance sheet leverage is
considered, AMR's sustainable growth rate is significantly less than
that of its two JV partners. In fact, I contend that AMR will shrink
in relative terms because of three factors: (1) the need to reduce a
$6.4B negative net worth, (2) its uncompetitive unit costs [and fare
levels] and, (3) projected negative returns on capital.
By contrast, Air France/KLM's ROI is estimated at 7% and Delta's at
12.6%. The major difference between these two airlines is reflected in
their capital structures, leverage levels, and net earnings required
to pay down debt and move toward an optimal blend of equity and debt.
I estimate Delta’s [book] equity deficit at $10 billion, while Air
France/KLMs' is only $1.5 billion, although Delta's merger with NWA
appears to have resulted in greater return benefits than those of the
Air France/KLM merger. (United + Continental's book equity deficit is
$9.8 billion, and AMR's is $12 billion.) Delta management wants to pay
down $7 billion in debt with cash flow over the next three years, and
if they manage to achieve this goal, it will move the company toward a
capital structure that reduces risk and the cost of capital. Air
France/KLM's need for debt reduction is significantly less.
It does appear that revenue and cost synergies from the immunized JVs
will help each airline in the short run. However, I suspect that the
revenue synergies will be competed away as the partners attempt to
capture larger market shares via lower fares and more seats, and as
labor costs increase at the larger merged airlines over time. There is
only X amount of demand at each price point, and it becomes a zero-sum
competitive game when there is above-market growth in seats by one
airline or a group of airlines in a JV. Competitors—especially
competitors in other alliances and JVs—are not going to roll over and
cede market share without a fight. Revenue synergies for only one JV
or one big merger will be much higher than what they will be for
multiple JVs and mergers. Collectively, the revenue synergies assumed
by each of the airlines results in a number that exceeds what I think
is possible from a top-down industry analysis. In other words, assumed
revenue synergies are likely overstated.
High-cost network airlines benefit from the JV arrangement because it
allows them to lower collective costs, which results in lower and more
competitive fares and higher seat growth. Some non-JV competitors will
be disadvantaged, as will certain JV partners in relative terms.
However, consumers in the JV markets may benefit because costs [and
fares] will fall as cost synergies are realized. Alternatively, the JV
airlines can reduce seats and force fares up, but this is unlikely to
happen because there is more incentive to pass along cost synergies to
the consumer, all else held constant. Why? Because passing along
benefits to the consumer increases traffic throughout the rest of the
route system and improves scope economies for the JV airlines. Revenue
synergies, if sustained, are icing on the cake for the JV partners.
Over and above the benefits of JVs, fares will have to increase
materially if the airlines are to move toward the rate of return that
is required to sustain shareholder support while at the same time
paying down debt and building equity via retained earnings. And don't
forget about labor’s expectation and demands. I estimate that fare
increases to cover expected labor cost increases for Delta and United
will be 3-4%. The JVs benefit the airlines because the alternative is
higher costs, lower returns on this segment of seat capacity, and
lower revenue share. Labor and shareholders benefit because of the
increased cash flows that can increase returns for each stakeholder.
Consumers benefit because it means lower fares than would be the case
otherwise because JVs result in lower costs, all else held constant.
However, a revenue share arrangement that accounts for cost synergies
may not result in a net benefit for an airline like AMR in the longer
term. The AMR pilots have every reason to be concerned about a JV
agreement that will likely result in less [or negative] growth
opportunity in the future. What the pilots are missing, though, is
that, without the JV, relative growth [or shrinkage] will be even
worse because AMR's labor and ownership costs are too high to allow
both growth and the required [risk-adjusted] return on capital. Simply
put, AMR has too much high-cost capital; its labor costs are too high,
mostly because of pension and health care liabilities; and its cost of
ownership [operating leases, interest on debt, and depreciation and
amortization] is too high because uncompetitive labor costs have led
to negative or inadequate retained earnings over the last 20 years.
The pilots have yet to understand this, so they continue to fight
management’s attempts to move toward a viable business model with
specious suggestions that American’s Joint Business Agreement with
British Airways and Iberia is a national security issue. However, the
profitable model to which they are moving may not possible because of
the capital structure and inadequate returns on capital. The solution?
Reduce capital and lower labor costs, although doing so may not be
possible outside of bankruptcy.
By Vaughn Cordle, CFA / October 2010
A metal neutrality requirement in airline joint venture (JV)
agreements appears to be a core requirement for DOT approval. This
requirement allows alliance partners to work around the legal
restrictions against merging and cross-investing in international
markets, but the arrangement may not be sustainable in the long run if
one or more of the partners are disadvantaged in terms of returns and
growth. Moreover, the DOT requires an update every 18 months, and
there are no guarantees that the JVs will be immunized after the
government reviews.
I estimate that AMR's return on investment (ROI) will be only 5%
[$300-$400m in net losses] this year compared to British Airway's 10%
and Iberia's 12%. What’s more, when balance sheet leverage is
considered, AMR's sustainable growth rate is significantly less than
that of its two JV partners. In fact, I contend that AMR will shrink
in relative terms because of three factors: (1) the need to reduce a
$6.4B negative net worth, (2) its uncompetitive unit costs [and fare
levels] and, (3) projected negative returns on capital.
By contrast, Air France/KLM's ROI is estimated at 7% and Delta's at
12.6%. The major difference between these two airlines is reflected in
their capital structures, leverage levels, and net earnings required
to pay down debt and move toward an optimal blend of equity and debt.
I estimate Delta’s [book] equity deficit at $10 billion, while Air
France/KLMs' is only $1.5 billion, although Delta's merger with NWA
appears to have resulted in greater return benefits than those of the
Air France/KLM merger. (United + Continental's book equity deficit is
$9.8 billion, and AMR's is $12 billion.) Delta management wants to pay
down $7 billion in debt with cash flow over the next three years, and
if they manage to achieve this goal, it will move the company toward a
capital structure that reduces risk and the cost of capital. Air
France/KLM's need for debt reduction is significantly less.
It does appear that revenue and cost synergies from the immunized JVs
will help each airline in the short run. However, I suspect that the
revenue synergies will be competed away as the partners attempt to
capture larger market shares via lower fares and more seats, and as
labor costs increase at the larger merged airlines over time. There is
only X amount of demand at each price point, and it becomes a zero-sum
competitive game when there is above-market growth in seats by one
airline or a group of airlines in a JV. Competitors—especially
competitors in other alliances and JVs—are not going to roll over and
cede market share without a fight. Revenue synergies for only one JV
or one big merger will be much higher than what they will be for
multiple JVs and mergers. Collectively, the revenue synergies assumed
by each of the airlines results in a number that exceeds what I think
is possible from a top-down industry analysis. In other words, assumed
revenue synergies are likely overstated.
High-cost network airlines benefit from the JV arrangement because it
allows them to lower collective costs, which results in lower and more
competitive fares and higher seat growth. Some non-JV competitors will
be disadvantaged, as will certain JV partners in relative terms.
However, consumers in the JV markets may benefit because costs [and
fares] will fall as cost synergies are realized. Alternatively, the JV
airlines can reduce seats and force fares up, but this is unlikely to
happen because there is more incentive to pass along cost synergies to
the consumer, all else held constant. Why? Because passing along
benefits to the consumer increases traffic throughout the rest of the
route system and improves scope economies for the JV airlines. Revenue
synergies, if sustained, are icing on the cake for the JV partners.
Over and above the benefits of JVs, fares will have to increase
materially if the airlines are to move toward the rate of return that
is required to sustain shareholder support while at the same time
paying down debt and building equity via retained earnings. And don't
forget about labor’s expectation and demands. I estimate that fare
increases to cover expected labor cost increases for Delta and United
will be 3-4%. The JVs benefit the airlines because the alternative is
higher costs, lower returns on this segment of seat capacity, and
lower revenue share. Labor and shareholders benefit because of the
increased cash flows that can increase returns for each stakeholder.
Consumers benefit because it means lower fares than would be the case
otherwise because JVs result in lower costs, all else held constant.
However, a revenue share arrangement that accounts for cost synergies
may not result in a net benefit for an airline like AMR in the longer
term. The AMR pilots have every reason to be concerned about a JV
agreement that will likely result in less [or negative] growth
opportunity in the future. What the pilots are missing, though, is
that, without the JV, relative growth [or shrinkage] will be even
worse because AMR's labor and ownership costs are too high to allow
both growth and the required [risk-adjusted] return on capital. Simply
put, AMR has too much high-cost capital; its labor costs are too high,
mostly because of pension and health care liabilities; and its cost of
ownership [operating leases, interest on debt, and depreciation and
amortization] is too high because uncompetitive labor costs have led
to negative or inadequate retained earnings over the last 20 years.
The pilots have yet to understand this, so they continue to fight
management’s attempts to move toward a viable business model with
specious suggestions that American’s Joint Business Agreement with
British Airways and Iberia is a national security issue. However, the
profitable model to which they are moving may not possible because of
the capital structure and inadequate returns on capital. The solution?
Reduce capital and lower labor costs, although doing so may not be
possible outside of bankruptcy.
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