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A Weak Industry in Desperate Need of Consolidation
Vaughn Cordle, CFA / January 23, 2008

Shareholders, managers, and Wall Street in general all are pushing mergers and consolidation because they
are the best options for the network airlines at this point in the business cycle. Moreover, U.S. airlines are facing
increasing competition from stronger foreign airlines that have superior service and lower costs. Consolidation
will be required to eliminate excess capacity, improve earnings, and boost share prices of airlines that must
improve profitability in order to improve the quality of service and avoid another painful round of restructurings. An
Open Skies agreement begins officially in March 2008 between European and U.S. cities, and competition is
heating up between the U.S. and Asian markets. Average fares and yields will fall as more capacity is introduced
across the Atlantic and the Pacific.

U.S. airlines have a distinct competitive disadvantage against foreign airlines that operate younger fleets with
employees who are more service oriented because of cultural and age differences. U.S. airlines have a long
history of poor labor relations with their heavily unionized workforces that are disgruntled after years of financial
distress. Moreover, U.S. airlines are less profitable, cannot reinvest in competitive resources at the same rate,
and are ranked at the bottom of the world’s airlines in terms of balance sheet strength. Younger and more
profitable Middle Eastern and Asian airlines are headed toward U.S. shores with lower-cost capacity and
superior service. With their older aircraft and demoralized employees, U.S. airlines will have difficulty competing.

The U.S. airline industry is the least profitable of the major regions. Since deregulation, U.S. government policies
have encouraged excess capacity, which has been great for consumers in terms of lower fares, but has resulted
in an industry that is unable to keep up in an increasingly competitive global market. The glut of U.S. airlines
causes destructive fare competition, with the result that no airline earns its cost of capital. Years of restructuring—
50 percent of the industry’s capacity was operated by airlines forced to file bankruptcy after 911—has resulted in
an industry that still cannot provide a normal rate of return for shareholders, satisfy labor, and provide a level of
service required to be competitive against foreign competition. The airline index has fallen 50 percent over the
last year, and will continue to fall if jet fuel costs remain high and economic growth weak.

The business case for mergers

A merger is a perfectly reasonable way to preempt a big fall in the share price when labor costs reset higher after
the amenable contract dates. Eventually, share prices will firm up as economic growth returns to trend and oil
prices fall; however, managers work for shareholders, and maximizing firm value is what they are paid to do. Big
shareholders are pressuring managers to act to reverse the downward spiral in share prices, and mergers may
be the best—or even only—option for those that have run out of options. Whether or not a merger is successful in
the long term is irrelevant to investors who are painfully aware that airlines are not suitable for long-term
investment. Without adequate profitability, customer service will continue to deteriorate as the airlines continue to
cut costs and squeeze more bodies into crowded seats. Labor relations are severely strained after years of
cutbacks, and the lack of "enthusiasm," and resultant poor service quality, only will worsen as contracts are
negotiated over the next few years.

AirlineForecasts has made the valuation case that mergers can create higher share prices even as the market
value of the newly-merged airline will be approximately the same as the two stand-alone airlines’ current
combined value—at least initially. The post-merger share price will be higher because the initial float of shares
available to trade will be less than the outstanding shares that, when finally issued, dilute share price in
proportion to share base dilution. Wall Street firms make a killing providing M&A services, and big investors have
time to cash out while the share prices are high. Significantly higher labor costs (employees will have to be
bought off with new higher cost agreements if they are to support a merger) will offset cost and revenue
synergies, which is why real market value creation cannot be sustained in a large merger. US Airways and
America West merged because US Airways was close to liquidating and America West was headed for
bankruptcy. Real synergies existed and jobs were saved; however, sour labor relations and operational
problems have resulted in an airline that is at the bottom of the world's airlines in terms of relative value.

The real value of a merger, however, must be measured as the difference between a status quo scenario share
price (much lower than today's prices) and the post-merger share price. This is how real (relative) value is
created, thereby justifying the decision to take on exceptionally high labor, political, and integration risks.

Absent a merger or two, and given high jet fuel prices, a case can be made that more than a few big and small
airlines are on a path to some form of restructuring or even bankruptcy. For some, divestiture of assets becomes
the next best option to raise cash and satisfy shareholders. Labor, of course, is focused narrowly on regaining
lost compensation and improving work rules, but may not be aware of the consequences when materially higher
labor costs torpedo the market value of an airline. Shareholders rightfully prefer that wealth-destroying airlines
merge or return cash—ideally before labor and bad industry fundamentals rob them once again of a normal risk-
adjusted rate of return. Hence, there is a risk to labor that the airline will be broken up and sold piecemeal to the
highest bidder if labor costs are perceived to go too high.

The role of labor

Labor uses acronyms to send messages to its members, managers, and investors when it is gearing up for
contract negotiations. Woe (without enthusiasm), Chaos (creating havoc around the system), and Creep (crew
response to excessive economic pressure) are symbols to unite and encourage union members to "unofficially"
slow down and drag down an airline's operation. Negotiation leverage is enhanced significantly once a job action
is under way because the airlines cannot afford the hit to customer service rankings and share price for any
length of time. Unions have condign power, which is the power to coerce.

Capital providers also have power—the ability to withdraw their support of the business. Shareholders will dump
the shares if expected returns do not materialize, and creditors have the power to put a company into bankruptcy.
In the final analysis, labor has the power to win a battle to extract value higher than the airline’s ability to pay, but
will lose the war if the airline is forced into bankruptcy or broken up. Job actions, official or not, will result in a
lower market value of the firm because shareholders will dump the shares. Woe, creep and chaos = dump it
(demanding unions mangle profits; investment tanks).

Without some form of consolidation, several big old-line airlines may be on a path that eventually leads to a full
breakup. An old airline is like an old person with hardening of the arteries and in poor health; it simply cannot
compete with younger, more efficient, and faster growing airlines. Labor disruptions and demands for higher
compensation can drive down market values well below the sum-of-the-parts value—and this is where
aggressive fund managers have an opportunity to gain control of the airline.

Business failure, like life and death, is a natural phenomenon in a market economy in which an industry
constantly must weed out the weak and diseased if it is to remain healthy and viable. This is the only way to keep
supply and demand in a rational equilibrium. In the airline industry, excess capacity—defined as the capacity that
exists above what is required for the industry to earn its cost of capital—is at the heart of the bad fundamentals.
There always will be excess capacity, but the market should be allowed to weed out the least efficient
competitors. If it cannot, the entire industry suffers. However, bankruptcy laws can be used to resuscitate even the
weakest competitor. The airline industry also suffers from a poor culture, which is like a cancer that can’t be
treated. It results from an older and heavily unionized workforce that measures its value from a level of
compensation that existed in an era that no longer exists. Current (network airline) employees are paying for the
sins of collective bargaining agreements of the past, and the hyper-competitive airline industry simply cannot
absorb excessive labor costs, especially in a $90-a- barrel oil world.

Consolidation provides excess capacity relief only in the short and intermediate term. Mergers do provide a boost
in the share price and a means to exit the ownership before labor costs gap up and drive down the share price.
Also, divestitures and liquidations can return the industry to viability. It's really about developing a rational global
network. Network executives have run out of options to prop up share prices at this point in the business cycle,
and mergers provide a much better option than spinning off assets, which could lead to an eventual full breakup.
Without an adequate return, shareholders will withdraw their enthusiasm and dump the shares of airlines that
underperform. This includes former Wall Street darlings Southwest and JetBlue.

How do politicians figure in?

It became painfully clear that there is little political support for mergers when congressional hearings were held
on US Airways’ proposal to merge with Delta Airlines. Democrats, in general, do not like big mergers and could
poison any merger deal that involves the big network airlines. Even Republicans will want to protect the
hometown airline, as it relates to jobs and the potential to lose a corporate headquarters. However, mergers, if
done right, can benefit consumers, labor, and capital providers because each can share the cost and revenue
benefits of a merger. Labor, if given the opportunity, will take more than its fair share, which is the primary reason
that big network airlines were unable to retain adequate profits during the last business cycle. Pricing power is
reduced as low-cost airlines capture a higher percentage of the total capacity.

Politicians simply should get out of the way and let the market determine winners and losers. If labor takes too
much in a big merger, so be it; competition only will increase as low-cost airlines' market share increases after a
merger or two. Smaller and more efficient operators will continue to grow faster than the industry, and it’ll be just
a matter of time before they displace uneconomic capacity that could emerge after a big merger. The Department
of Justice will determine if concentration that results from a big merger is in the best interest of the consumer,
and this agency should be allowed to do its job without undue political meddling. Carving out certain overlapping
routes may be necessary to prevent concentration. However, the U.S. airline industry must rationalize if it is to
reverse the downward spiral in customer service and compete on a global playing field.

A logical scenario

AirlineForecasts has developed a scenario that examines the timeline of events leading to one or more of the big
networks breaking up, with the parts sold to the highest bidder. Big is better in terms of scope and scale
economies; however, bigger airlines equals more powerful unions that will capture more than labor’s fair share
of the value created. In other words, other stakeholders—customers and shareholders—get shortchanged. The
big network alliances that have formed are portfolios of branded flag, regional, and feeder airlines. Over time, the
most efficient operators will grow and the least efficient will shrink. Cultures, profitability, and the age of the
workforce/fleet will determine the winners and losers as measured by shareholders, labor, and the consumer.

Small efficient and high quality operators like WestJet and JetBlue can partner with bigger international airlines
and thereby join the global alliances. Over time, these types of low-cost and high-quality airlines will displace
high-cost and poor-quality carriers. Merging is a strategic option that buys the big airlines time and provides
economies quickly, even if they are offset by higher labor costs later. The real value in a merger is that it
eliminates excess and uneconomic capacity. The portfolio of airlines, as represented by the big alliances,
improves returns and lowers risk for shareholders. It provides a rational way to coordinate supply and demand. It
also benefits the consumer because travel around the globe becomes easier. Small and large competitors can
connect to the global network, which means that competition will force airlines to remain fit and trim. Advances in
technology and today's fast movement of capital will not allow a weak competitor to survive for very long.

The bottom line

Mergers and consolidation are needed in an industry that clearly is in trouble with $90-a-barrel oil and an
economy that either is in, or is heading to, a recession. Moreover, foreign competitors are more efficient and offer
better service quality. The U.S. airlines are unable to compete, which means that more high paid union jobs
eventually will be lost. A merger or three could stabilize the industry by eliminating excess capacity and enhancing
profitability. Labor and the consumer will benefit from a healthier industry that can afford to invest properly in
human and physical capital. Without that investment or a big fall in oil prices, the industry will continue its
downward spiral of worsening customer service quality, unhappy employees, and negative returns on capital.

vaughn@airlineforecasts.com