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Thursday, February 14, 2013

The AMR - US Airways Merger

It will be a few weeks before the management projections behind the merger are disclosed publicly, in a proxy for US Airways shareholders or
a disclosure statement in the AMR bankruptcy, but I have a hard time
seeing how this will be a particularly successful merger, even though it
may have become inevitable.  

If you go to the MIT Airline Data Project, you can look at operating data
back to 1995 for all the major US airlines.  One of the most useful
metrics is the "Stage Length Adjusted System Passenger Yield per Equivalent Seat Milewhich measures how much revenue each airline gets from flying one seat one mile, adjusting for the varying distances of different flights[i].  Basically, who is more successful at turning an equivalent amount of capacity into dollars?

The data are pretty consistent over time, with occasional variations.
During the 90's, American led the group every year, but over the last
decade, United has almost always generated the highest yield among all
carriers, while American has fallen to 2nd or 3rd; US Airways or
America West usually generates the lowest yield, not only among
the major carriers, but often behind smaller low-cost carriers like
JetBlue,  Frontier and Alaska.  If US Airways' underperformance
could be raised to American's level, there would be a benefit from
the merger, but, because US Airways is less than half the size of
American, the overall impact won't be that great, and I don't know
whose management team will be making the relevant decisions.
That level of detail has not been made public yet, if the decisions
have even been made.

If you look at the era of the last US Airways merger, with America
West, you'll see a huge jump in yield immediately after the merger,
in 2006 and 2007, which might give one hope, but it was short-lived;
the next year, they returned to the bottom ranking among the majors
and have stayed there ever since.  I suspect that the outperformance
in those two years just served to draw competition from other carriers
and the profitability of their 06-07 footprint is now more widely
distributed.  If you look at the low-cost carriers' yield beginning the
following year, like JetBlue, Southwest and so on, most of them have
increased their yield consistently while US Airways' has reverted to
its historic levels.  So I infer the smaller carriers ate its lunch and it has
not been able to defend itself.  Which doesn't augur favorably for its
ability to increase yield in the future, although perhaps as a bigger company
it will be more of a threat. 

On cargo revenue, the same pattern exists. American ranks high, but US
Airways doesn't, and anyway it's a small amount of revenue.

On the cost side, the picture is mixed.  Using the same stage-length-adjusted,
per seat mile metric on the expense side, but excluding fuel, we can see that
American is the median among the major carriers and US Airways slightly
better, but they all lag behind the rest of the industry.  We can also see that,
after the America West / US Airways merger, the combined entity’s costs per
seat mile soared, and for three years the combined entity was far more expensive to run than its peers on a per seat mile basis, but eventually they did get that metric back in line with their peers.   

Both airlines rank at the bottom of the industry in employee productivity,
although US Airways ranks best among the major carriers, probably as a
legacy of America West's days as a non-major.  If they could somehow
cut American employee compensation to US Airways levels, it would be
significant, but somehow I don't think their deals with the unions are designed
for that outcome.  In addition, I went back and checked the effect of the
Delta / Northwest merger on headcount and found there was not a lot of job loss. At the end of '06, when the merger was announced but not yet consummated, they had about 85,000 employees and in their last 10-K, five years on, they  have 77,000 or 10% less, so not a major contributor to profitability.

On consumer facing metrics, both airlines are pretty mediocre, although US
Airways has definitely improved in recent years. But the future does not bode
well.  As the management blog at Bloomberg Businessweek puts it, “in general, the bigger the airline, the lower the ranking.”

On an operating cash flow basis (the "net cash provided by (used in) operating
activity” part of the audited financials), it's not even close. Even combined,
these two companies don't generate as much as Southwest or half as much as
United (including Continental) or Delta (including Northwest).  The MIT site
does not provide a calculation that spreads cash flow over available seat miles, but we know the combined airline will be the largest American-based airline (which can be confirmed by adding up their system miles on this webpage), so their low ranking in cash flow generation would only look worse on a per seat mile basis.

The press release announcing the merger claims that the companies will realize
“more than $1 billion in annual net synergies by 2015” which is broken down
into $900 million of “network revenue synergies” and $150 million of
“cost  synergies” above and beyond the concessions made so far by AMR unions. While this sounds really impressive, keep in mind that the combined
revenue base right now is “approximately $40 billion” according to the press
release, so the “network revenue synergies” are only about a 2.25% increase,
which is so small that it will be hard to verify. 

That’s a pretty small amount of cost synergies, too, but it’s hard to argue for
much more.  As the CEOs recognized in their press conference there is very little overlap of routes.  They don’t plan to close any hubs.

The fleet configuration is interesting.  AA has historically been all-Boeing,
while US Airways has become increasingly Airbus-dominant.  AA placed
a massive order with Airbus back in 2011 for the narrow body aircraft that US Airways flies, so it is possible that combining the carriers will enable US
Airways’ expertise with Airbus craft to transfer over to the new American
deliveries and result in some efficiency gains, but I suspect they would be
small in the scheme of things and far off.  

Realistically, AA would have realized cost savings anyway without the merger,
through the application of bankruptcy law and practice to its cost structure.
And to do the merger there will be $1.2 billion of “one-time” transition costs
over the next three years. For a company that is projected to have
an equity cap of $11 billion, that is pretty large. Effectively they’re
paying 11% of the company for a revenue (not profit, revenue) gain of 2.25% and de minimis cost synergies, if I read this correctly. The press release claims the transaction will be accretive “to US Airways shareholders” come 2014 but that can only be a function of the timing of GAAP accounting for the one-time costs and the fact that American is just a bigger and better company once they get labor costs in line.

I certainly don’t know anything about the management skills of the individuals
involved.  AMR stakeholders wind up with 72% of the combined company so
it’s strange that the new CEO comes from US Airways.  I suspect that simply
reflects a deep resentment on the AA unions’ part toward the outgoing CEO
who seems to be paying the price for being the bearer of bad news to unions
that had never gone through  a restructuring before.

In a brief web search for industry insiders’ views on the merger, the only
knowledgeable bloggers I found were unimpressed with the merger or
blogger aptly sums up the cultural differences between the two:  “One flies
to China, the other to Chattanooga”.  Seniority integration among the
unionized workforce remains to be addressed.  There are two separate
pilots’ unions that have to be integrated as well.

In the end, it’s really hard to see what US Airways is bringing to the table,
except a faster resolution of AA’s union issues, mainly by way of offering
a different CEO so that the AA unions can reap some psychic income. But
the merger is clearly desired also by the investors who bought AA paper
at much lower prices 12-18 months ago, as it clears the decks for emergence
from chapter 11 in fairly rapid fashion and time is money, and the debt has
risen so high recently that the creditors have no reason to fight for a better
deal – further upside would likely accrete mostly to the equity, so it’s time
for everyone in the case to move on.  A good win for the US Airways team,
which   leveraged the unions' desire to bring down Tom Horton at AA into a
merger that enables them now to run a much bigger airline with less risk
of failure. 

[i][i]  If you eliminate the adjustment for stage length, it doesn't alter the rankings among the major carriers, although the differences among them become more compressed.   Using the unadjusted metric of "system passenger yield", the shorter-hop airlines like Southwest, Frontier and Hawaiian tend to look best, because the miles component of the seat miles denominator is smaller, making yields higher.