In November 2011, American Airlines filled Chapter 11 bankruptcy protection and said that it was determined to emerge from bankruptcy as a stand-alone company. Some of the driving forces that have led to bankruptcy were the increase in fuel prices and the decrease in profitability since 2007. In scope of Chapter 11 protection, the company intends to reorganize its business affairs so that it can pay its creditors who are mostly the airline’s employees.
For American Airlines to gain back its competitiveness, it has to increase its revenue by $3 billion annually. Reducing labor by 13,000 people (represents 16.6 percent of the total work force), cutting labor costs by $2 billion, adding flights to five major airports and partnering with European and Japanese airlines were the four things Thomas Horton, the CEO of American Airlines, had originally planned. However, many analysts immediately questioned the ‘$1 billion extra revenue ever year’ envision Horton outlined in his reorganization plan.
Horton insistently mentioned that he prefers to remain an independent company rather than merging with another airline. “For years I’ve said that I think consolidation has been — can be healthy and constructive for the U.S. airline industry. But right now we are in the midst of a very complex restructuring and so our focus is singularly on returning the company to profitability and growth. The idea of doing the two together strikes me as a bridge too far” said Horton in an interview with Alaska Journal of Commerce. Staying as a stand-alone company would mean additional job losses, compensation reductions and other expense cuts for 10, 000 nonunion workers.
According to Zephry, a research database, AMR is valued at an estimated
$120,011,275 based on the 335,227,024 shares outstanding and the closing share price of $0.358 on 11/01/12, the last day of trading. The timeline following the announcement of bankruptcy reveals some interesting facts about the domestic airline industry in United States. First of all, on January 25th, U.S. Airways Group Inc. claimed an interest in a possible merger with AMR Corporation and has hired Millstein & Company, Barclays PLC and Latham & Watkins LLP to evaluate the acquisition.
Two days later, Delta Air Lines Inc. reported to have the same interest. Furthermore, on April 25th, International Airlines Group, parent of British Airways and Iberia, stated that they have hired an analyst to look into the possible transaction as well. American Airline’s top competitors are considering buying the bankrupt company in order to increase their market share.
Right now, 41 percent of the market share in the U.S. domestic airline industry is owned by three companies (Delta Air Lines: 15.2%, United Continental Holding Inc:14.8% and Southwest Airlines Co.:10.8%). This is due to an increasing number of mergers. In 2009 Delta Airlines acquired Northwest Airlines and in 2010 United Airlines acquired Continental. Furthermore, Southwest Airlines will complete acquiring AirTran Airways before 2014.
“Consolidation, in our review, represents a later stage for a mature industry that is seeking ways to address its financial volatility… Our view is that consolidation is part of a longer-term process that should ultimately allow the global airline industry to efficiently allocate capital and assets such that a positive return on invested capital can be achieved…On the surface, airlines pursue mergers as a means to improve profitability…and their competitive positioning via an expanded network. Longer-term, consolidation should improve industry viability while mitigating industry volatility and consequently lower its cost of capital,” said John P. Heimlich, V.P. and Chief Economist at the Air Transport Association of America.
Among all others, U.S. Airways was the first company to take action towards an acquisition. On April 20th, U.S. Airways announced that three major labor unions of AMR Corporation have agreed to support the possible merger in order to have a collective bargaining power. The three unions, Allied Pilots Association, the Association of Professional Flight Attendants and Transport Workers Union represent nearly 55,000 American Airlines employees (10,000 pilots, 17,000 flight attendants and 26,000 mechanics and ground workers).
Dough Parker, Chief Executive at U.S. Airways, highlighted that union agreements do not mean that both airlines have agreed to merge in any case. “It only means we have reach agreements with these three unions on what their collective bargaining agreements would look like after a merger and that they would like to work with us to make a merger a reality. To get the actual merger, many more things must happen including gaining the support of AMR’s creditors, its management” he said to his employees.
However, do American Airlines and U.S. Airways have a choice? Can both companies be profitable considering the recent changes in the industry? Rick Seaney, CEO of FareCompare, fears that airlines are becoming ‘too big to fail’ such as the auto industry and banks. The domestic airline industry in the United States is becoming an oligopoly.
Oligopoly is one of the many models that explains the demand of a firm. In an oligopoly, there are few firms producing the majority of products. These firms are producing similar or slightly differentiated goods. The demand the firms face is downward sloping because consumers choose between three or four major companies. In the domestic airlines industry, these three companies are Delta, United and Southwest. In an oligopoly, competition is relatively low and the market power is relatively high compared to those companies that are in perfectly competitive markets.
In a perfect competition, firms are price takers- meaning that demand and supply of the market determines the price and the price determines the rate of production. The competition brings back the price to marginal cost and there are no economic profits in the long run.
However in an oligopoly, firms have power on prices to some degree. In addition, barriers to entry, such as economies of scale and cost advantage production techniques make it harder for new firms to enter the market. For example, a new firm who wants to enter the airline industry would not benefit from economies of scale. Economies of scale is the decrease in average total cost for every unit produced due to teamwork, specialization and spread of fixed costs. For example, Delta faces economies of scale by having large number of routes. The company is able to buy its cabin food at a much lower cost than that of competitors because it buys in bulk.
Not only that but also due to increased number of routes, top companies attract larger customers. Customers are loyal to a specific airline as they get benefits from frequent flier programs. Because they can use their advantage miles with variety of routes, they prefer major airlines rather than airlines with low market share. Benefits from additional routes is one of the main reasons why American Airlines and U.S. Airways should merge. In order to understand the factors leading to merger, we need to look more into the business lines of both companies.
U.S. Airways Group Inc (LLC) and AMR Corp (AAMRQ) both compete in two industries: air transportation and air passenger transportation. LLC has four product/service groups and AAMRQ has three product/service groups. A combined entity would have 75% product/service overlap. At first, this number might seem significant. However, one should always compare it to other scenarios. For instance,
Delta Airlines (DAL) and AAMRQ would also have 75% product/service overlap in a merger. As a matter of fact, analyzing lines of business and products gives a biased estimation. SWOT analysis, along with business lines, should be considered.
In SWOT analysis, one thing that stands out is the fact that U.S. Airway’s weakness is American Airline’s strength. U.S. Airways is greatly impacted by the U.S. economy because its business concentration is solely in U.S. 76.9% of revenue depends on one particular region. However, American Airlines has diversified business operations. As a matter of fact, its business does not rely one particular economy.
A merger would combine airlines’ route networks and would make their ranking number one among U.S. domestic carriers in terms of seat-miles-flown. Secondly, a merger would reduce the costs occurred at facilities at both airlines as they would have to decide on a single central hub. The companies would also benefit savings from reduced aircraft leases and reduced redundant management.
Analysts estimate the merger to bring $1 billion in additional revenue and $500 million savings in non-labor costs. Merger will also save 6,200 of the 13,000 jobs that will be lost. Most importantly, the merger will give them the power to be able to compete with other industry leaders.
What would a merger mean- increase in ticket fares? Absolutely. An increase in ticket fares would be due to two factors: lack of competition and increase in fuel expenses. If a merger happens, there will be only four major companies in the airline industry. The decrease in supply will increase prices as companies will have greater power. Secondly, the ticket prices will go up because of increasing fuel prices.
On March 8th, U.S. Energy Information Administration forecasted the average jet fuel price to be $3.00 per gallon. There was a significant increase of $0.36 from the previous forecast. $3.00 per gallon jet fuel is estimated to increase U.S. airlines’ fuel expenses by $15 billion. Companies have no choice but to increase prices in order to cope with the expenses. If the two companies decide not to merge, they will lose further profits due to increasing fuel prices.
A merger would also mean changes in market share. It is clear that with a merger only four airlines will have the majority of power. However, some industry analysts have doubts that this means oligopoly. In an interview with Bloomberg, Will Randow claimed the airline industry is not becoming an oligopoly because low cost airlines such as Southwest are able to compete with other major airlines. However, this does not change the factors that lead the American Airline and U.S. Airways merger.
A merger seems feasible for both companies to enjoy higher profits associated with larger market share. The increase in routes and cost saving reductions will be additional benefits other than the market share. However, the merger is likely to happen when American Airlines gets out of bankruptcy. This is primarily due to the fact for the company to remain its brand reputation. Secondly, the remaining steps required in the acquisition process will take a good amount of time.