On March 24, 2008 my first post on Why Airline Mergers Don’t Work opened with the following paragraph:
Ever wonder why over the last 30 years Southwest Airlines management (NYSE: LUV) spent only $0.03 on mergers and acquisitions for every $1.00 of shareholder value they created? By comparison Delta management (NYSE: DAL) spent $2.35 for every $1.00 of value they created. And Northwest (NYSE: NWA) spent $1.61 on M&A for every $1.00 of value they created. In Louisiana we have a name for this kind of strategy: Jumping over a dollar to get to a nickel.
In a nutshell I found that airline mergers don’t work because the bigger an airline gets the greater is its exposure to low price carriers like Southwest. This exposure forces management to meet lower fares in more markets which puts inescapable downward pressure on ticket prices, revenues and earnings. In air travel scale is not a blessing, it’s a curse. Of course the two biggest M&A losers cited above went ahead with their merger and now have become what Delta advertising proudly proclaims is the world’s largest airline.
VALUE vs. REVENUE ORIENTATION
Sales revenue and market value interact in circular, subtle and often unobservable ways. After years of research on the interaction between market value and sales revenues I gave it many different names. Perhaps the most descriptive is this one:
Risk-Adjusted Differential: RAD.
Like they say about Smucker’s jam, with a name like that it better be good. It is. Here are three of the most important characteristics of RAD:
1. The risk-adjusted difference [RAD] between a firm’s share of value [SOV] and share of revenues [SOR] in a group of its peers is an index of managements’ orientation toward value creation vs. revenue generation. When the difference is positive, the firm is value oriented. When it’s negative, the firm is revenue oriented. When the difference is zero, management is equally value and revenue oriented.
2. Dividing a firm’s time series of RAD observations by its sigma creates a normally distributed variable with an expected value of zero. When RAD is two sigma above or below this expectation a 95% confidence interval on value vs. revenue orientation is created.
3. As a result of these underlying properties one can transform RAD into the probability that a firm’s management is value or revenue oriented by looking up any given observation and its standard deviation in a Z table.
The purpose of this article is to apply these conclusions to nine U.S. airlines over the most recent 14 quarters. The results are at once intuitively meaningful and surprising.
VALUE-REVENUE ORIENTATION
The following table lists the ticker symbols of nine major airlines followed by their mean Risk-Adjusted Differential [RAD], sigma and associated probabilities that management has a long-term value vs. revenue orientation. You can easily verify these probabilities by looking up the mean RAD and sigma for each firm in an online (Z-Calculator).
The management teams of only two U.S. airlines, JBLU and LUV, have a high probability of being value oriented:
• JBLU had an average RAD over the 14 quarters of +3.1 with a sigma of 1.1. Conclusion? The long-run probability that JBLU management is value oriented is virtually certain.
• LUV, the perennial front runner on this metric, also had an average RAD of +3.1, but with a sigma of 9.3. Conclusion? Given the volatility of its risk-adjusted differentials the long-run probability that LUV management is value oriented drops to 0.6. So there’s a 40% chance they are revenue oriented as well.
Three of these airlines straddle the fence: management is both value and revenue oriented:
• ALK sits right in the middle of the probability distribution. It posted an average RAD of +1.0 with a sigma of 0.8 giving it an even chance that management is both value and revenue oriented.
• DAL, with its vaunted history of mergers culminating in the acquisition of Northwest Airlines, had an average RAD of -0.9 with a sigma of 8.7. Conclusion? The probability that the DAL management team has its eyes on long-run value creation is 0.4. It more likely (0.6) they are revenue oriented, following the time-worn dictum that more market share means greater earnings.
• LCC, another carrier with an unremarkable history of acquisition, had an average RAD of -1.0 with a standard deviation of 4.0 giving its management just a 0.3 probability of being value oriented. LCC management is clearly after revenue, believing that scale creates earnings.
Management of the remaining four airlines have basically thrown value out the window. All four exhibit average RADs less than -2.0. And have had for many more than the latest 14 quarters. Running in and out of bankruptcy hasn’t change the basic posture of any of these carriers:
• AMR and UAUA are equally uncompromising in their revenue orientation with average probabilities of 0.8 and 0.9 respectively.
• By the numbers, CAL and FRNTQ management are dedicated exclusively to revenue generation: the chances their management teams have any real long term interest in value creation is virtually zero.
TIME SERIES SHARPEN THE PICTURE
The results reported above are brought into sharper focus when viewed as a time series. The following chart compares the value leader (JBLU) with revenue leader (CAL) over the most recent 14 quarters.
The neutral point in the Value Orientation Index in this chart is 0.0, identified by the white dotted line. This orientation is value-neutral because the difference between a firm’s share of value and share of revenues in its peer group is zero.
Observations greater than +2.0 over a long period of time are extremely unlikely, since ± 2 (defined by the green and red dotted lines) create a 95% confidence interval. All but one of JBLU’s index values is greater than +2. While every one of CAL’s numbers is less than -2.0. It’s easy to see from this chart why the probability is virtually 1.0 that JBLU management is value oriented while that of CAL is virtually zero. Which firm would you want to put your money on? That depends on your preference for value vs. revenue oriented strategy.
LUV and UAUA are compared in the following chart. This appears to be just another case of one company’s management (LUV) being value oriented while the other (UAUA) is revenue oriented. But, you might also notice there is a surprisingly high correlation (0.6) between the Value Orientation Indices of the two companies. That is due in large measure to UAUA’s exposure to LUV’s price leadership in the market segments they have in common. More evidence that scale in airlines is not a blessing.
The final chart in this series compares ALK with DAL – on of the three smallest ($827 M revenue) and the largest airline ($7,000 M revenue) in this space. ALK management appears to be taking the lead in creating value over the last three quarters with RADs of 1.6, 2.3 and 3.0 corresponding with probabilities of 0.77, 0.95 and 0.99 respectively. DAL managements’ RADs have slipped from +0.9 to +0.6 to +0.2 corresponding with revenue oriented probabilities of 0.50, 0.48 and 0.46 respectively.
The distress sufffered by all nine airlines in the market downturn does not conceal the fact that DAL’s merger with NWA didn't work. Scale is not a blessing in the airline business. Downward price pressure from greater exposure to discount carriers eventually kick in to spoil the future.
The number and size of companies included in this analysis matter very little – the Value Orientation Index is insensitive to both the number and size of companies included. If you want to understand the details behind this analysis, review my 18 minute audio slide show Y’all Buckle That Seat Belt.
Thanks for viewing. As always your comments are welcome.
~V
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