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E. Han Kim
  E. Han Kim

Not So Friendly Skies: A Look at M&As in the Airline Industry

6/19/2008 --

Soaring fuel prices force companies to consider consolidation—but at what cost to consumers?

Things are so tough for the airlines these days that even a critic of mergers in that industry is softening his stance, at least a little. E. Han Kim, the Fred M. Taylor Professor of Business Administration at Ross, points out that soaring oil prices coupled with a slowing economy are stressing airlines just as some are coming out of major restructurings. Delta Air Lines Inc. and Northwest Airlines Corp. want to merge, and others are likely to follow. In the following Q&A, Kim lends his perspective to proposed deals in the airline industry and provides a snapshot of the overall environment for mergers and acquisitions, given credit market conditions.

The airlines and financial markets have been pushing for mergers, saying they need to be done. But they sometimes cause anxiety with Congress and the flying public. Are we going to see them anyway?
Kim: Whenever you talk about mergers and acquisitions the two key drivers are efficiency gains and market power. To increase efficiency, you cut costs by reducing redundant operations and duplicate work forces, where route service overlaps. By combining their hubs, merged airlines can also reduce costs and increase efficiency. This efficiency is good for everybody. It's good for airlines, and hopefully it's good for customers, because cost reductions theoretically will get passed onto customers through lower fares.

It's all good except for those people who lose jobs and who experience wage cuts. The pain afflicts a lot of people because the airline business is a labor intensive service industry. Unfortunately, this pain is necessary for the survival of the industry.

However, what's really hurting airlines right now are higher fuel costs coupled with severe competition. Because of the severity of competition, it is difficult for any single airline to pass on their higher fuel costs to customers. By merging, they can reduce the competition on overlapping routes.

So they get to cut a competitor out and get more pricing power that way?
Kim: Yes. By increasing their market power, airlines can then pass on the higher fuel costs. And in the long run consumers should have to bear higher fuel costs. But increased market power in the airline industry often translates into higher airfares, fewer route choices, and poorer customer service. That's exactly why the customers and the Congress get involved. Regulators don't feel very enthusiastic about airline mergers, especially the mergers with many overlapping routes. If merging airlines serve completely different routes with little overlap, then the merger may not be considered anti-competitive.

But market power comes not just from reduction of competition in overlapping routes; it also comes from eliminating a threat from what we call a multimarket contact. Say airline A has 90 percent market share on a particular route and I have a 10 percent market share. So my rival is the dominant player there. But then I serve another route in which I have 70 percent market share and airline A has only 30 percent. Now airline A would be very careful in terms of lowering their airfares in the route I dominate. If it cuts the airfares in this route to increase its market share, there is a threat I may retaliate by cutting airfares in the other route my rival dominates.

What about the proposed Delta-Northwest merger?
Kim: My impression is that they don't have that many overlapping routes. Regulators tend to focus on how many overlapping routes the merging airlines have in determining whether a merger is anti-competitive. I think they would look favorably on Delta-Northwest.

So in that multi-market contact context, what kind of power is gained with the proposed Delta-Northwest merger?
Kim: I doubt that gaining market power through multi-market contacts is a primary consideration in the Delta-Northwest merger at the present time. Nevertheless, the combined firm will cover more routes and, as a result, the merger will provide more protection against the threat of price cuts by rivals. In the current situation with high fuel prices, in which airlines need to increase airfares and the industry is consolidating, such protection may not have an immediate value until airlines become profitable again.

At the present time, the more dangerous market power is obtained through a merger of airlines with substantial overlapping routes. If you let such mergers take place and reduce the number of airlines that serve a particular route, then it may lead to something closer to monopolistic power. The monopolistic power not only gives them pricing power, it also creates something worse than that---monopolistic inefficiencies and bad customer services that come with them.

But you think they're going to happen, and that they might be necessary to a certain extent?
Kim: Yes. The big difference is that with the skyrocketing oil prices, airlines cannot survive unless they can pass on the higher fuel cost. They have to find a means to pass them on. All the airlines are losing money. Airlines are not charity organizations. Before 9/11, there was a lot of fat in the industry. Since then they have implemented a lot of efficiency moves. I doubt there is much slack left for further efficiency gains. So how can they deal with the higher fuel costs? One way is through mergers. Mergers may provide further efficiency gains through economies of scale and scope, as well as increased market power, which may enable them to pass on the higher oil price to customers. As I said, the danger with the latter is not just the higher airfares, but poor service that comes with it. That's the reason I'm still somewhat reluctant to endorse airline mergers. . . But then, I might add, now with the skyrocketing oil prices, the overriding concern is their ability to survive.

How do these airlines, some of which recently emerged from Chapter 11, finance these takeovers?
Kim: Stock swaps. They don't have to pay cash. They do stock swaps, using their shares as currency.

Turning to a more general view of mergers and acquisitions, are we coming out of the period where the brakes were put on deals because of turmoil in the credit markets, or is it too soon yet?
Kim: The credit risk is still high, and so are the financing costs. One of the drivers of M&As before the subprime crisis was the cheap financing cost, which facilitated the boom in leveraged buyouts. The subprime crisis is having serious spillover effects to the rest of the financial market. As long as this continues, M&A activity will probably stay pretty low. A lot depends on what happens to the credit market.

Written by Terry Kosdrosky

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