Friday, April 18, 2008

The Delta-Northwestern Airline Merger

Color me excited! I can write about a topic that doesn't mention Jeff Immelt, GE, Iran or even Jack Welch.

Earlier this week, Delta and Northwest Airlines agreed to merge their two companies. Needless to say, this attracted quite a bit of attention. Airline profitability, fuel costs, economies of scale, union power, and consumer service and satisfaction all received lots of ink as pundits and analysts opined on this event.

However, in my opinion, industrial economics pretty much guarantees that, even with this merger, airlines are still not fated to consistently outperform the market.

Why might this be true?

Because of these industry characteristics: easy entry, complicated exits, little control over most costs, high percentage of long-lived, expensive fixed assets on the balance sheets, and too much competition to reliably set prices which provide sufficient profitability.

I have written on this theme in prior posts here and here. The second linked post references an additional three prior airline-oriented posts. Of those three, this post, from nearly two years ago, frames this whole issue rather nicely. It even includes a very lucid reader comment noting that airlines are still pretty much required to function as a utility, flying to and from destinations which will never really pay their way, just to provide 'service.'

As I wrote, in some cases, several times in those prior posts, at some point, today's airlines have to admit to limits to growth, market saturation, and the probably reality that there is a 'right size' for most airlines, in terms of areas served, plane types flown, size of flight crews, and number of flights, before too much uncertainty of demand and costs make the model unsustainably profitable.

All of that said, the best solution is probably regional and buyer-segment-based competition/organization. Which is what I've argued in prior posts.

But as I wrote this post, it occurred to me that the reference to the year-ago post, and the reader's comment about the 'utility' aspect of airlines, begs another question.

Do not airlines resemble, to some extent, power-generation utilities? For example, in today's world, airlines, like energy utilities, are necessary. We couldn't really think of our modern world without them.

Yet who ever thinks of electrical/power utilities as growth equities? Nobody. Instead, they are viewed more like bonds.

Airlines are somewhat like that, insofar as major components of their cost structure are out of their control, yet pricing is not in their power. However, unlike utilities, which are granted monopolies, or quasi-monopolies, airlines are not.

So airline equities lack the upside of non-utility-like companies, but also the downside, reliable fixed-income-like behavior of utility equities.

They are in a really bad, gray in-between world. And with easy entry, difficult exit, and large shared-resource components, such as airports and the FAA ATC system, no airline ever controls all that much of its profitability dynamics.

In fact, historically, about the only thing an airline can grab and hold, uniquely and competitively, is the lowly physical gate. Owning gates can translate into a non-duplicatable advantage in a local market.

But that's about it.

With that in mind, the various articles this week in the Wall Street Journal about this merger begin to make more sense. Holman Jenkins' excellent editorial on Wednesday reminded us of the parallel of the airline industry to legal shipping industry 'conference' price and volume collusion. Only our own Senators and Representatives have forgotten this little detail.

On the same day, the Journal's Travel column wrote of this merger,

'Two drunks holding each other up is not a good idea, says an aviation consultant.'

The only positive spin on the merger came from- you guessed it- Delta and Northwest.

I find myself in the same position on airline equities that I have always held. Someone has to fly the airplanes and operate the airlines. Like someone has to generate America's power.

But I don't think you'll see my equity portfolio selection process choosing an airline anytime soon. Aside from some very occasional growth spurts for the likes of a younger Southwest Airlines, these companies simply have little to no prospects for consistently superior total return performance.

Their industry dynamics mitigate against that, and probably always will. Mergers or no.

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