Agency Costs and Airlines

Apparently, USAirways (the recently merged product of America West and US Air) has made a bid for buying Delta out of bankruptcy.  The bid is around $4 billion in cash and $4 billion in USAirways stock.  Which got me thinking about airline mergers in general.

Companies can be thought of as having tangible assets (trucks, airplanes, factories) and intangible assets (reputation, employees, brand names, contracts).  Most companies are worth far more than the book value of their tangible assets.  Most of Microsoft's value, for example, is in it's products, its brand, its franchise, its contracts, its people, etc., not in hardware or buildings.  As a result, most acquisitions are completed at prices far above the book value of the assets of the purchased company.  The difference is called "goodwill" by accountants and "enterprise value" by economists.

But enterprise value is a problem in airline mergers.  Most investors expect to pay and get paid a premium over asset values in a merger.  But I am not sure there should be any such premium nowadays for airlines, because I fear that the typical airline's "goodwill", or the value of their intangible assets, may be negative.

Take the example of Delta.  Unlike scrappy competitors like Southwest and JetBlue, Delta has a lot of baggage (so to speak).  First and foremost, they have terrible legacy union contracts that mean that pay all of their employees much more money than do startup airlines and they are much more constrained by work rules in improving productivity.  They have huge and building under-funded retirement and medical accounts.  They have legacy contracts that may suck, and they often have hodge-podge mixed fleets that are hard to maintain.  All of this tends to add up to a negative effect on value.

The one positive intangible companies like Delta have is their brand value, and I would argue that most of that is tied up in their frequent flier programs[** Update Below].  Without these programs, most frequent fliers have demonstrated that they would switch airlines for trivial improvements in fares.  This value in the frequent flier programs was demonstrated in the America West merger (among others), when Juniper Bank contributed $455 million (!) to the merger for the right to issue the visa card attached to the program.  Wow.

Given this problem of negative enterprise value, it is not surprising that savvy upstarts like JetBlue and Southwest before it have not grown by acquiring other companies.  Both are willing to take advantage of bankrupt competitors to grow, but they only have bought assets (like planes and gates) rather than whole enterprises, so they don't inherit legacy contract or union issues.  When the companies who are making money do things one way, and the companies who find themselves in bankruptcy court every five years do it another way, the difference probably matters.

Which brings me to the title of the post and agency costs.  It is really, really uncertain whether buying Delta is good for the USAirways shareholders.  Since buying airline equities has always been a losing proposition over the long haul, the deal only makes sense if 1)  They are getting a screaming deal, either because of Delta's bankruptcy or because they are doing the deal in just the right part of the business cycle; or 2) They can really harvest synergies, which in this case would have to include shutting down entire hubs, such as Charlotte in favor of Atlanta or Cincinnati in favor of Pittsburgh.   While I can't speak to the latter with any facts, you have a better chance betting Arizona will win the Superbowl than betting any acquisition hits its promised synergy values.

But if the value of the acquisition is unclear for shareholders, there is one group that almost certainly benefits:  USAirways management.  Management, even if shareholders don't get a great deal, will benefit in both monetary and non-monetary (e.g. status) ways from running an airline three or four times as large as the current enterprise.  This mis-match in incentives between hired management and shareholders is called agency costs, and is something every board should be more cognizant of when approving acquisitions.

**Update:  A rant on the ethics of frequent flier programs


  1. Craig:

    "Without these programs, most frequent fliers have demonstrated that they would switch airlines for trivial improvements in fares"

    The way that all these frequent flyer programs are linked, I can get miles for my Northwest account when I fly Delta, Continental, and probably other airlines. This seems to dilute the value of these programs, because I can price-compare and still get miles.

  2. dearieme:

    Is the size of these "agency costs" a sign of defective company law?

  3. JohnDewey:

    Large airlines compete fiercely for contracts with corporate customers and profesional firms. American, United, and Delta hold an advantage over other U.S. carriers because of their huge U.S. and International route structures. If U.S. Airways wants to compete for the lucrative corporate contracts, they need more routes and more frequencies.

  4. Skip Oliva:

    This deal may never get off the ground if the Justice Department's Antitrust Division gets involved. The Division has traditionally been extremely paranoid about airline mergers, to the point where I suspect they'd prefer the entire industry collapse.

  5. Ironman:

    There's also the cutthroat nature of the competition among the airlines to consider as well. It's not unheard of for one airline to bid on another just for the purpose of disrupting any plans it may have been developing to be acquired by a third carrier (not yet publicly identified.)

    It would also have the advantage of cranking up the acquisition costs to the third airline, which for some of the more bloodthirsty among airline execs, would be reason enough to offer it. Considering what America West's management went through in acquiring U.S. Airways, they might just consider the move to be "payback."

  6. Anonymous:

    Useless Air has the worst corporate culture of any airline. If there was anything you liked about Delta, understand that USAir will ruin it, just as it destroyed Pacific Southwest Airlines 20 years ago. USAir literally flew PSA into the ground. Three years after acquiring the most successful and largest airline on the West coast, USAir withdrew completely from that market. In fact, Alaska Airlines' whole business today only exists because USAir bought then shut-down PSA. You could understand an airline buying a competitor to shut it down, but buying a non-competitor, in a faraway market, to shut it down? Either idiocy or uncommon malice.

  7. Eric:

    It's funny to still refer to Southwest as a "scrappy startup airline." They started fighting to get their operating certificate in the late 60's and started flying in 1971. They're certainly not as old as Delta, American, United, Allegheny (aka US Air)- but 35 years of nothing but profits and growth and absent of labor furloughs is completely unheard of in the airline industry. Maybe the fact that they still might view themselves as a "scrappy startup" which needs to keep fighting is the reason they've become the 800lb. gorilla of the airline industry. They're definitely not resting on their laurels the way a classic airline would.

    It never ceases to amaze me how instead of emulating Southwest's keys to success, legacy airline CEOs malign them and choose to keep doing business as if it's the old airmail days with guaranteed contracts for each route. It's all about the philosophy of the guys at the top- it's always seemed to me that the legacies operate as if it's their god-given right to be an airline and that the customers should just flock to them because they've been around since the 30's. Meanwhile, the companies which consistently profit such as Southwest, Jetblue, Airtran, et. al. all seem to operate as if they're real businesses operating in a free, consumer-driven market. That's really the key difference, and I don't know if it can ever be fixed by mergers and acquisitions as one major buys another major. How's the whole American Airlines/TWA thing working out?

    Don't bet on the antitrust laws preventing this merger from happening. For some reason, the government seems to let the legacy airlines get away with things that no other airline and most other dominant companies in other industries could never do. After all, if the government hadn't bailed US Air out of its financial troubles in 2004, we wouldn't even be having this discussion.

  8. JohnDewey:

    Erik: "How's the whole American Airlines/TWA thing working out? "

    Of the large international airlines, American Airlines seems to be in the best shape. Their cash has increased from about $1.2 billion at their post-Sept11 low point to about $5 billion today.

    American Airlines is the only legacy carrier that has never filed for bankruptcy. That's a source of great pride for them.

    It's unfortunate that the federal government has interfered so much with the airline industry. Both America West and U.S. Airways were able to survive through large federal loans. United, and U.S. Airways used bankruptcy as a means of shedding huge pension obligations. Delta used the leverage of bankruptcy to end its union-contracted pensions. Such assistance has made it difficult for the stronger legacy airlines - American and Continental - to compete fairly.

  9. JohnDewey:

    Erik: "It never ceases to amaze me how instead of emulating Southwest's keys to success, legacy airline CEOs malign them and choose to keep doing business as if it's the old airmail days with guaranteed contracts for each route. "

    Erik, as an airline industry employee, I may have a different perspective.

    Legacy airlines' hub-and-spoke networks allow them to concentrate international passengers, enabling many more cost-effective international flights. Such networks also allow small markets such as Knoxville or Des Moines or Boise to enjoy one-stop connections to the entire nation and half the world. Hub-and-spoke networks are still the most efficient form for national and international carriers. Such networks didn't make sense for Southwest when it was a regional airline, or even later when it was growing.

    Do you have access to Southwest Airlines route maps from 15 years ago? If you compared it with Southwest's current map, you'd discover something interesting. Rather than legacy airlines change to emulate Southwest, it is Southwest network that is becoming hub oriented.

    Here's the link for Southwest's current route map.

    To see Southwest's hubs, click on "Show Only Nonstop Service" in the lower left corner of the map. Then move the cursor over Chicago, Baltimore, Nashville, and Houston.