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Yeah it happened again, another airline declared bankruptcy but this time it was American Airlines and not Northwest Airlines. This time the bankruptcy wasn’t precipitated by some kind of cataclysmic event. This time was the seventh time it happened in the airline industry since 2000. This time, the proposed solution to the problem was once again a merger. I took a closer look to see why the airline industry was such loser and why mergers were so common.
Did you know that at the end of 2009 the book value of domestic carrier assets totaled $169 billion and the book value of shareholders equity totaled only $10 billion? Yeah… me either. This is bad.
To put this in perspective a little bit, lets apply what we’ve learned thus far in our Financial Reporting class; If Assets = Liabilities + Shareholder Equity this would mean that the domestic carriers collectively have a $159 billion of liabilities on their books. From this we can further deduce that a disproportionate amount of the industries assets have been financed through debt. With just one more leap of faith we can get closer to the heart of the issue; assuming that most of that debt carries interest and most of those assets (airplanes and equipment) are depreciating we can now begin to see the picture a bit clearer but we are still missing one key ingredient.
Did you know that from 1979 to 2009 the airline industry lost a whopping $59 billion dollars? No, I didn’t either, but now I am beginning to understand why bankruptcies and consolidations have been such a staple of the industry. If you are loaded with debt and your assets are not making money ten out of ten times the creditors are going to be coming after your assets. This makes sense right? Now let’s consider why the consolidation makes business sense as well.
On the operating income is a function of two things: revenue and expenses. Both of these factors play an equally important role in determining the ability of a company to sustain in a competitive market place. Unlike many other industries, the airline industry is a slave to price. When price becomes the leading differentiator, the game changes from of who can create the best product to who can be best at reducing cost. To compound this problem, the airlines operate in a space where their greatest cost is largely uncontrollable (oil). So now they are forced to not only compete among themselves, but with a slew of new low cost carriers, who are more lean, nimble, and better prepared to operate under this framework.
So what do you do when you are bleeding cash, you are being priced out on your best routes, are overextended and competing with other companies who are also overextended, in markets that don’t have enough demand to satisfy the supply? You consolidate and reduce competition, because competition is an implicit cost of participation and by joining you are not only improving synergies but also winning on the reduced price competition.
While I can certainly understand the anti-trust concern of the DOJ in their decision to file a law suit to stop the American Airline and U.S. Airway merger I don’t necessarily agree with it. In their current form, I can’t see how American Airlines can continue to operate without paring down their operation. And if they are forced to exit markets, wouldn’t their absence in those markets be just as detrimental to those consumers? I guess only time will tell.