Why Delta-Northwest won't work
Industry consolidation is supposed to cure the airlines' most intractable ills, right? It won't.
By Barney Gimbel, writer
NEW YORK (Fortune) -- There was little doubt last summer when former Northwest Airlines executive Richard Anderson took the helm at Delta Air Lines that the carrier would gobble up a competitor. It was just a matter of which one and when.
So Wednesday's board meeting to finalize a merger between Delta (DAL, Fortune 500) and its smaller rival, Northwest Airlines (NWA, Fortune 500), surprised no one. Shareholders clamored for it. Analysts gave their blessing. And the media breathlessly reported its inevitability. Consolidation, the thinking goes, will solve all of the industry's woes.
Not so fast. An analysis of the likely deal terms suggests this merger won't overcome the many problems facing airlines. In the end, we might just have a bigger company plagued by the same problems, including sky-high oil prices and powerful labor unions. Ditto for United (UAUA, Fortune 500) and Continental (CAL, Fortune 500) if they too, as has been widely reported, tie the knot. Let me explain.
What a difference a year makes
It was just over a year ago that Delta's former CEO, Gerald Grinstein, warned a packed room of U.S. senators about the perils of airlines mergers. Grinstein was there to fight off a hostile bid from US Airways (LCC, Fortune 500) and had a phalanx of uniformed Delta pilots standing behind him. He called the transaction "anti-competitive" and said it would "threaten the future stability of our nation's transportation industry."
For a lot of reasons, Grinstein didn't want to sell his airline to US Airways. It was his baby. He had nursed it back from the brink of insolvency and he wasn't about to let what he considered to be an unworthy competitor snap it up and reap any rewards. He may have believed what he told Congress: Once Delta emerged from bankruptcy, it would be worth far more than US Airways' $9.5 billion offer.
Things didn't work out as Grinstein had hoped. Today Delta is worth only $6.7 billion and Grinstein - and his team - are gone. Anderson inherited an angry board of directors and impatient shareholders. The only way to fix the problem was to find a partner - and fast.
What changed was the price of oil. At $100 a barrel, oil is almost double what it was when Grinstein testified in January 2007. It's become all but impossible for airlines to turn a profit. Add to that the inability to hike fares substantially, mounting foreign competition, and signs of a economic downturn, and it's no wonder airlines are scrambling for alternatives.
Combining with a rival would give airlines some much-needed capital. "This is about survival." says former Continental chief executive Gordon Bethune, who recently advised a New York hedge fund that wants Delta to merge with either Northwest Airlines or United Airlines. "These companies just need more revenue than they can generate with that kind of expense level."
Two theories are driving airline merger talks. Cost-cutting by flying the same amount of passengers on fewer airplanes is one. Delta, for instance, has nine daily flights between Nashville and its Atlanta hub. Northwest flies three times a day from Nashville to its Memphis hub. But the passengers often aren't going to either city; they're connecting to Los Angeles or Dallas or Boise. By merging, the combined carrier could, say, cut three flights and still meet demand.
The potential savings is what drove US Airways to bid for Delta last year. US Airways suggested it could save nearly $1 billion by combining the two carriers and lopping off 10 percent of the flight schedule.
But belt-tightening isn't driving the Delta-Northwest talks, according to published reports. The "new" Delta doesn't plan to cut many jobs or reduce much capacity. They don't even plan to drop any hubs. If that remains the plan, then the combined carrier won't be able to generate more revenue through higher fares.
Instead, they plan to boost revenue by leveraging their global network to seize market share. It makes sense in theory: Northwest has an extensive Asian presence while Delta has a large European and Latin American network. The problem is, size alone won't stimulate demand. The new Delta would have to use its larger footprint to steal customers from competitors - a tough proposition if other airlines merge too.
The only way Delta-Northwest plans to save money is through cutbacks in Northwest's Minneapolis base, and by combining their respective airport operations, reservation lines and technology departments. Even so, the costs savings would be negligible - and possibly offset by any deals to secure the approval of the airlines' labor unions. If Delta agrees, say, not to lay off pilots then it can't reduce the number of planes or routes it flies.
None of this bodes well for the airline industry. After a Northwest-Delta deal, expect to see the remaining large carriers - American, Continental, United and US Airways - attempt similar mergers with similar terms. And then what do you have? Bigger companies flying the same routes with the same airplanes - only now with higher labor costs. For some reason, in the airline business, people always forget that bigger doesn't mean better.
Comments
This article echoes some of the discussion points brought up in class regarding the NW-Delta merger and also introduces some new ideas.
Gimbel contends that a merger between NW and Delta will not help the two companies overcome the airline industry's bigger problems, namely oil prices and powerful labor unions. In addition, Gimbel suggests airline mergers have become a survival tactic, one that will provide much needed capital in the face of rising foreign competition, slimmer margins, and the general economic downturn. Cost-cutting is cited as the driving force behind airline mergers, as consolidated companies can attempt to fly the same amount of passengers with using fewer airplanes. However, as we discussed in class, those in charge of the NW-Delta merger insist cost-cutting is not the driver behind the merger. In fact, according to published reports, once merged, the new company would not plan to cut many jobs, would not reduce much capacity, and would not drop any hubs. The plan is to increase revenue by "leveraging their global network to seize market share."
I think one would be naive to believe that NW-Delta truly believes the merger will create such an incredible amount synergy that would result in the necessary revenue increases to justify the merger. I have no doubt that large cutbacks are planned. However, Gimbel suggests that even with cutbacks in NW's Minneapolis base and with combining airport operations and corporate departments, cost savings will be negligible at best, taking into account the deals the companies need to make with labor unions in order to push forward the merger. Clearly, bigger does not always mean better. In this case, as Gimbel also suggests, bigger just means a larger company facing the same problems.
One thing I wish this article would have discussed were possible ideas to truly improve the situation faced by today’s airlines. I have yet to come across an article that offers a positive, viable solution. Perhaps, given the current state of the industry, there is none?
Posted by: Jenny Sliwinski | February 25, 2008 10:47 PM