Southwest to Buy/Merge with Airtran

They have operated somewhat different business models, and have had little direct competition between each other in the markets they serve and routes they fly. On the other hand, they both operate route networks focused primarily on shorter rather than longer flights, and most of their business is from point to point passengers rather than people connecting through a hub and spoke network.

But does this make the two airlines well suited to merge? Southwest is paying almost a 50% premium over AirTran's current share price to buy it out, and while Southwest talks the traditional talk about 'synergies' it seems that applying the Southwest business model to the AirTran operation will swing AirTran from a healthy profit in 2009 to future losses.

So why is Southwest doing this rather than growing organically? There only seems one possible reason.

In an announcement that caught the industry by surprise this morning, Southwest and AirTran announced their intention to merge, with Southwest buying AirTran in a deal valued at about $1.4 billion, with AirTran shareholders getting about $7.50 for each share (that was trading around $4.50 prior to the announcement with a price trending down).

Not only is this unexpected, but the reason for the merger is far from clear (not that airline mergers ever make much sense, but this one makes even less sense than many).

AirTran has almost 400 take-offs and landings a day in/out of ATL, with leases on 22 gates and access to additional gates if needed, with nonstop flights to 53 destinations from there. This sounds like a large footprint - and it is - but Atlanta is a huge airport (the nation's busiest) and in total AirTran's operations represent only 22% of Atlanta's total traffic. Atlanta is most notable for being Delta's hotly defended home town fortress hub.

Southwest currently has no presence in Atlanta at all, and if it continues AirTran's presence unchanged, Atlanta would become its third largest hub (after Chicago/Midway and Las Vegas).

This is arguably the crown jewel in AirTran's crown, and the ability to instantly get critical mass in Atlanta, combined with neutralizing the potentially bruising competition Southwest would suffer if forced to compete not just against Delta but also, simultaneously, against AirTran, is probably the most attractive part of the deal to Southwest.

AirTran's second and third largest presences are in Orlando (this is of less value to Southwest) and Baltimore (95 movements a day to add to Southwest's current 362).

It also has just under 40 movements a day at La Guardia that will probably be much appreciated by Southwest.

AirTran also has a minor presence at Dallas/Fort Worth (flights to Atlanta, Milwaukee, Baltimore and Orlando) that Southwest will not be able to continue due to the terms of its agreement allowing it to operate from Dallas/Love Field.

Sure, Southwest says it will get valuable experience learning about AirTran's 'near international' flying and its less frequent service to some smaller markets, but there's nothing there worth paying much money for.

And there is the empty claim of $400 million a year in synergies, but that is completely unquantified (and perhaps may remain always unquantifiable).

Most notably, AirTran has 86 Boeing 717 planes (the largely unloved plane that Boeing itself 'inherited' from McDonnell Douglas and which Boeing quickly discontinued) that Southwest is unlikely to want to integrate into its famously and always all-737 fleet.

It will be interesting to see how the actual resale prices realized of these planes will compare to their current book valuations; this could significantly impact on the overall net worth of AirTran's assets. For sure, because Southwest is such a hugely important customer to Boeing, it can probably pressure Boeing to buy them back, but with AirTran having 86 of the total run of 155 of these planes, it will be hard to get them absorbed into the second hand market at good prices.

UPDATE 30 Sep : The Wall St Journal is saying that Southwest has committed to keeping the 717s. This is astonishing. Perhaps the most distinctive cornerstone of Southwest's operation to date has been its rigid adherence to a one plane type fleet. Furthermore, if it is now to add a second airplane type to its fleet, wouldn't it make much more sense to choose a current model plane that it could buy as many of as it wished/needed into the future, rather than a discontinued plane that is no longer being produced, and of which there are only 70 more in the entire world, all but 20 of which are still being actively used (and used up) by other airlines?

(The other 20 planes are owned by Boeing Capital and are definitely available. They were first used by MidWest, and then more recently by Mexicana prior to that airline's bankruptcy.)

AirTran has two cabin planes - a business and coach class, compared to Southwest's all coach class planes.

Southwest has said it will discontinue the two class option and reconfigure the merged airline's planes as single class planes. This is sure to dismay some of AirTran's more frequent and business fliers.

AirTran has also had a conventional approach to seat assignments, unlike Southwest's policy.

Some people hate Southwest's open seating methodology, others simply accept it, and almost no-one likes it. Southwest has again said it will extend its non-assigned seating to the AirTran operation, something which will probably dismay some current AirTran passengers.

Airtran has some international routes around the Caribbean, something Southwest has avoided to date, other than looking north to Canada.

Southwest says that it will continue these international routes and that it is keen to learn from the experience.

Again unlike Southwest, AirTran charges for bags and ticket changes. AirTran charges $15 for a first bag, $25 for a second, and $50 for each extra bag. Southwest allows two bags free, and then charges $50 for extra bags.

AirTran earned about $160 million in bag fees in the last year. Southwest says it will discontinue charging bag fees on its merged AirTran operations.

AirTran also charges $75 if you want to change your ticket. Southwest charges nothing, and says it will remove the ticket change fees on the AirTran services.

In terms of size, in 2009 Southwest had revenues of $10.35 billion, profit of $99 million, and carried 86 million passengers.

Airtran is much smaller - about a quarter the size. It had revenues of $2.34 billion, and carried 24 million passengers but ended up with a great profit of $135 million - more than twice Southwest's profit.

In terms of airline size, and measured by passenger enplanements, and using the six months Jan through June 2010, currently Southwest is already the largest US carrier in terms of domestic passengers carried. If one includes international traffic to/from the US as well as domestic traffic, it becomes the second largest carrier, behind Delta.

The almost completed merger of United and Continental would make that the third largest carrier (in terms of domestic and international combined passenger numbers).

Adding AirTran's passenger enplanements would make the new airline clearly the largest by both measures, ie :

Million Passengers Enplaned, Jan - Jun 2010

Airline	Domestic	Domestic and International
Southwest & Airtran	62.9	63.1
Delta (& Northwest)	43.3	53.4
United & Continental	36.3	47.8

It is only a couple of decades ago that the major 'dinosaur' airlines sneered at the low cost carriers and considered them irrelevant and not worth factoring into the business models.

How times have changed - Southwest/AirTran is now decisively the very largest of airlines (in terms of passengers flown).

This is interesting, and keep in mind that Southwest is paying $1.4 billion for an airline with a market value of $840 million; an airline which made a higher than normal profit of $135 million last year. Southwest is paying a 67% premium over AirTran's market valuation.

Southwest says that this purchase meets its requirement of generating a 15% return on capital invested - 15% of $1.4 billion is $210 million.

So where will this money come from? Oh yes, Southwest talks about '$400 million in synergy' - let's see if we can pin this down a bit.

Two things we know for sure. Southwest will remove the bag fees and the ticket change fees.

These had represented a $210 million/year income item for AirTran (remember the airline made $135 million profit in 2009 - take away its fee income and the airline is running at a loss).

Business travelers (and frequent travelers, with the two generally being synonymous) are a profitable airline's life blood. These people fly more often and generally pay much higher fares. They also have brand loyalty as part of the 'embrace' between airline and passenger created by frequent flier programs and the upgrades/etc given to higher level frequent fliers.

Such passengers are massively motivated by the chance of scoring an upgrade to business/first class, and sometimes will even pay full fare to travel in that cabin. Such passengers are massively demotivated at the thought of there being any risk of them ending up in a middle seat squeezed between two other passengers.

AirTran had provided a reasonably appealing service to such people. AirTran operates two cabin planes with both business class and coach class. Its planes have 12 business class seats and either 105 (for the 717 planes) or 125 (for the 737-700s) coach class seats.

Southwest intends to take out the business class seating and make it all coach class, and interestingly, Southwest's 737-700s in an all coach class configuration also carry the same 137 passengers, so it isn't as though a switch to all coach class would be compensated by having more seats to sell.

Who wants to guess how many business/frequent travelers will abandon AirTran when it converts to the Southwest model?

Southwest makes the claim about benefitting from $400 million a year in synergies through 'a highly complementary network and fleet commonality'.

Firstly, AirTran has 86 Boeing 717 planes that are not part of a 'fleet commonality'. Southwest has rigidly adhered to a one plane type fleet - the Boeing 737, currently with only the three models 737-300, 737-500 and 737-700 in its fleet. It is exceedingly unlikely it will keep these odd-ball 717s, and will instead have to dispose of them.

Disposing of such a large number of 717s (in total only 155 were produced) will be difficult and may risk the potential to lose money on their disposition. Even the best case scenario shows no synergy or positive outcome from this.

Secondly, route synergy is perhaps a definitional thing, but however you define the concept of route synergy, you're straining the definition to breaking point to see $400 million of value here.

The two airlines currently have little route overlap. And because both carriers offer primarily point to point rather than hub and spoke type networks, adding extra destinations won't be of as much value as it would be for a hub and spoke carrier which is designed to transport people from just about anywhere, via a hub, and on to just about anywhere else.

Hub and spoke carriers derive flow-through benefits across their entire route network for each extra destination. Point to point carriers derive massively much less benefit.

It is traditional for airlines to make empty references to synergy as justifying their mergers. But it is very uncommon to see any real synergy reflected in future bottom line profits.

Just remember Southwest's promise of a $400 million boost to its bottom line from this merger, and look for it in the future. My guess is you won't find it.

Will converting AirTran to Southwest's revenue model allow it to greatly increase the revenue it earns per passenger flown? And/or will the Southwest model (and perhaps some, ahem, synergies!) allow AirTran to increase the loads on its flights and become more profitable that way?

To answer the second question first, AirTran enjoyed an amazing passenger load factor last year of 79.8% - the highest it has ever achieved. Now contrast that with Southwest's lower 76.0% load.

This suggests two things. First, there is almost no effective remaining capacity on AirTran flights at present, so there's no remaining potential to grow revenue by putting more people on flights (it is operationally impossible to run an airline with an average load much higher than 80%).

Second, one could tongue-in-cheek suggest that Southwest should adopt AirTran's policies if it leads to a higher load factor, rather than apply its policies to AirTran.

Does Southwest expect that switching from the AirTrain to the Southwest business model will in some way compensate for the loss of $210 million in pure profit by giving up the luggage and ticket change fees? Let's look at that.

In 2009, Southwest flew passengers an average of 863 miles, and charged them 13.29c per mile flown. AirTran flew passengers an average of 775 miles and charged them 11.24c per mile flown. In other words, AirTran's fares were about 15% cheaper - but don't forget the fees.

If we look at the underlying total revenue per available seat mile (including fees, and adjusted for passenger load factors), Southwest averaged 10.56c per ASM, and AirTran had 10.05c per ASM. The difference in this more important measure of revenue is much less profound.

And wait, that's only half the equation. Southwest's operating costs per ASM were higher than AirTran's. Southwest had a cost of 10.29c compared to AirTran's 9.29c. This means that Southwest's business model was earning it 0.27c/ASM whereas AirTran's model was earning it 0.76c/ASM - nearly three times more per mile flown. No wonder tiny AirTran made more profit than huge Southwest last year.

Re-jigging the AirTran business plan to conform to Southwest's increasingly amorphous business plan does not seem to offer any potential to discover 'hidden' profit and may in fact reduce the profit contribution of AirTran to the new merged entity all the way down to zero, or possibly even worse.

There's another cloud on the horizon. AirTran's agreement with its pilots became amendable in 2005. In 2007 a tentative agreement was reached, but the pilots then refused to accept it, and now the matter is undergoing mediation through the National Mediation Board.

Additionally, its flight attendants are also negotiating for a new agreement. AirTran's agreement with its flight attendants became amendable in 2008.

The resolution of both these issues will almost certainly see an increase in AirTran's labor costs.

AirTran reports that its maintenance costs are expected to increase as its planes age and variously come out of warranty and also start to require more expensive maintenance.

Firstly, Southwest is planning to buy AirTran for 69% more than its current market valuation. If we accept the market capitalization of AirTran as fairly and accurately reflecting its value as a going concern, today, then Southwest is paying two thirds more than it should - nearly $550,000 over the odds - to buy AirTran. That is, to be polite, a bold move on Southwest's part.

Secondly, the changes Southwest plans to make to the AirTran operation threaten to completely zero out AirTran's profitability, while showing no clear scope for compensatory improvements in revenue generation.

If AirTran - as a going concern - is worth somewhere around $850 million, how much less is it worth if a new owner takes away $210 million a year in net revenue from a business that only makes $135 million a year in profit (and that in a good year)?

So what is the huge 'X-factor' we don't clearly see? There seems to be only one possible reason for Southwest's actions.

The one thing missing from the financial analysis so far is Southwest immediately getting a major hub and 'critical mass' in Atlanta. How much might that be worth to Southwest?

The answer to that is unclear, as is also the underlying imperative need to pay so much money to get a 'turnkey' operation dumped in its lap at Atlanta. Obviously there is great value in simultaneously getting a major market presence in ATL and in neutralizing the airline that might have been the more aggressive at competing with Southwest (from the context of having the greatest dependency on ATL as a hub and the lowest costs, allowing for AirTran to very aggressively discount below Southwest's costs if needed).

So does it really boil down to Southwest spending about $1.4 billion to buy a hub in Atlanta that is generating about $1.25 billion a year in gross revenues, and an unknown amount of profit (possibly even a loss)?

This is an amazing thought. If (when) Southwest takes over AirTran's operations, and when it removes AirTran's business class seating, Delta will no longer need to keep a lid on its own business/first class fares for travel from Delta.

At present Delta has undoubtedly been mildly constrained by AirTran's presence in Atlanta, not only in terms of what it can charge for coach fares but also what it can charge for premium fares.

Southwest's assumption of AirTran's flights will more or less continue the pressure on Delta for coach class fares (although note that Southwest has a higher average fare level than AirTran), but it will remove the pressure on Delta that had previously related to premium cabin fares, due to Southwest abandoning the business class model.

It is hard to see anything good coming from this for passengers. Southwest has higher average fares than AirTran, but doesn't offer frequent flier benefits such as upgrades or preassigned seating.

Occasional leisure passengers who tactically buy air tickets only when special deals are offered are unlikely to see much change, or perhaps a mild reduction in specials offered. But people who travel regularly can expect less comfort/convenience.

And those Delta passengers who have been benefitting from AirTran competing with Delta can expect to see Delta's premium cabin fares firm, and if Delta should win some of the people formerly flying in AirTran's business class cabin, the availability of free upgrades will probably diminish too.

Like all airline mergers, there's nothing good in it for us as passengers. And notwithstanding the claims of '$400 million in synergy', there seems little good in it for Southwest Airlines either.

But - what do I know?! Southwest's stock price closed up 8.7% today subsequent to this merger announcement at the beginning of the day.

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