The collapse of the Delta - USAirways merger Feb/Mar 2007

SAirways' proposal to merge with Delta collapsed on 31 January, when Delta’s Creditors Committee formally refused to consider any reorganisation proposal other than management’s 19 December standalone plan. In refusing to fully consider USAirways' offer, Delta’s creditors walked away from their rights under the US bankruptcy laws to leverage the competition between competing bidders to get the highest possible overall compensation.

The USAirways' plan had the advantage of 10% deeper cuts in capacity than Delta’s standalone plan; such capacity cuts have been the primary driver the industry’s improved unit revenue performance. USAirways also hoped to force an additional round of Chapter 11 cost cuts (as they had prior to last years' USAirways- America West merger), and achieve significant merger cost and network optimisation synergies. Since launching the hostile bid for Delta on 15 November, USAirways emphasised that the opportunity for additional chapter 11 restructuring and financing improvements was the key to the deal, and that the scale effects and cost synergies normally associated with "industry consolidation" were secondary factors. USAirways claimed that over half of its estimated savings potential (and thus the entire rationale for the merger) would disappear once Delta emerged from bankruptcy protection.

Merging carriers as large as Delta and USAirways (the third and seventh largest US carriers) would have been a daunting, risky undertaking, especially given the turmoil of recent years, and the still incomplete US–HP integration. Both have serious service issues (US is rated eighth out of the ten major carriers under the DOT’s service quality rankings, while DL is ranked tenth) and there are major differences in management style and corporate culture.

USAirways' initially offered $8.7bn for Delta, and then increased that offer to $10 bn on 11 January, with roughly half to be paid in cash, and half in USAirways stock. Delta claimed its standalone plan would achieve a higher value, between $9.4 and $12bn, but creditors will get no cash under this plan, and Delta’s valuation appears highly dubious. It is not clear why a troubled, bankrupt carrier, without any major changes to its network strategy or competitive positioning, should suddenly become worth more than Southwest Airlines, or worth more than American and Continental combined. A quarter of the value Delta imputed was based on extrapolating recent airline stock price increases (50% appreciation between August and December). USAirways' plan assumed RASM improvements linked to its capacity cuts, but Delta’s valuation assumed normal supply/demand rules would not apply, and claimed RASM gains larger than USAirways had projected, even though they intend to expand capacity 3% per annum.

Delta management and unions ally

The battle between the USAirways and Delta plans was complicated by widely divergent interests among creditors. Current employees and aircraft and trade suppliers want more operations, even when that compromises profits and equity value. Laid off and retired employees, bondholders, and the US taxpayers (who were left with Delta’s cancelled pension obligations) are totally dependent on cash payments and the value of newly issued stock. The Delta plan was clearly tailored towards the interests of the first group, the USAirways plan towards the latter. While there was no doubt that Delta’s current employees would not initially welcome a plan with less flying, USAirways hoped that careful scrutiny of the two plans would focus attention on flaws in Delta’s plan, and that a majority of creditors would support a plan with substantial up–front cash payments over a plan totally dependent on extremely optimistic estimates of fare increases and future stock prices. USAirways' bid was killed by an alliance between Delta management and its pilots union, who cleverly engineered an aggressive PR program built around the claims that a DL–US merger would be horribly anti–competitive, and then used the fear of an extensive antitrust review to railroad through a plan highly favourable to the current employees and trade creditors, without the review/negotiation process that USAirways and the bondholders had hoped for. Delta management, led by CEO Gerald Grinstein, COO Jim Whitehurst and CFO Ed Bastian appeared to view the bidding in personal terms–would they be the people to save Delta, or did the job need to get turned over to Doug Parker of USAirways because they had failed? Although the 74 year old Grinstein had long ago announced plans to step down once Delta was out of bankruptcy, Delta management stood to capture hundreds of millions of dollars worth of stock in the new company, thus had ample incentive to do everything possible to thwart Parker’s bid. The pilots unions is the best organised of all creditors, thus it is not surprising that management’s plan was aligned with their interests, with capacity growth, and less dramatic cuts elsewhere. The major trade creditors (Boeing and Pratt & Whitney were on Delta’s Creditor Committee) have every incentive to support whatever management proposes, and no incentive to fight with the people who might be placing future aircraft orders in order to get a better deal for retirees, bondholders or taxpayers.

To get the creditors to walk away from their rights to scrutinise both plans carefully and conduct a competition between bidders, Delta management needed to convince them that actual implementation of a USAirways merger was wildly improbable, and thus management’s standalone plan was the only realistic option. The creditors' decision, according to press reports, was totally driven by superficial PR claims that cannot survive serious scrutiny. Delta’s PR campaign reached fruition at a 24 January Senate Commerce Committee hearing where Grinstein and Parker testified about USAirways' merger proposal. Grinstein first presented arguments that a DL–US would cause irreparable damage to consumers and competition and could not withstand antitrust scrutiny. Grinstein relied on a methodology developed when the Legacy carriers carried over 95% of US airline passengers and his overall arguments were inconsistent with the stated positions of the Department of Transportation, and the basic antitrust policies of the Bush Administration.

One cannot accept Delta’s argument that DLUS clearly violates the antitrust laws without also immediately accepting that all of the potential between Legacy carriers being discussed would be equally illegal. Other Legacy mergers (such as Delta–Northwest or United–Continental) would involve larger carriers, with more network overlap, and more international routes that have much greater barriers to new competitive entry. To avoid undercutting his "mergers would be bad for consumers" arguments, Grinstein testified that Delta had never explored merger options with Northwest, although later press reports confirmed that such discussions had, in fact, taken place. Grinstein then argued that DL–US would immediately trigger mergers between United, American, Northwest and Continental, leaving DL–US as the weakest player in a highly consolidated industry. While not totally implausible, this claim ignores that the USAirways bid depends totally on chapter 11 restructuring opportunities that would not be available to any future merger, and ignores the fact that three of the four airlines (all but United) have stated that they see no financial basis for pursuing mergers.

The only basis for Grinstein’s claim was the drumbeat of newspaper articles claiming "industry consolidation is inevitable", although the only "merger are inevitable" claimants quoted in these articles were the United Airlines press office and investment bankers salivating over possible deal fees. Congress has no role in merger reviews, and the Commerce Committee was not considering any aviation legislation, but Grinstein then used the subsequent press coverage, which featured several Senator’s aggressive support of the Delta employees opposed to merger, to convince creditors that USAirways' "highly anticompetitive" plan would never be implemented.

Delta’s bondholders and fired/retired employee creditors abandoned efforts to create a bidding war between plans on 31 January, a week after the Senate hearings, and only two days after Delta first assembled a financing plan for its standalone plan. To gain final acceptance, Delta agreed to let the Creditors Committee appoint the members of the new Delta Board of Directors, and limited management’s stock award to 4% of the company (instead of the 8% given to United management, cutting their likely windfall to the $300–400m range). According to the Wall Street Journal, "the committee plans to install people who embrace consolidation as a strategic option and made clear to Delta in recent days that this was a condition of gaining its approval for the airline’s standalone plan". Having railroaded the creditors with claims that a USAirways merger could never be implemented, Grinstein locked–in control of Delta by promising those same creditors that they could pursue a bigger, even more problematic merger.

It is quite possible that Delta’s creditors would have selected a standalone plan, even after a process of careful review and negotiations. But it is difficult to believe that the events of January produced the best result for Delta or their creditors. Delta plans to emerge from chapter 11 in April, only four months after the (very sketchy) first draft of a reorganisation plan was first prepared, and creditors no longer have any leverage to demand improvements. Delta management will owe their control of the company and their multi–million dollar stock awards to the strong support provided by the pilots union, which could quickly create complicate company decision–making. The final verdict on Delta’s plan should be clear by mid–2008 when it will apparent whether Delta is achieving their aggressive unit revenue forecast, and whether the value of Delta’s new stock justified the decision to walk away from the USAirways offer.