Southwest's acquisition of AirTran: What will really happen at Atlanta? October 2010
Southwests planned acquisition of AirTran seems like a smart strategic move for both carriers. But can the worlds leading LCC really generate the famous Southwest effect at Atlanta, where AirTran has already given Delta a run for its money? Will the take–over enable Southwest to resume organic growth?
Southwest, the fourth largest US carrier in terms of system RPMs, announced on September 27 that it had entered into a definitive agreement to acquire AirTran Holdings, the parent company of AirTran Airways, in a $1.4bn cash and stock deal (or $3.4bn including AirTrans net debt and capitalised aircraft leases). AirTran is the eighth largest US carrier, about a quarter of Southwests size; it began life as ValuJet in 1993 and in the past decade has positioned itself as a high–quality LCC with the lowest unit costs in the industry.
The deal has been unanimously approved by the boards of both companies. It is expected to close in the first half of 2011, subject to the approval of AirTran shareholders and regulatory clearances. The deal is not contingent on any union approval.
Under the terms of the agreement, AirTran shareholders will receive a combination of Southwest stock and cash valued between $7.25 and $7.75 per share, depending on the average trading price of Southwest stock in a 20–day period ending three days prior to the closing of the deal. At least $3.75 of it will be in cash. Based on share prices on September 24, the transaction values AirTrans stock at $7.69 (or $1.4bn in the aggregate), representing a premium of 69%. AirTran shareholders would receive around 57m Southwest common shares, or 7% of its total on a proforma basis, as well as $670m in cash.
Law firms scrutinising the transaction on behalf of AirTran shareholders have suggested that the offer may undervalue the company, noting that at least one analyst had a price target for AirTran as high as $11 per share. However, analysts consider alternative bids unlikely. There are normal provisions to deal with superior proposals, including a timeframe for Southwest to respond and a break–up fee of $39m.
This would be a straight acquisition, anticipating the full commercial and operating integration of AirTran into Southwest over a two–year period. AirTran will lose its brand and identity, and its fleet will be transitioned to Southwest logo, colours and configuration. Corporate functions will be consolidated into Southwests Dallas headquarters. The plan is to eventually operate under a single operating certificate.
The deal is significant in that it would be the first combination between major US LCCs, bringing together airlines that generated $11.2bn and $2.5bn revenues in the 12 months ended June 30. It is also a rare move Southwest, which likes to grow organically only its second large acquisition (following Morris Air in 1993).
The acquisition would reinforce Southwests position as the largest US carrier in terms of domestic passengers and its solid number four ranking in terms of system RPMs. With the closing of the UALContinental merger in the same week as the Southwest–AirTran deal was announced, it is amazing to think that US airline industry consolidation has got to the point where there are just four clear leaders: the big three legacies and Southwest.
AirTran will give Southwest some exciting new opportunities in eastern US, especially access to Atlanta — the worlds busiest airport where it has hitherto not been able to establish even a foothold and a modest near–international network. But those opportunities also pose unique challenges for a carrier whose hallmark is simplicity. How will Southwest handle the Atlanta market? When integration is completed, how much will its business model have changed?
Southwest can certainly afford the AirTran acquisition. It plans to fund the $670m cash payment out of cash reserves. As of late September, Southwest had $3.3bn of cash, a fully available $600m unsecured credit line and over $7bn in unencumbered assets (primarily owned 737s). After the AirTran acquisition liquidity would remain very strong, with unrestricted cash exceeding $3bn or 20% of combined 2010 revenues.
Furthermore, there may not be any negative impact on Southwests industry–leading credit profile. While assuming about $983m of balance sheet debt and $1.7bn of capitalised aircraft leases from AirTran, Southwest is sticking to its plans to pay down debt in 2011 and 2012. Fitch has actually affirmed Southwests BBB ratings and stable outlook, though S&P placed the ratings on credit–watch negative.
The deal seems to be universally liked by analysts, because it will enable Southwest to resume growth without acquiring aircraft in the near–term. Many in the financial community feel that risk is minimised by acquiring another successful LCC with similar values and strategies. JP Morgan analysts pondered in a late–September research note that integration challenges were preferable to more capital–intensive outcomes (new planes and organic growth). The verdict of BofA Merrill Lynch analysts was very clear from the heading of their research note: Right price, right time, right target.
The curious thing about the Southwest- AirTran combination is that it has been on the cards for a long time, but the two parties never got together to talk about it until recently. Many analysts have suggested it over the years. AirTrans leadership has frequently gone on record saying that they were open to being acquired. And Southwests CEO Gary Kelly conceded in the investor call on September 27 that it has been a good idea for a long time. Then why did it take so long? Why now?
The first thing to note is that Southwests move has nothing to do with the acceleration The curious thing about the Southwest- AirTran combination is that it has been on the cards for a long time, but the two parties never got together to talk about it until recently. Many analysts have suggested it over the years. AirTrans leadership has frequently gone on record saying that they were open to being acquired. And Southwests CEO Gary Kelly conceded in the investor call on September 27 that it has been a good idea for a long time. Then why did it take so long? Why now? The first thing to note is that Southwests move has nothing to do with the acceleration The curious thing about the Southwest–AirTran combination is that it has been on the cards for a long time, but the two parties never got together to talk about it until recently. Many analysts have suggested it over the years. AirTrans leadership has frequently gone on record saying that they were open to being acquired. And Southwests CEO Gary Kelly conceded in the investor call on September 27 that it has been a good idea for a long time. Then why did it take so long? Why now? The first thing to note is that Southwests move has nothing to do with the acceleration of the legacy–airline consolidation process. It is in no way a response to Delta–Northwest, United–Continental or any of the smaller–carrier mergers or international deals.
The short explanation for the delay given by Kelly: We werent ready. It wasnt the right time for us.
Southwest is fiscally an extremely responsible company. Even though it has earned profits for 37 consecutive years, 2008 and 2009 turned out to be financially rather challenging, in the first place because of the waning of the airlines advantageous fuel hedges and subsequently the recession. As a result, Southwest has had a few extremely busy years trying to find solutions. The numerous projects tackled by the airline have been discussed at depth in Aviation Strategy briefings (see January/February 2008 and April 2009 issues); here is a quick summary.
First, to compensate for the substantial hike in costs after losing the fuel hedge advantage, in mid–2007 Southwest embarked on an all–consuming drive to boost revenues by $2bn–plus annually. It was a major challenge for an airline that had hitherto focused mainly on keeping costs low. The effort has been highly successful, leading to lucrative new ancillary revenue streams, refinements to the business model and new products aimed at attracting more business traffic.
Second, there has been a major drive to get the technology and systems in place to support the new revenue activities another formidable challenge because Southwest was built on simplicity and had some serious catching up to do on the technological front.
Third, after reporting its first quarterly net losses in memory in late 2008, Southwest suspended ASM growth and began to defer aircraft deliveries another first for the carrier. Contrary to large LCCs in other world regions, which continued growing through the recession, Southwests total capacity fell by 5.1% in 2009 and by another 3.3% in first–half 2010.
Fourth, to enhance the profitability of its network and maintain staff morale, Southwest embarked on a network optimisation drive. This meant eliminating flights in less profitable markets, while venturing into high–profile new cities, including Minneapolis, New York LaGuardia and Boston Logan in 2009.
With all of that to manage, and given Southwests conservative nature, it was hardly surprising that the airline did not want to take on a major merger or acquisition. That said, in the summer of 2009 Southwest did seek to buy another LCC, Frontier, through the Denver–based carriers bankruptcy auction process. The deal made much sense but was scuppered by Southwest pilots refusal to endorse it.
But the environment is now very different. In the past 12 months or so, Southwest has led the industry in demand, yield and profit margin recovery. In this years June quarter its operating margin was an excellent 13%. With continued extremely modest capital spending, Southwest should continue to grow its cash flow and reduce debt in 2011. CFO Laura Wright noted: This puts us in an excellent position to structure a transaction in a manner that preserves our strong balance sheet but which also allows an opportunity to provide superior returns on the investment to our shareholders.
Kelly noted that since Southwest is currently not growing its route system organically, now is an opportune time to manage a major acquisition. Furthermore, Southwest is now more confident in its capabilities on the revenue side. Since the merger may not produce any net cost savings, it all hinges on whether we can make the networks work.
What AirTran offers
Southwest wants AirTran for the profitable growth opportunity that it offers. Southwests growth opportunities have diminished as its network has grown nationwide. It has also been unable to access some major markets or build up frequencies due to unavailability of slots. It is indicative that Southwest is now seriously considering converting some of its 737–700 orders to the larger 737–800 (an option that it has always had) to help it grow at slot–restricted airports.
The growth opportunity through AirTran arises because the networks are complementary. AirTran would give Southwest 30 new destinations. Although the two overlap on 20 nonstop routes, which is more than United–Continentals 14 and Delta- Northwests 12 (JP Morgan figures), there is significant overlap at only two airports: Baltimore/Washington and, to a lesser extent, Orlando. The consensus among analysts and industry observers is that, given the lack of competitive constraints at those two airports and Southwests pro–consumer reputation, there are not likely to be any DoJ–mandated divestitures.
But the most important reason Southwest is acquiring AirTran is that it offers access to Atlanta, the largest US city Southwest does not serve. AirTran is the second largest carrier at Atlanta, with a 22% market share (compared to Deltas 62%) and a sizeable hub operation covering 57 cities. CEO Kelly likens Atlanta to the big pools of growth opportunities that Southwest had in the 1990s (particularly California), as well as the Chicago and Denver opportunities in the last decade. In terms of us filling our network gap, the major market that we dont touch domestically that our business customers particularly want is Atlanta. So this is clearly a strategic move for us to fill that gap.
Southwest will also gain improved access to the three most important Northeast business markets: New York, Boston and Washington. It will gain more slots at LaGuardia and Boston Logan and, for the first time, be able to operate to Washington Reagan.
Southwest will also gain access to many smaller domestic cities that it does not serve today (because it is primarily a point to- point carrier). Southwest executives commented: That will also fit in very well with our desire to continue growing our route map domestically.
And, significantly, Southwest will gain access to key near–international leisure markets in the Caribbean and Mexico, accelerating its own plans to go international. AirTran operates at least weekly, and in some cases daily, scheduled flights from Atlanta, Orlando and Baltimore/Washington to Aruba, Cancun, Montego Bay, San Juan, Nassau and (from February 2011) Punta Cana.
Southwest has long contemplated near international service. Codesharing on WestJet flights to Canada and on Volaris flights to Mexico was supposed to be the first step in the process, with own–account international operations following after a few years. But the WestJet deal fell through last year (after the Canadian carrier forged a similar relationship with Delta), and the Volaris deal has been delayed by Southwests struggles to upgrade its reservations technology to handle international code–shares (now expected to be implemented in 2011).
Kelly confirmed in the late–September investor call that Southwest has taken the decision to replace its reservations technology and has narrowed the search down to two systems. That will bring the necessary capability, at least on the commercial side, to offer international service. In the meantime, Southwest would keep AirTrans international service and learn from it, before eventually moving those operations under its own roof when it has the capability. While additional international expansion is probably several years away, one thing is clear: long–haul expansion to Europe is not on the cards; the furthest place that Southwest is likely to go is South America.
The AirTran acquisition would contribute to the gradual eastward march that Southwest began more than a decade ago, after its 1990s growth spurt in California. It would result in an approximate eight percentage- point decline in the Wests share of seats offered and a corresponding increase in the Easts share of seats. Specifically, the West coast and Southwest regions would account for about half of the combinations total seats (51.4%, compared to 59.7% previously), while the Eastern half of the country would account for about a third of the seats (32.7%, up from 25.1%). Midwests share would remain roughly unchanged at 15–16%. International and Puerto Rico would account for 0.2% of the seats.
The two airlines fleets are compatible in that they include only Boeing aircraft and large numbers of 737–700s. However, AirTran does bring in a different fleet type, the 717–200, and in significant numbers too (86). Although Gary Kelly sportily described the 717 as very cost–effective and an airplane that we think we can manage well, it will be interesting to see if Southwest could actually get rid of the type, and if not, how it would operate the 717 and what the impact on costs would be.
Importantly, like Southwest, AirTran is a high–quality, low–cost operation with a very solid low–fare brand. Both have employee–centric cultures and dedicated workers with kindred warrior spirits who care about serving customers. AirTran is a profitable operation, though its margins have been lower and much more variable than Southwests.
But there are some differences. AirTran uses a hybrid hub–and–spoke network, whereas Southwest is point–to–point. AirTran is actually much more upmarket: it offers two classes and advance seat selection, contrasting with Southwests very basic approach (even after the past two years new product offerings). AirTran sells through GDSs, Southwest does not.
Synergies and dis-synergies
Southwest expects the AirTran acquisition to produce at least $400m of net annual synergies by 2013. This would be about 3% of the $13.7bn combined annual revenues in the 12 months to June 30 in line with other recent airline combinations. One–time costs related to the acquisition and integration, to be incurred from close to 2013, are projected to be $300–500m.
The synergies will be driven mainly by the expanded and diversified network. The stronger joint network will facilitate hundreds of new itineraries to the combinations 100m–plus existing customers. There would be incremental revenue from new Atlanta markets. The increased customer base would support the addition of brand new destinations. The combined company would have a more powerful FFP, providing a significant revenue opportunity (strengthening the new FFP that Southwest is scheduled to launch next year). And Southwest believes that, as the networks are combined, it will be able to capitalise on joint marketing, its schedule optimisation and revenue management capabilities, its BusinessSelect and EarlyBird products and, of course, its popular Bags Fly Free programme.
Interestingly, Southwest is counting on producing the famous Southwest effect at Atlanta, even though it is replacing an existing low–fare carrier there. A study by Campbell–Hill Aviation Group, which was retained by Southwest to evaluate the consumer benefits of the transaction, found that more expansive low–fare service at Atlanta alone has the potential to stimulate over two million new passengers and $200m–plus in consumer savings annually.
On the cost side, there are potential savings in advertising and distribution, facilities, corporate overheads, duplicative information technology, scale efficiencies and reduced financing rates thanks to the larger scale. The cost synergies are expected to substantially offset the dis–synergies of the deal, principally higher labour costs.
S&P noted in a late–September communiqué that Southwests labour costs are among the highest in the industry for the 737s it flies, while AirTrans are among the lowest. When two merging airlines have different levels of compensation, the pattern has been for the lower–paid employees compensation to rise to match that of the airline with higher pay. The rating agency considered the labour dis–synergies to be the greatest risk in this merger.
BofA Merrill Lynch estimated that AirTrans wage rates are 30% below Southwests, which would imply more than $150m of labour dis–synergies. Southwest has not released its own estimate, though it is apparently included in the $400m net synergy figure. In other words, the anticipated revenue synergies dwarf the cost issues.
CFO Laura Wright stated that the AirTran transaction should allow Southwest to meet its overall ROI and profitability targets sooner. The value created for shareholders fully supports the significant premium to be paid to AirTran shareholders. When the $400m net synergies are fully realised, Southwest expects to exceed its 15% pretax return on invested capital target and produce a healthy return on equity of over 20%. Including the net synergies but excluding one–time costs, the deal is expected to be accretive to Southwests pro–forma EPS in year one and strongly accretive in subsequent years.
Southwest is embarking on a challenging undertaking, but it is not new to mergers and its recent track record of moving very slowly and methodically with difficult projects to ensure a successful outcome gives much cause for optimism. With the AirTran deal, there are integration risks essentially in two areas.
First, technology integration, which has caused problems in many airline mergers, is a particular concern given Southwests difficulties in that area in recent years and because Southwest plans to move to an entirely new reservations platform in the middle of the AirTran integration.
Second, as Fitch put it, labour force integration is always a wild card in airline combinations. While the AirTran deal is not contingent on any union approval, successful integration will not be possible if labour does not cooperate or if there are serious disputes. Integration of pilot seniority lists, which affects future pay, promotions and flying assignments and has to be determined by the two pilot groups, is typically the toughest issue — it has still not been achieved at US Airways following its 2005 merger with AWA.
In this deal one potential problem is that Southwests pilots are more senior than AirTrans, because Southwest has a longer operating history. If the unions merge the lists on the strict order of seniority, AirTrans pilots would find themselves at the bottom of the list, which would probably cause a lot of friction. Southwests management hopes that the pilots will find a fair and equitable way of merging their seniority lists.
Southwests pilots have adopted very hard line positions in the past. Their insistence of putting Frontier pilots at the bottom of the list helped scuttle that deal last year. In their initial statement on the AirTran acquisition, the pilots said that no stone will be left unturned to protect SWAPA pilots interests.
On the positive side, the potential growth opportunity associated with this deal may reduce the stakes of seniority integration. AirTrans pilots can also look forward to much higher pay, greater job security and a better relationship with their management.
Even though Southwest will be happy to continue operating the 717–200s, which are well suited to AirTrans smaller markets, it really does not need another aircraft type. All but six of the 86 717s are leased, which makes it harder to manage changes to the fleet. But Southwest is likely to have already approached Boeing Capital about potential solutions such as early termination of leases.
If Southwest has to continue operating the 717s, it has already said that it would not want to cross–train crews and have them switching back and forth between the 717s and 737s. The 717s would probably be fenced off within the network until the leases expire or agreement is reached with Boeing on their transition. Southwest may also seek lease rate reductions, given its stronger balance sheet and credit profile.
Some analysts have suggested that Southwest might delay any plans to switch to the larger 189–seat 737–800s, given the added complexity of the 717s. But Kelly refuted such ideas, saying that the two types are not mutually exclusive but complementary and that the 737–800 might fit in well in Southwests broader strategy for the next decade. Kelly stated: In my opinion, we have a better fleet plan going forward contemplating the 737–800 as a component. It can be more cost–effective on current routes. Clearly well have more growth opportunities if we can bring the -800 to the property. There are just some routes that we wont fly if we dont have the -800.
Southwest was previously expected to decide on the 737–800 by year–end. It recently won approval from its flight attendants to add the type, though it is still discussing the plans with its pilots.
What will happen at Atlanta?
Southwest has made it very clear that Atlanta is where the big numbers are. Kelly stated: It is about bringing more competition, bringing more low fares. We see a number of city–pair opportunities to go in with lower fares and stimulate traffic in classic Southwest fashion. Kelly also reminded that Southwest likes markets that are overpriced, and the icing on the cake is if they are also under–served. It would be a reversal of the retrenchment that AirTran has been on in the last few years at Atlanta.
But some industry observers have questioned if Southwest can really stimulate traffic at a hub that has already been a battleground between a legacy and an LCC for more than a decade.
A study released on October 4 by Boyd Group International suggested that Southwest is likely to have a material effect in only two of the top 25 O&D Atlanta markets: Salt Lake City and Newark. Southwest is replacing an existing low–fare airline, not introducing low fares to Atlanta. The report called ridiculous projections of hundreds more flights per week or hundreds of millions in fare savings, pointing out that the major demand markets at Atlanta are already stimulated and that every local O&D market at Atlanta is wildly over–served.
The Boyd report made the point that AirTrans Atlanta flights depend on flow traffic for around two thirds of the passengers. Southwest too depends on flow traffic at many locations these days; at Chicago Midway, 43% of its passengers are not local O&D. Nevertheless, the report argued, more reliance on banking schedules will be critical at Atlanta. The extent to which Southwest will need to stimulate Atlanta as a hub goes far beyond anything it has done in this regard before.
It is not at all clear what the impact on Delta might be. Some analysts have downgraded Delta merely on the basis that it will face a tougher LCC competitor at its main hub, but others believe that Delta is not uniquely threatened. JP Morgan analysts are in the latter camp, noting that Southwest is probably a more rational competitor than AirTran (because it has higher costs and is more profit–oriented) and that the 37 cities unique to Southwest (which it could link to Atlanta) represent less than 1% of Deltas system revenue.
The Boyd report noted that Delta has succeeded in Atlanta in all three counts that matter: carrying more flow traffic than AirTran, maintaining a strong yield premium, and maintaining high load factors. There are no indications that this situation will change when Southwests Red Bellied Warriors pull up to the gate.
But Atlanta may one day make an interesting case study of airline brand loyalty. On the one hand, Delta may gain business traffic if AirTrans passengers do not like Southwests open–seating policy and more basic product. On the other hand, Southwests Bags Fly Free policy may prove so popular that Delta will have to reverse its strategy for competitive reasons and lose a major revenue stream. With such considerations in mind, Southwests executives have stressed that they want to use the integration as an opportunity to learn from AirTran and are not ruling out future changes to the brand.
The transaction is widely regarded as a near–term positive for the US airline industry. By eliminating the lowest–cost, lowest yield producer, it is likely to enhance capacity and pricing discipline. Of course, the longer–term implications are less favourable since the acquisition is likely to encourage Southwest to start growing its fleet again.