Friday, April 18, 2008

Issues With The Delta-Northwest Merger - Part 2

There is one critical question that no one is asking about the Delta-Northwest merger: “If the reasons for the merger are to have the financial strength to survive the high fuel environment and reallocate airplanes to higher-profit, international routes, then is the merger necessary?”

I think if they earnestly asked this question, then they would realize that the Delta-Northwest merger might not make them as profitable as they had hoped. Here’s why:

1. Northwest had $3 billion in cash and cash equivalent and Delta had $2.8 billion as at December 2007. If they thought that they didn’t have sufficient financial strength alone, then what makes them think that by combining their two companies together that they will automatically achieve it? It is analogous to stating that 1 + 1 equals 3. That corporate-speak of financial ‘synergies’ does not exist as they will have additional cost of legal and PR expenses on top of their existing cost structure. This will result in a faster depletion of their combined cash position.

According to Delta’s 2007 annual report, page F-12, Delta spent $237 million in professional fees with their bankruptcy filing. So, given that the merger will be less complicated than a bankruptcy but still a costly proposition, one can assume that they will incur about half of this, or $118.5 million in professional fees fro the merger. Add in 10% margin of error and duplicate this cost for Northwest, we arrive at an immediate hit to the new Delta’s financial reserve of approximately $261 million.

2. Delta-Northwest plan for growing revenue is to reallocate airplanes to more profitable international routes. They also plan on keeping all their current hubs and maintain as much of the routes as possible, less the routes that they will have to give up per the antitrust ruling. To achieve this, they will have to buy or lease new equipment to effectively compete in the more profitable international routes against foreign carriers that fly newer airplanes. The reason is that Northwest’s fleet is the oldest at an average age of 18.5 years and Delta is not too far behind at an average age of 13.8 years. If they try to expand internationally using older equipment, it will be a failed effort.

Purchasing new airplanes for international routes will mean more cash layout. But wait; there is a long wait list for new airplanes as both Boeing and Airbus have multi-year backlogs, according to the Star Tribune report:

“The two principal manufacturers used by Delta and Northwest -- Boeing and Airbus -- are booked with orders for several years. There's a four- to five-year backlog for the Boeing 777, a wide-body fairly new to the Delta fleet, Hamilton said. Airbus is back-ordered until 2012. Northwest is scheduled to be the first U.S. carrier to get the widely anticipated Boeing 787 Dreamliner, but Boeing repeatedly has pushed back the delivery time, now into 2009.”

Leasing new equipment is also going to be difficult as the leasing companies have most of the equipments already leased. So, any immediate growth in international flights will be small and incremental as they are only able to replace the older airplanes at a snail’s pace.

3. All airline companies have code-sharing partner that allows them to book a passenger end to end, even internationally. This allows the carrier to advertise fares for routes that they cannot fly directly and earn revenue for booking the passenger without actually having to incur the cost of flying the passenger. Both Northwest and Delta already have worldwide code-sharing partners called the “SkyTeam.” So through the SkyTeam, they are able to achieve an international presence by proxy, which allows them to generate revenue.

4. Delta and Northwest are staking their profitability on flying more international routes. However, obtaining the necessary authority from the FAA and the destination country for some international routes is a complex and long process.

5. With the EU-US Open Skies Agreement, effective as of March 2008, competition on routes between the U.S. and the European Union will be real, as it permits any carriers on both side of the ocean to fly directly. This means that any low-fare EU carrier, such as RyanAir, can offer flights between EU and the U.S. and undercut major airline companies; a throwback to Sir Freddy Laker’s “Sky Train”, the original low fare airline. This will reduce any cost advantage Delta-Northwest was counting on to generate additional revenue.

6. Finally, even if Delta-Northwest wants to expand their international routes to serve more cities, there is the problem of capacity as many airports have limited gate slots available. No gate access, no flight.

So the two reasons Delta raised for the merger of (1) financial strength to survive the high fuel environment and (2) reallocate airplanes to higher-profit, international routes, seems to all smoke and mirrors.

I think American Airline chairman and chief executive Gerard Arpey is correct in his assessment that the challenge facing the airline industry is “being profitable” regardless of size and that while consolidation may be one way to achieve profitability; it is simply one of the ways.

So far, Delta-Northwest has failed to clearly demonstrate that their proposed merger will result in a profitable carrier. What they have clearly demonstrated is a lack of strategic vision to profitability, a clear enterprise risk. Given the challenging times faced by the airline industry, it is strategic vision that is sorely needed now.

Ed Kim

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