Wednesday, April 16, 2008

Why The Delta-Northwest Merger Doesn't Make Financial Sense

According to MarketWatch, Delta is projecting approximately $1 billion in cost savings by reducing overhead and improving cost-overhead structure, particularly through the use of better leverage its purchase of bulk items, such as fuel. Further, Ed Bastian, Delta’s CFO is quoted as expecting the synergies to be achieved by 2012.

I think the market didn’t believe the cost savings projections, and neither do I. Here are the reasons why I think the merger makes no financial sense, even if it does happen.

No Cost Savings Realized
Fortune was prescient in its reporting by writing that the merger will not result in any cost savings.

“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.”

As soon as this merger occurs, expect a flurry of mergers to occur. Already there are stories of potential United and Continental merger. This makes better sense than the Delta-Northwest merger as United and Continental fly similar equipments (see chart) and their routes (United here, and Continental, here) do not overlap as much as Delta-Northwest. Moreover, United and Continental have sufficient international presence to be competitive with the new Delta.

Different Configuration Of Equipment
Further, Delta and Northwest are flying different airplane configurations. Delta is exclusively Boeing while Northwest is predominately Airbus. This means that they will have to retain all of the pilots and maintenance crew. No cost savings here. In fact, there may be additional cost with the merger, as they will have to replace older airplanes, especially the 94 DC-9s flown by Northwest. If the new Delta replaces the 94 DC-9 with either the B737 or A320, they are looking at approximately $50 million per airplane, or approximately $4.7 billion over the next 3 to 5 years.

Overlapping Route Will Cause Labor Problems And Added Costs

In order for the merger to pass the Department of Justice antitrust review, Delta-Northwest must demonstrate that they are able to relinquish some of the overlapping routes to other carriers.

However, any reduction in routes – major routes such as NY and Atlanta and Detroit and Atlanta – or reduction in number of flights in and out of the Cincinnati hub will be difficult, as any reduction in routes or flights will mean negotiation with various unions, including the pilots, mechanics, baggage handlers, and flight attendants. Any successful negotiation will result in major concessions to the various unions, which will result in immediate cost to the new Delta.

Example of the route overlaps between Delta and Northwest

Flights Between NY and Atlanta:
Delta has 40 flights daily from Newark (EWR) to Atlanta (ATL) using Boeing on nearly all of its flights. In total, Delta has 98 flights daily out of the three NY airports (22 flights daily from JFK, 36 flights daily from LaGuardia (LGA), and 40 flights daily from EWR). Northwest has 22 flights daily from Newark to Atlanta using only Airbus on its flights (it only has 2 flights to Atlanta from LGA).

Flights between Detroit and Atlanta:
Northwest has 14 flights daily from Detroit to Atlanta using Airbus on 29 of its flights and DC-9 on 5 of its flights
Delta has 34 flights from Detroit to Atlanta using their Delta Connection Partners of 28 of its flights and MD-88 and MD-90 on eight (8) of its flights

Resistance From Legislators
Both Delta and Northwest have over 100 flights in and out of the Cincinnati hub. According to a 2006 USAToday report, Cincinnati is Delta’s second-largest hub and is a major contributor to the area’s economy:
”…it [Delta] employs more than 7,000 in conjunction with its locally based subsidiary, Comair. One estimate of the airport's overall economic impact on the region last year was pegged at $4.5 billion a year. That was before Delta cut about 26% of its flying and began reducing about 1,650 jobs for both at Delta and Comair — but those cuts were expected to take only $400 million plus out of the regional economy.”

How will the merger play out in the case of Cincinnati hub? If the Justice Department sees a near monopoly of the Cincinnati airport by the new Delta (and it will) and orders it to drastically reduce its gate holding and give up routes (highly likely), one can see a major battle here as the two states, Ohio and Kentucky, fight to keep the merger from happening to reduce the probability of Delta taking more money out of the local economy. Again, no cost savings here as the legal and PR costs will eat into any projected gains from the ‘synergies’ touted by Delta.

CNNMoney reports “[Minnesota] state lawmakers were searching for ways Tuesday to prevent a Delta-Northwest combination that would leave Minnesota without a major airline headquarters.” The Minnesota state government could use their agreement with Northwest to force Delta into making “quicker repayment of $245 million in outstanding loans and cancel $200 million worth of lease breaks over the next 20 years.” Again, no savings here if Delta has to pay upfront to settle the broken agreement. Add in the legal and PR costs, again, the new Delta could be looking at another $300 to $350 million hole.

Based on the facts, I cannot fathom where the Delta CEO and CFO are able to pull $1 billion in savings by 2012 out of the merger or reach $4 billion in free cash flow, sometime between 2009 and 2011. With the news of this merger, there are going to be other mergers ready to be done, waiting in the pipeline for the antitrust review to be completed. As soon as this merger is done, look for United and Continental to merge, which will force American Air and USAir to look to merge as well. Perhaps, by the time merger mania is over, we will end up with one national airline:

Ed Kim

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1 comment:

Lee Baker said...

You drastically overstated the number of flights between various cities. I didn't check all of the numbers, but all them look high. The first one I checked, for example, Delta's routes from Newark to Atlanta, you list as 40 flights daily. In actuality, it's 10 (if you count their regional partner). I think the confusion comes in reading the timetables. Most entries have a beginning and ending date, allowing for slight changes in times.