It’s been quite some time since the Cardinal graced us with his presence, but today he’s back to fight the “American will merge” rumors. I agree with what he says here completely.
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A lot of silly things are being said in the wake of the announced takeover of AirTran by Southwest. For instance, there’s renewed speculation about what American needs to do. Here’s a Reuter’s article as an example.

The article mentions potential merger partners for American: Alaska, JetBlue and US Airways.

This speculation is almost certainly useless. So long as American’s management remains remotely sane and rational, American won’t be merging with anyone anytime soon.

The reasons are simple: (1) American’s stock is too beaten down and (2), American’s costs are too high.

Market Caps
Let’s look at some market capitalizations. A company’s market cap is the value of its outstanding equity (the price of its stock times the number of shares outstanding). It’s the theoretical amount you would need to pay to buy 100% of the company. It’s theoretical because, in fact, to actually acquire the company generally requires paying a takeover premium (otherwise the company’s management is likely to make it hard for its company to be taken over).

The following amounts are in $ billions.

2.1 American (AMR)
1.8 Alaska (ALK)
1.9 JetBlue (JBLU)
1.5 US Airways (LCC)

It’s readily apparent that factoring in a takeover premium on any of Alaska, JetBlue or US Airways would mean that AMR would have to fork over around 50% (or maybe even more) of its equity to any acquire any of these airlines.

American, of course, is vastly larger than any of these three potential partners. So why is American’s market cap only marginally larger?

Good Guys Finish Last
The issue is that American is not making much, if any money. It’s a huge enterprise, but it’s basically breakeven at best at the moment. Ironically, this is because American and Continental were the only two legacy major airlines not to completely screw over their shareholders after 9/11 by going bankrupt. Delta, Northwest, United and US Airways (twice!) went through the bankruptcy carwash after 9/11, which enabled them to crush costs, including labor and aircraft finance costs, at the cost of destroying all shareholder value. American did the right thing by its shareholders and, by the skin of its teeth, avoided bankruptcy. This preserved value for shareholders, but it meant American has had a much tougher time reducing costs. While Continental did not go bankrupt post 9/11, it was the beneficiary of two prior bankruptcies in the 1980s and 1990s. American stands alone as the only legacy major to never screw its shareholders in this fashion, but it has left it in a very poor cost position. Ironically, because the other legacy majors did destroy all shareholder value in the past, they are now in a much better position today. In this regard, at least, good guys finish last.

In fact, American’s cost position handicaps its merger prospects twice over. First, its market cap is beaten down, so its stock is a weak currency with which to purchase another company. But secondly, because American is so big relative to any of its potential targets, were American to take over another airline, American’s costs would be more-or-less instantly imposed on the operations of the other airline. So, for instance, if American were to take over US Airways (which has significantly lower costs) American’s labor scales would essentially immediately apply to US Airways employees (this is actually more or less a direct consequence of US government labor law, so essentially just a fact of life). Blam! US Airways’ routes would instantly become less profitable.

In other words, the minute that American took over one of these carriers, its higher costs would instantly destroy a lot of the value for which American just paid. That 50% that American just paid would be buying much less that you might initially think.

(This discussion has implicitly assumed American uses stock to purchase a target. If it used cash, that would be even worse, because American would pay hard dollars for value that would then be destroyed — if it used stock, at least it wouldn’t have increased its net debt uselessly, “only” destroyed shareholder value).

For this reason, unless AMR management completely loses its senses, AMR will not do a merger for the foreseeable future. As far as Mergers and Acquisitions are concerned, American is in a box. It can’t do a merger without throwing away a lot of shareholder value.

This is why you see American doing things like entering into partnership agreements with JetBlue. It’s not necessarily American’s usual mode, but it’s one of the few things they can do these days. They need to make nice because they have few reasonable alternatives.

Stuck In A Box, For Now
So can American get out of this box? In some ways, it’s not up to them. Except in times of distress, airline costs tend to increase, especially at the legacy majors. So, if American can hold the line on costs, the other legacy major airline costs are likely to get relatively worse than those of American. It’s not a real great place to be in, waiting for your competitors to suck more so that you relatively suck less. And there’s a serious snag: American’s employees are furious about their lack of wage increases and desperately want to force American into paying them more. Pilots, flight attendants and mechanics all want a pound of flesh (and then some) from American. They’re each willing to strike American to get what they want — and like other legacy major airlines, American can’t long tolerate a strike without going into bankruptcy.

That’s the other way American could get out of its box — declare bankruptcy. But that would almost certainly completely destroy shareholder value, and since the airline is, at least ostensibly, run in the interests of the shareholders, American can’t do that while reasonable alternatives remain. So American can’t exactly choose bankruptcy either.

So, for now, it’s highly unlikely that American can do anything to get itself out of it’s mergers and acquisitions box, and any speculation about that is, at best, ill-informed.

But Not Dead
Don’t misunderstand — American’s situation is hardly desperate, it’s just not good. It’s not in danger of bankruptcy any time soon (unless its unions do something stupid, and that cannot be ruled out, unfortunately). It’s still a powerful competitor, the third largest airline in the US. It still “owns” Dallas and Miami and has a big chunk of Chicago and New York. It’s finally got approval for anti-trust immunity with British Airways, which will help on the margin. American’s just stuck for now on the M&A front. Moreover, so long as its profits remain largely ephemeral, there’s no good case for organic growth either.

So, for now, unless something big changes in the environment (or American’s management loses its sanity), expect American to be largely stuck for the foreseeable future. For now, all they can do is try to improve their cost position relative to the industry. Tough sledding, but no one said this was an easy business.

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The Cardinal is a long-time industry observer, who is currently [redacted]. He was previously a [redacted] at [redacted]. Prior to this he worked at [redacted], [redacted] and [redacted]. To his sorrow, he lives in [redacted] and in his spare time enjoys [redacted with extreme prejudice].

I’ve seen countless articles/posts/interviews talking about how the Southwest/AirTran merger is going to be terrible for every other airline out there. The newly-created behemoth will dominate and crush everyone around. Seriously? Don’t believe conventional wisdom here. This merger is actually good news for most airlines. And one of the biggest winners might be Frontier.

For Frontier, there are a couple of things that should help relieve some pressure in both its hubs. We can start with the most obvious place for gains to be made, Milwaukee. Frontier, Southwest, and AirTran have been in a royal rumble in Milwaukee for awhile now. There isn’t enough room for the three of them, but nobody wants to blink first. Now, there will only be two airlines and rationalization of the network can’t be far behind. Here’s a fancy-pants Venn diagram showing where things stand today:

Southwest and AirTran only overlap on four routes out of Milwaukee (three of which Frontier flies as well), but on those, capacity will likely come down and that can only help the situation. But that’s only part of it. There are another five or six cities that AirTran and Frontier both serve from Milwaukee that I expect will only be served by Frontier in the future.

Right now, AirTran has a deal with SkyWest to fly regional flights in Milwaukee. There is no way that deal is surviving the merger, so my guess is service to those cities will quietly disappear. Maybe we’ll see one or two stay on with larger aircraft (St Louis?), but the rest will probably go away.

Lastly, there’s DFW. Southwest will not serve DFW when the merger is complete, so the current flight from Milwaukee will go away. Maybe it will eventually be served from Dallas/Love, but that won’t be legal until 2014.

So in Milwaukee, things should start to look better. And then there’s Denver.

Frontier and Southwest are competing in Denver, but AirTran has only a token presence. Why is that a good thing? Distraction. Much of Southwest’s growth has been focused on Denver, and now Southwest will be busy bringing AirTran into the fold. I don’t expect we’ll see nearly the focus on Denver as we’ve seen before.

That’s bound to be good for Frontier. (And yes, United’s distraction from its Continental merger will help there as well.) But Frontier isn’t the only beneficiary. Sure, distraction can help everyone except for Delta, which will be the focus of the distraction at its Atlanta home base. But what’s the chance that Southwest continues to serve all those smaller cities from Atlanta that AirTran serves today? Delta might end up with more frequency to compete against on big routes but competition might disappear completely on smaller routes. And that’s where legacy carriers enjoy the highest fares.

Oh, and what’s the chance that AirTran’s challenge to Allegiant in Orlando with sub-daily flights sticks around? I’d be surprised to see Southwest stick with that strategy. Spirit will probably be happy as well assuming that Southwest’s higher costs make it easier to Spirit to compete in the Caribbean. In other words, there are potential opportunities for just about everyone here, even Delta.

I like to try and ease into the work week, but Southwest rudely prevented that from happening by announcing the airline would acquire AirTran bright and early yesterday morning. But that’s ok. I forgive them. This is a really interesting move for the airline, so it’s worth shifting into overdrive here. I put a post up yesterday on BNET about what’s good about this (I have another going live today on what’s bad), but here I want to talk what it means for you, the customer. Unlike the United/Continental so-called “merger of equals,” this one is all Southwest. Also unlike that merger, we actually know a fair bit about how the post-merger Southwest will look, surprisingly. So, here’s what we know.

Southwest Rules, AirTran Drools
Make no mistake here. Southwest is the acquiring airline and AirTran’s name and brand will disappear completely. Headquarters will be at the Southwest campus in Dallas. I can’t say I’m sad to hear that. AirTran’s legroom on the 717s are so awful that I try to avoid them despite the fact that I love my Douglas jets. I’ve also found some of AirTran’s customer service policies to be more along the lines of customer disservice and I look forward to those dying as well.

You can use that basic plan as your general guide on what stays and what goes in the combined airline, but that doesn’t mean everything AirTran does is bad and will go. No, Southwest will find what it likes and keep it. I’m just not sure what that might be.

No Fees, No Change
Though Southwest will always want to hedge its bets by saying that things could change in the future, we can expect the bulk of the Southwest product to remain. In fact, CEO Gary Kelly gave some examples:

• No change fees (AirTran charges $75 today)
• No bag fees (AirTran currently charges $20 for the first and $25 for the second)
• All coach class (AirTran currently has a business class cabin)
• Open seating (AirTran lets you pay extra for a seat assignment today)

Southwest Will Fly Douglas Jets
For the first time (if you exclude the Muse Air acquisition years ago), Southwest will operate some good ole’ Douglas jets. Ok, so they’re actually Boeing 717s, a design Boeing continued when it bought McDonnell Douglas back in the 1990s, and AirTran has 86 of them. Southwest has confirmed that it will keep the planes. Today, they’re configured with 12 business class seats and 105 knee-crunching coach seats. Southwest expects to still have 117 seats onboard but without business class. That means your knees will also be free to roam about the country along with the rest of you.

This will complement Southwest’s fleet of 25 737-500s which today seat 122 people. The capacity on those is close enough that Southwest will be able to schedule them similarly, I would assume. You can also expect to see Southwest’s massive fleet of 737s seating 137 people grow by about 50 planes when AirTran’s 737s get painted. But there will also be this new opportunity of a 100+ strong fleet of airplanes with 20 fewer seats. That can be used to serve smaller markets.

No Route Decisions Except That DFW is Toast
As you would expect, it’s way too early for the airline to be announcing route decisions but there is one that has already been made. When the merger is complete, Southwest will not serve DFW because under its Wright Amendment settlement, it says it won’t serve the airport. Today, AirTran serves Atlanta six times daily, Milwaukee twice daily, and Orlando once a day. Those will disappear, but they could come back from Dallas/Love in 2014 when the Wright Amendment is lifted.

Some have talked about how Southwest is a point-to-point airline while AirTran is a hub-and-spoke airline, but I disagree. Look at some of Southwest’s bigger cities and they look a lot like a hub to me. In fact, CEO Gary Kelly said “We don’t see Atlanta developing for us any different than the way we operate Chicago Midway.”

Where I do expect to see change is on the small city side. Yes, the 717s will help serve smaller cities that Southwest can’t serve today, but a lot of AirTran’s business is short term incentive deals that I’m not a fan of. Southwest clearly isn’t against airport incentives, as it showed when it went into the Florida panhandle, but I can’t imagine it’s going to be as interested in most of the incentive opportunities since very few of these turn into sustainable opportunities. While AirTran is happy going in and out of markets on a whim, Southwest wants to build sustainability.

We also know that we’ll see Southwest’s airplanes finally land at places like Washington/National, Charlotte, Memphis, Des Moines, and Wichita, places that have been rumored for years. And there will be the ability go international now as well. Lots of opportunities are opened up with this deal, but I expect lots of doors will be closed on the smallest cities in the network.

But beyond city selection, there will be big schedule changes as well. I think this chart sums things up nicely:

Southwest is all about frequent flights whereas AirTran just throws flights out there one or two at a time (or less than daily on some routes). The traditional Southwest market is a lot different than the traditional AirTran market (if there is such a thing), so Southwest is going to have to figure out how it wants to serve the Molines and Allentowns of the world, if in fact it does at all.

And that’s really what we know so far. Lots of speculation out there on what could and couldn’t happen, but it will all unfold in the months to come. They expect to close on this next year, and I don’t imagine there will be any pushback from the feds. They love Southwest, so this should get the seal of approval.

Now let’s see what you think. I’m particularly interested in what Atlantans have to say about this. Will it make you more or less likely to fly Southwest/AirTran?

[Original photo via Flickr user Mark on AirTran Team]

I know it’s been almost a month since by visit to Delta, but I still have just a couple more posts. Today, it’s time for a good old-fashioned Across the Aisle.

In a very strange legacy of the old days, Delta’s exec team has its own office building that’s full of wood trim and is somewhat imposing. With that first impression, I expected some serious formality for my meeting with Glen Hauenstein, EVP Network Planning, Revenue Management and Marketing. Glen is not what I expected. When I walked into his large office, he was welcoming but quiet (the latter of which seems to surprise many). We headed over to his sitting area to have a wide-ranging chat on the business.

Cranky: Tell me more about your current planning strategy. You’ve added flights in Raleigh, there’s the new Heathrow flying. I don’t quite understand if there’s a set strategy here or if it’s just opportunistic.

Glen: The US domestic carrier model is evolving and there are lots of changes. In the last year, American has vacated nonstop service from Raleigh/Durham and St Louis. The airline industry has an amazing ability to fill voids. Look at Eastern. They disappeared and the void was filled almost instantly.

So, we’re always looking for opportunities in markets that are underserved by other carriers. We’re willing to experiment. If we weren’t willing to experiment, we wouldn’t have found things like Africa. By nature, it’s a very risky business, so you have to be willing to take risks.

Cranky: Ah, so it’s about American right now?

Glen: When American chooses to vacate Hartford to Raleigh/Durham, we chose to fly it with a regional jet. That’s not against American, one man’s loss is another man’s gain. I don’t know if this will work, but it’s worth trying.

Cranky: Let me stick with the American theme for a second. What about New York City, where you compete with them? How are things going?

Glen: We’re very pleased with our New York performance, especially this year. That’s a big lynchpin. Look at the total seats in the metro area and we’re in a virtual dead heat with Continental.

Cranky: Now I have to ask, what does it mean for you to “win” New York. Delta likes to say that a lot, but it’s not clear exactly what that means. How do you win and beat the other guys?

Glen: It’s not necessarily about beating the other guys. For us to win, we have to have a long term sustainable franchise. Does that mean others have to lose? More reporters like to drum that up. This isn’t a war, it’s about market equilibrium.

Right now, we’re really working hard on LaGuardia. We’re adding bigger clubs, better concessions . . . just trying to make the New York experience better.

Cranky: That brings me to the slot swap. Where does that stand right now? I know you have the litigation, but do you think there’s hope for this?

Glen: Clearly we have litigation that’s proceeding, but we’d hope that this could be resolved without it. There are several new facts that have come out since that order. First is JetBlue entering National. Second is the Continental/United agreement with the DOJ at Newark. Hopefully we get another opportunity to talk to the government because legal action is a last resort.

Cranky: But you’re going ahead with fixing up LaGuardia even though you were proposing to switch terminals there?

Glen: Making our customers wait for the resolution [to the swap] wasn’t something we could do. I’m pretty excited about how the LaGuardia experience will change.

Cranky: Sticking with the other big New York issue, what about the 3 hour ground delay rule? New York is obviously the epicenter of that. What do you think about it?

Glen: I think the government’s intentions were honorable. Whether it has the desired end result depends on who you’re talking to.

Cranky: Have there been more cancels because of it?

Glen: We have turned back flights getting close to 3 hours and have canceled them. The total number is not that great, but if you’re on a plane that gets turned back at 2.5 hours and cancels, then it becomes very personal.

The first of part of solving a problem is deciding whose problem it is to solve. It has to be a collaborative effort [and not just on the airlines]. Government has come to solutions before that have worked. When you have tarmac delays approaching 3 hours, there is something wrong in the equation.

Cranky: Let’s head to the other side of the country. You’ve tried to build up LAX a couple of times and it hasn’t worked. So what are your plans for our side of the country?

Glen: Well, we have a four corner strategy. We have great positions in New York, Atlanta, Seattle, and now LAX with Alaska. With Alaska, it’s our intent to position the two carriers together as much as possible. The terminal relocation has been delayed a couple times, but it looks like there’s a firm date in early 2011 now. Putting more feed into that gateway is important. Long haul does really well for us.

Cranky: I’m curious about Alaska, because they also work with American. Is the current setup sustainable?

Glen: Alaska has been a great partner and we’ve had a very successful launch of new services with them. For example, 73 percent of people on our new Transpacific flights from Seattle are connecting. Some of that is from Delta hubs, but Alaska is a big part of that. The travel experience is seamless. It will be great for Seattle too. Being able to provide long haul to connect with Alaska, it’s worked out. It’s a great relationship and we’re excited about the future there and in LA.

Cranky: Let’s talk about our favorite buzzword, ancillary revenue. Is there any low-hanging fruit left? What’s next?

Glen: It’s an opportunity to give consumers more choice. On one end of the spectrum is the Spirit model. We don’t aspire to be that, but I do admire their model. This industry is on the verge of letting customers choose what’s important to them. Airlines have always been viewed as a “yes or no” company. Allowing consumers to choose from a menu, build your own airline seat/experience is great. The ability to segregate out people who just want the rock bottom fare versus the person who wants it all, it’s something we don’t really do well today.

Different airlines have different approaches to the merchandising side of the model. It gives the opportunity to differentiate experience. One issue is that the guy paying $700 is sitting next to the guy paying $79. The reason we can have 15 flights in a market is both of those guys. But in the product delivery itself, how do you make that $700 person feel like they’re getting more. It’s about differentiating the product.

Cranky: Now, from the SkyMiles side, how do you deal with the highest elite members not necessarily bringing the highest value?

Glen: Every industry has that issue. We’re figuring out how to recognize the highest yielding customers. It’s not so much a problem of Diamond members not deserving to be there but rather there are Silver and Gold members who should be higher.

Cranky: Is SkyPriority one of the vehicles for that?

Glen: It’s one, I think. There is a large amount of work on the tech side so our most valuable clients are taken care of. It’s important. Go back to places like Raleigh/Durham. We are the largest carrier, but people have many choices.

Cranky: Let’s switch gears a little here. I’m hearing that your summer operational performance was not very good. Have you figured out what happened?

Glen: We gave ops a very challenging schedule to achieve. In turn, ops was trying to streamline some of its practices. We may have crossed in the night on that. By the second week of August, they were at the top of their game. A sign of a good airline is when they face those challenges head-on, find it really quick. It was clearly not something we were excited about, but it got fixed.

Cranky: Before I let you go, I have to ask you about one of my favorite things. You were at Alitalia right?

Glen: Yeah, it was a very interesting place. Until recently it was owned by the state. So imagine if there was one US airline and it was run by the government. How would that be? Given that constraint, I’d say they’re actually doing pretty well. But things are changing.

Cranky: Thanks for taking the time to talk Glen.

Glen: My pleasure. Have a safe flight home.

And with that, I was off to chow down on some good ole’ Southern cookin’ (followed by the customary triple bypass). Thanks once again to the Delta folks for bringing me out there. This was a great way to get a better understanding of where they’re trying to steer this ship. Of course, steering a massive airline this size is a lot easier to talk about than it is to achieve. So now we get to sit back and watch as they work to make big changes.

Continental/United Merger: How Pilots Can Resolve Their Labor Standoff – BNET Headwinds
It’s all about the 90 to 110 seat jets. This should be a great framework to use.

Memo to Airlines: Looks Like You Can’t Cram Any More Butts Into Seats – BNET Headwinds
Load factors have started to level off as airlines have realized they can’t get much above where they are in terms of loads.

The iPad is the Greatest Thing in Inflight Entertainment (Or is It?) – BNET Headwinds
Some think the iPad is the new giant of inflight entertainment. I think it’s just the beginning of more and better options.

All Airports Want Low Fare Airlines — but Not All Can Keep Them – BNET Headwinds
Huntsville is failing at keeping its low fare airline, which proves once again that not everyone can support that kind of service.

The Battle of Ontario: How to Mismanage a Small but Really Expensive Airport – BNET Headwinds
Ontario Airport has put out a report and the findings aren’t pretty. There is a lot of cost-cutting that needs to happen.

How to Mismanage an Airport, Part II: High Overhead, Outrageous Salaries – BNET Headwinds
In part II, we look at specifics of Ontario’s bloat.