atpcliff
Well-known member
- Joined
- Nov 26, 2001
- Posts
- 4,260
Hi!
Credit Suisse:
LCC Merger Proposal
Industry Thoughts & New Valuation
• US Airways proposal to merge with Delta suggests industry consolidation is more likely
than not. From our perspective, the question has consistently been not whether the
industry consolidates, but when, which is why consolidation has been a consideration
in our Overweight sector stance and ratings.
• The cyclical majors still have a 30-40% cost disadvantage (excluding fuel) to low cost
carriers despite their restructuring over the past few years, and management teams can
only extract so much flesh from the hide of labor before labor snaps. Consequently, the
next logical step to achieving lower costs is through economies of scale.
• We do not cover Delta and hence make no recommendation on shares, but make some
key assumptions which are critical to our industry thesis. In particular, US Airways’
proposal to merge with Delta is compelling, but, it is not in Delta’s interest to rush into
the arms of US Airways. Rather, from Delta’s standpoint, it’s easier to extract a better
deal if it plays “hard to get.” Like buying a car, you don’t get the best deal until your
ready to walk off the lot. That said, we handicap the odds of a successful US
Airways/Delta merger at ~40%. Instead, Delta is probably more interested in what UAL
might put forth given Delta’s likely interest in UAL’s coveted slots at London Heathrow.
In either event, Delta will be hard pressed to present a deal to its creditors that is more
attractive than that presented by LCC, so could be forced into a deal.
• Airline stocks spiked 101% during the 1989 merger mania. The same upside today
would naturally stretch valuations; hostile takeovers also unlikely given weak balance
sheets. However, a more efficient industry likely results in equity valuations that are
higher than where they are currently. It is premature to make changes to our estimates,
but we start with the assumption that the industry could be at least 10-15% more
profitable should it consolidate, and hence have adjusted or valuation multiples
accordingly to represent the option-like component to earnings power for the industry.
• The biggest obstacle naturally is labor, which perhaps counter intuitively, may have an
interest in going along. In our 9/22/06 UAL note, we pointed out that a stronger industry
could have likely sidestepped devastating cuts to wages following 9/11; as evidence,
Southwest awarded its pilots a 20% raise (over the life of the contract) in 11/01;
Southwest could do that because it has historically been a financially stronger airline.
Delta has been full of surprises over the past few years, but believe it ultimately
concludes that consolidation is the endgame given a domestic network which we
assume is simply too vulnerable to low cost competition, and an international strategy
that will prove difficult to execute should Continental and AMR decides to crack down on
transatlantic flights (note that we do not cover Delta and are not making any
recommendations on its securities).
In general, conventional thinking is that before building an international network, it is first
essential to build a domestic network (as Continental has done at Newark); that’s
because domestic critical mass is an important component to ultimately feeding an
international network (Pan Am ultimately a victim of a brilliant international network that
lacked domestic critical mass). With roughly 70 gates at its Newark hub and sufficient
domestic critical mass, Continental has the power to flow traffic across its system to key
transatlantic routes (at the expense of Delta). AMR of course has always had a
significant presence at JFK as well, and also stands poised to make it tough on Delta if
it [AMR] so chooses. Thus, we assume Delta is better off with a partner.
Thus, we believe Delta seroiusly considers US Airways proposal, but likely also turns to
UAL, another logical partner, to see what kind of deal UAL might be willing to craft.
Ultimately, US Airways may have to pony up more if UAL concludes that the strategic
benefits are greater than the $1.65B estimated by US Airways (we believe US Airways
may be being conservative based on our proforma modeling – taking 10% capacity out
with no employee cuts does not seem reasonable; for example, no need for 2 revenue
management departments). At any rate, UAL may conclude the benefits are even
greater for it and could ultimately decide it can afford to offer more. Consequently,
though we believe the economics of the US Airways offer work well, we do not conclude
that US Airways and Delta ultimately merge. If either UAL or US Airways finds a way to
preserve Delta’s NOLs, any deal could likely become even more valuable. On the other
hand, should US Airways happen to miss out on Delta, all is not lost - Northwest could
also make an interesting alternative partner.
The airline industry is akin to a monopolistic oligopoly – that is, there are a few players
that really behave like a monopoly (given the network aspect of the industry).
Consequently, we do not expect others to stand by to be left behind. And if the airline
industry is serious about consolidation, it would probably be an easier pill for the
Department of Justice to swallow (and the odds of consolidation coming to fruition,
better) if they looked at consolidation on a big picture basis. Consequently, we expect
other merger announcements in the near future. Given weak balance sheets, we are
not anticipating that carriers will buy other carriers, which means that potential deals are
(again) likely to be mergers rather than acquisitions. And if that proves to be the case,
social issues (i.e. deciding who ultimately runs the show) will be the first hurdle for any
two partners to clear.
Regardless, a Delta/US Airways combination would make it the largest carrier in the US.
Note that the AMR/TWA and US Airway/America West mergers were easier for the
Department of Justice since it could apply a failing carrier doctrine. It is not clear that
Delta is failing and if the DOJ does not apply the failing carrier doctrine, it would likely
apply a more rigorous analysis. At the outset, the obvious carve-outs are the Shuttle
(e.g. slots at DCA and LGA) and potentially some routes out of Charlotte and Atlanta
where combined they have disproportionate market share. Based on a pull of DOT
data, we found Delta’s Shuttle revenues for the year ended 2Q06 were about $162M vs
$237.6M for US Airways.
The natural bidders for the Shuttle routes are of course AMR
and jetBlue. And given key AMR noncore holdings (frequent flyer business/asset
management arm), not to mention a hefty cash position, AMR – worst case – can likely
afford to overpay for the assets given its strong inroads in the lucrative corporate travel
business.
UAL will have to think fast and consider its strategic options on an accelerated time
table; Continental? Or Delta? Both Continental and UAL are in the strategic catbird
seat given their hub and route structures and in the case of UAL, its slots at London
Heathrow (which both Continental and Delta would desire). We believe a
UAL/Continental combination makes the best sense given domestic and international
networks that complement each other more thoroughly than a UAL/Delta combination.
However, Northwest’s golden share, which gives Northwest super voting rights to block
any CAL deal that involves equity, is an obstacle for a potential UAL/CAL deal. One
potential way around that is for Continental to craft an all cash deal, which as we
understand it, would not require the approval of shareholders.
US Airways Group (LCC)
• If the US Airways/Delta deal were to go through, we believe US
Airways stock could be valued as high as $78 based on our taxadjusted
proforma income statement/balance sheet, which is
P/E based target price, though would amount to an EV/EBITDAR
multiple of 4.8x, an EV/EBITDAR multiple on the low end of
where we think the company could ultimately trade. Thus, a $78
potential target price could prove conservative if US Airways
could demonstrate more consistent profitability.
• However, we are raising our target price to $72 for now, which
reflects a 40% chance of the proposed deal going through as
announced, and at the same time, recognizes that consolidation
in some shape or form is more likely than not, ultimately
resulting in higher valuations for US Airways and the entire
airline group.
• Risks to our target price for US Airways include those facing the
airline industry as a whole: record high fuel prices, a cooling
economy, terrorism, labor and maintenance issues, weather,
and outbreaks of disease that could affect travel behavior. US
Airway's biggest long-term risk is its direct competition with
Southwest in Phoenix, Las Vegas, Philadelphia, and Pittsburgh.
A key company specific risk is the ongoing integration of
America West with US Airways (in particular, the integration of
the two pilot groups).
cliff
YIP
Credit Suisse:
LCC Merger Proposal
Industry Thoughts & New Valuation
• US Airways proposal to merge with Delta suggests industry consolidation is more likely
than not. From our perspective, the question has consistently been not whether the
industry consolidates, but when, which is why consolidation has been a consideration
in our Overweight sector stance and ratings.
• The cyclical majors still have a 30-40% cost disadvantage (excluding fuel) to low cost
carriers despite their restructuring over the past few years, and management teams can
only extract so much flesh from the hide of labor before labor snaps. Consequently, the
next logical step to achieving lower costs is through economies of scale.
• We do not cover Delta and hence make no recommendation on shares, but make some
key assumptions which are critical to our industry thesis. In particular, US Airways’
proposal to merge with Delta is compelling, but, it is not in Delta’s interest to rush into
the arms of US Airways. Rather, from Delta’s standpoint, it’s easier to extract a better
deal if it plays “hard to get.” Like buying a car, you don’t get the best deal until your
ready to walk off the lot. That said, we handicap the odds of a successful US
Airways/Delta merger at ~40%. Instead, Delta is probably more interested in what UAL
might put forth given Delta’s likely interest in UAL’s coveted slots at London Heathrow.
In either event, Delta will be hard pressed to present a deal to its creditors that is more
attractive than that presented by LCC, so could be forced into a deal.
• Airline stocks spiked 101% during the 1989 merger mania. The same upside today
would naturally stretch valuations; hostile takeovers also unlikely given weak balance
sheets. However, a more efficient industry likely results in equity valuations that are
higher than where they are currently. It is premature to make changes to our estimates,
but we start with the assumption that the industry could be at least 10-15% more
profitable should it consolidate, and hence have adjusted or valuation multiples
accordingly to represent the option-like component to earnings power for the industry.
• The biggest obstacle naturally is labor, which perhaps counter intuitively, may have an
interest in going along. In our 9/22/06 UAL note, we pointed out that a stronger industry
could have likely sidestepped devastating cuts to wages following 9/11; as evidence,
Southwest awarded its pilots a 20% raise (over the life of the contract) in 11/01;
Southwest could do that because it has historically been a financially stronger airline.
Delta has been full of surprises over the past few years, but believe it ultimately
concludes that consolidation is the endgame given a domestic network which we
assume is simply too vulnerable to low cost competition, and an international strategy
that will prove difficult to execute should Continental and AMR decides to crack down on
transatlantic flights (note that we do not cover Delta and are not making any
recommendations on its securities).
In general, conventional thinking is that before building an international network, it is first
essential to build a domestic network (as Continental has done at Newark); that’s
because domestic critical mass is an important component to ultimately feeding an
international network (Pan Am ultimately a victim of a brilliant international network that
lacked domestic critical mass). With roughly 70 gates at its Newark hub and sufficient
domestic critical mass, Continental has the power to flow traffic across its system to key
transatlantic routes (at the expense of Delta). AMR of course has always had a
significant presence at JFK as well, and also stands poised to make it tough on Delta if
it [AMR] so chooses. Thus, we assume Delta is better off with a partner.
Thus, we believe Delta seroiusly considers US Airways proposal, but likely also turns to
UAL, another logical partner, to see what kind of deal UAL might be willing to craft.
Ultimately, US Airways may have to pony up more if UAL concludes that the strategic
benefits are greater than the $1.65B estimated by US Airways (we believe US Airways
may be being conservative based on our proforma modeling – taking 10% capacity out
with no employee cuts does not seem reasonable; for example, no need for 2 revenue
management departments). At any rate, UAL may conclude the benefits are even
greater for it and could ultimately decide it can afford to offer more. Consequently,
though we believe the economics of the US Airways offer work well, we do not conclude
that US Airways and Delta ultimately merge. If either UAL or US Airways finds a way to
preserve Delta’s NOLs, any deal could likely become even more valuable. On the other
hand, should US Airways happen to miss out on Delta, all is not lost - Northwest could
also make an interesting alternative partner.
The airline industry is akin to a monopolistic oligopoly – that is, there are a few players
that really behave like a monopoly (given the network aspect of the industry).
Consequently, we do not expect others to stand by to be left behind. And if the airline
industry is serious about consolidation, it would probably be an easier pill for the
Department of Justice to swallow (and the odds of consolidation coming to fruition,
better) if they looked at consolidation on a big picture basis. Consequently, we expect
other merger announcements in the near future. Given weak balance sheets, we are
not anticipating that carriers will buy other carriers, which means that potential deals are
(again) likely to be mergers rather than acquisitions. And if that proves to be the case,
social issues (i.e. deciding who ultimately runs the show) will be the first hurdle for any
two partners to clear.
Regardless, a Delta/US Airways combination would make it the largest carrier in the US.
Note that the AMR/TWA and US Airway/America West mergers were easier for the
Department of Justice since it could apply a failing carrier doctrine. It is not clear that
Delta is failing and if the DOJ does not apply the failing carrier doctrine, it would likely
apply a more rigorous analysis. At the outset, the obvious carve-outs are the Shuttle
(e.g. slots at DCA and LGA) and potentially some routes out of Charlotte and Atlanta
where combined they have disproportionate market share. Based on a pull of DOT
data, we found Delta’s Shuttle revenues for the year ended 2Q06 were about $162M vs
$237.6M for US Airways.
The natural bidders for the Shuttle routes are of course AMR
and jetBlue. And given key AMR noncore holdings (frequent flyer business/asset
management arm), not to mention a hefty cash position, AMR – worst case – can likely
afford to overpay for the assets given its strong inroads in the lucrative corporate travel
business.
UAL will have to think fast and consider its strategic options on an accelerated time
table; Continental? Or Delta? Both Continental and UAL are in the strategic catbird
seat given their hub and route structures and in the case of UAL, its slots at London
Heathrow (which both Continental and Delta would desire). We believe a
UAL/Continental combination makes the best sense given domestic and international
networks that complement each other more thoroughly than a UAL/Delta combination.
However, Northwest’s golden share, which gives Northwest super voting rights to block
any CAL deal that involves equity, is an obstacle for a potential UAL/CAL deal. One
potential way around that is for Continental to craft an all cash deal, which as we
understand it, would not require the approval of shareholders.
US Airways Group (LCC)
• If the US Airways/Delta deal were to go through, we believe US
Airways stock could be valued as high as $78 based on our taxadjusted
proforma income statement/balance sheet, which is
P/E based target price, though would amount to an EV/EBITDAR
multiple of 4.8x, an EV/EBITDAR multiple on the low end of
where we think the company could ultimately trade. Thus, a $78
potential target price could prove conservative if US Airways
could demonstrate more consistent profitability.
• However, we are raising our target price to $72 for now, which
reflects a 40% chance of the proposed deal going through as
announced, and at the same time, recognizes that consolidation
in some shape or form is more likely than not, ultimately
resulting in higher valuations for US Airways and the entire
airline group.
• Risks to our target price for US Airways include those facing the
airline industry as a whole: record high fuel prices, a cooling
economy, terrorism, labor and maintenance issues, weather,
and outbreaks of disease that could affect travel behavior. US
Airway's biggest long-term risk is its direct competition with
Southwest in Phoenix, Las Vegas, Philadelphia, and Pittsburgh.
A key company specific risk is the ongoing integration of
America West with US Airways (in particular, the integration of
the two pilot groups).
cliff
YIP
