Buy AirTran and Merge
The largest US carrier gets even bigger
- but why?
AirTran was founded in
1993 as ValuJet and renamed AirTran in 1997.
It now seems fated to
disappear entirely in 2011 based on Southwest's planned
Both Southwest and AirTran have
been successful low cost airlines.
They have operated somewhat
different business models, and have had little direct
competition between each other in the markets they serve and
routes they fly. On the other hand, they both operate
route networks focused primarily on shorter rather than longer
flights, and most of their business is from point to point
passengers rather than people connecting through a hub and spoke
But does this make the two
airlines well suited to merge? Southwest is paying almost
a 50% premium over AirTran's current share price to buy it out,
and while Southwest talks the traditional talk about 'synergies'
it seems that applying the Southwest business model to the
AirTran operation will swing AirTran from a healthy profit in
2009 to future losses.
So why is Southwest doing this
rather than growing organically? There only seems one
Southwest Announces its Plan to
In an announcement that
caught the industry by surprise this morning, Southwest and
AirTran announced their intention to merge, with Southwest
buying AirTran in a deal valued at about $1.4 billion, with
AirTran shareholders getting about $7.50 for each share (that
was trading around $4.50 prior to the announcement with a price
Not only is this unexpected,
but the reason for the merger is far from clear (not that
airline mergers ever make much sense, but this one makes even
less sense than many).
Let's first look at the
potential for combining route systems.
The biggest thing the
AirTran purchase gives Southwest is a hub in Atlanta.
AirTran has almost 400
take-offs and landings a day in/out of ATL, with leases on 22
gates and access to additional gates if needed, with nonstop
flights to 53 destinations from there. This sounds like a
large footprint - and it is - but Atlanta is a huge airport (the
nation's busiest) and in total AirTran's operations represent
only 22% of Atlanta's total traffic. Atlanta is most
notable for being Delta's hotly defended home town fortress hub.
Southwest currently has no
presence in Atlanta at all, and if it continues AirTran's
presence unchanged, Atlanta would become its third largest hub
(after Chicago/Midway and Las Vegas).
This is arguably the crown
jewel in AirTran's crown, and the ability to instantly get
critical mass in Atlanta, combined with neutralizing the
potentially bruising competition Southwest would suffer if
forced to compete not just against Delta but also,
simultaneously, against AirTran, is probably the most attractive
part of the deal to Southwest.
Other major AirTran presences
AirTran's second and third
largest presences are in Orlando (this is of less value to
Southwest) and Baltimore (95 movements a day to add to
Southwest's current 362).
It also has just under 40
movements a day at La Guardia that will probably be much
appreciated by Southwest.
AirTran also has a minor
presence at Dallas/Fort Worth (flights to Atlanta, Milwaukee,
Baltimore and Orlando) that Southwest will not be able to
continue due to the terms of its agreement allowing it to
operate from Dallas/Love Field.
Other Things AirTran Has that
Southwest Might Want
Ummm - nothing.
Sure, Southwest says it will
get valuable experience learning about AirTran's 'near
international' flying and its less frequent service to some
smaller markets, but there's nothing there worth paying much
And there is the empty claim
of $400 million a year in synergies, but that is completely
unquantified (and perhaps may remain always unquantifiable).
Things Southwest Doesn't Want
AirTran definitely has some
things that Southwest does not want.
Boeing 717 planes
Most notably, AirTran has 86
Boeing 717 planes (the largely unloved plane that Boeing itself
'inherited' from McDonnell Douglas and which Boeing quickly
discontinued) that Southwest is unlikely to want to integrate
into its famously and always all-737 fleet.
It will be interesting to
see how the actual resale prices realized of these planes will
compare to their current book valuations; this could
significantly impact on the overall net worth of AirTran's
assets. For sure, because Southwest is such a hugely
important customer to Boeing, it can probably pressure Boeing to
buy them back, but with AirTran having 86 of the total run of
155 of these planes, it will be hard to get them absorbed into
the second hand market at good prices.
UPDATE 30 Sep :
The Wall St Journal is saying that Southwest has committed to
keeping the 717s. This is astonishing. Perhaps the
most distinctive cornerstone of Southwest's operation to date
has been its rigid adherence to a one plane type fleet.
Furthermore, if it is now to add a second airplane type to its
fleet, wouldn't it make much more sense to choose a current
model plane that it could buy as many of as it wished/needed
into the future, rather than a discontinued plane that is no
longer being produced, and of which there are only 70 more in
the entire world, all but 20 of which are still being actively
used (and used up) by other airlines?
(The other 20 planes are
owned by Boeing Capital and are definitely available. They
were first used by MidWest, and then more recently by Mexicana
prior to that airline's bankruptcy.)
Two cabin service (and
AirTran has two cabin planes
- a business and coach class, compared to Southwest's all coach
Southwest has said it will
discontinue the two class option and reconfigure the merged
airline's planes as single class planes. This is sure to
dismay some of AirTran's more frequent and business fliers.
AirTran has also had a
conventional approach to seat assignments, unlike Southwest's
Some people hate Southwest's
open seating methodology, others simply accept it, and almost
no-one likes it. Southwest has again said it will extend
its non-assigned seating to the AirTran operation, something
which will probably dismay some current AirTran passengers.
Airtran has some
international routes around the Caribbean, something Southwest
has avoided to date, other than looking north to Canada.
Southwest says that it will
continue these international routes and that it is keen to learn
from the experience.
Again unlike Southwest,
AirTran charges for bags and ticket changes. AirTran
charges $15 for a first bag, $25 for a second, and $50 for each
extra bag. Southwest allows two bags free, and then
charges $50 for extra bags.
AirTran earned about $160
million in bag fees in the last year. Southwest says it
will discontinue charging bag fees on its merged AirTran
AirTran also charges $75 if
you want to change your ticket. Southwest charges nothing,
and says it will remove the ticket change fees on the AirTran
Ticket fees netted AirTran
about $50 million in the last year.
The Two Airlines Compared
In terms of size, in 2009
Southwest had revenues of $10.35 billion, profit of $99 million,
and carried 86 million passengers.
Airtran is much smaller -
about a quarter the size. It had revenues of $2.34
billion, and carried 24 million passengers but ended up with a
great profit of $135 million - more than twice Southwest's
Southwest had 537 aircraft
at the end of 2009, compared to AirTran's 138.
In terms of airline size,
and measured by passenger enplanements, and using the six months
Jan through June 2010, currently Southwest is already the
largest US carrier in terms of domestic passengers carried.
If one includes international traffic to/from the US as well as
domestic traffic, it becomes the second largest carrier, behind
The almost completed merger
of United and Continental would make that the third largest
carrier (in terms of domestic and international combined
Adding AirTran's passenger
enplanements would make the new airline clearly the largest by
both measures, ie :
Passengers Enplaned, Jan - Jun 2010
Domestic and International
Southwest & Airtran
It is only a couple of decades ago that the major 'dinosaur'
airlines sneered at the low cost carriers and considered them
irrelevant and not worth factoring into the business models.
How times have changed -
Southwest/AirTran is now decisively the very largest of airlines
(in terms of passengers flown).
The Financial Impacts of
Southwest's Business Model on AirTran
This is interesting, and
keep in mind that Southwest is paying $1.4 billion for an
airline with a market value of $840 million; an airline which
made a higher than normal profit of $135 million last year.
Southwest is paying a 67% premium over AirTran's market
Southwest says that this
purchase meets its requirement of generating a 15% return on
capital invested - 15% of $1.4 billion is $210 million.
So where will this money
come from? Oh yes, Southwest talks about '$400 million in
synergy' - let's see if we can pin this down a bit.
Southwest Negative Synergy -
Cost of $210 million/year
Two things we know for sure.
Southwest will remove the bag fees and the ticket change fees.
These had represented a $210
million/year income item for AirTran (remember the airline made
$135 million profit in 2009 - take away its fee income and the
airline is running at a loss).
Southwest Negative Synergy -
Loss of business and frequent travelers
Business travelers (and
frequent travelers, with the two generally being synonymous) are
a profitable airline's life blood. These people fly more
often and generally pay much higher fares. They also have
brand loyalty as part of the 'embrace' between airline and
passenger created by frequent flier programs and the
upgrades/etc given to higher level frequent fliers.
Such passengers are
massively motivated by the chance of scoring an upgrade to
business/first class, and sometimes will even pay full fare to
travel in that cabin. Such passengers are massively
demotivated at the thought of there being any risk of them
ending up in a middle seat squeezed between two other
AirTran had provided a
reasonably appealing service to such people. AirTran
operates two cabin planes with both business class and coach
class. Its planes have 12 business class seats and either
105 (for the 717 planes) or 125 (for the 737-700s) coach class
Southwest intends to take
out the business class seating and make it all coach class, and
interestingly, Southwest's 737-700s in an all coach class
configuration also carry the same 137 passengers, so it isn't as
though a switch to all coach class would be compensated by
having more seats to sell.
And, as we all know,
Southwest famously does not allow pre-assigned seating.
Who wants to guess how many
business/frequent travelers will abandon AirTran when it
converts to the Southwest model?
So what and where is the $400
million Synergy Southwest Claims
Southwest makes the claim
about benefitting from $400 million a year in synergies through
'a highly complementary network and fleet commonality'.
So let's look at these two
Firstly, AirTran has 86
Boeing 717 planes that are not part of a 'fleet commonality'.
Southwest has rigidly adhered to a one plane type fleet - the
Boeing 737, currently with only the three models 737-300,
737-500 and 737-700 in its fleet. It is exceedingly
unlikely it will keep these odd-ball 717s, and will instead have
to dispose of them.
Disposing of such a large
number of 717s (in total only 155 were produced) will be
difficult and may risk the potential to lose money on their
disposition. Even the best case scenario shows no synergy
or positive outcome from this.
Secondly, route synergy is
perhaps a definitional thing, but however you define the concept
of route synergy, you're straining the definition to breaking
point to see $400 million of value here.
The two airlines currently
have little route overlap. And because both carriers offer
primarily point to point rather than hub and spoke type
networks, adding extra destinations won't be of as much value as
it would be for a hub and spoke carrier which is designed to
transport people from just about anywhere, via a hub, and on to
just about anywhere else.
Hub and spoke carriers
derive flow-through benefits across their entire route network
for each extra destination. Point to point carriers derive
massively much less benefit.
It is traditional for
airlines to make empty references to synergy as justifying their
mergers. But it is very uncommon to see any real synergy
reflected in future bottom line profits.
Just remember Southwest's
promise of a $400 million boost to its bottom line from this
merger, and look for it in the future. My guess is you
won't find it.
Converting to Southwest's
Will converting AirTran to
Southwest's revenue model allow it to greatly increase the
revenue it earns per passenger flown? And/or will the
Southwest model (and perhaps some, ahem, synergies!) allow
AirTran to increase the loads on its flights and become more
profitable that way?
No room for extra passengers
To answer the second
question first, AirTran enjoyed an amazing passenger load factor
last year of 79.8% - the highest it has ever achieved. Now
contrast that with Southwest's lower 76.0% load.
This suggests two things.
First, there is almost no effective remaining capacity on
AirTran flights at present, so there's no remaining potential to
grow revenue by putting more people on flights (it is
operationally impossible to run an airline with an average load
much higher than 80%).
Second, one could
tongue-in-cheek suggest that Southwest should adopt AirTran's
policies if it leads to a higher load factor, rather than apply
its policies to AirTran.
Little chance to charge higher
Does Southwest expect that
switching from the AirTrain to the Southwest business model will
in some way compensate for the loss of $210 million in pure
profit by giving up the luggage and ticket change fees?
Let's look at that.
In 2009, Southwest flew
passengers an average of 863 miles, and charged them 13.29c per
mile flown. AirTran flew passengers an average of 775
miles and charged them 11.24c per mile flown. In other
words, AirTran's fares were about 15% cheaper - but don't forget
If we look at the underlying
total revenue per available seat mile (including fees, and
adjusted for passenger load factors), Southwest averaged 10.56c
per ASM, and AirTran had 10.05c per ASM. The difference in
this more important measure of revenue is much less profound.
Southwest has higher costs
And wait, that's only half
the equation. Southwest's operating costs per ASM were
higher than AirTran's. Southwest had a cost of 10.29c
compared to AirTran's 9.29c. This means that Southwest's
business model was earning it 0.27c/ASM whereas AirTran's model
was earning it 0.76c/ASM - nearly three times more per mile
flown. No wonder tiny AirTran made more profit than huge
Southwest last year.
Re-jigging the AirTran
business plan to conform to Southwest's increasingly amorphous
business plan does not seem to offer any potential to discover
'hidden' profit and may in fact reduce the profit contribution
of AirTran to the new merged entity all the way down to zero, or
possibly even worse.
AirTran's Labor Challenges
There's another cloud on the
horizon. AirTran's agreement with its pilots became
amendable in 2005. In 2007 a tentative agreement was
reached, but the pilots then refused to accept it, and now the
matter is undergoing mediation through the National Mediation
Additionally, its flight
attendants are also negotiating for a new agreement.
AirTran's agreement with its flight attendants became amendable
The resolution of both these
issues will almost certainly see an increase in AirTran's labor
AirTran reports that its
maintenance costs are expected to increase as its planes age and
variously come out of warranty and also start to require more
So What is Southwest Actually
Getting for its Money?
Let's summarize these
Firstly, Southwest is
planning to buy AirTran for 69% more than its current market
valuation. If we accept the market capitalization of
AirTran as fairly and accurately reflecting its value as a going
concern, today, then Southwest is paying two thirds more than it
should - nearly $550,000 over the odds - to buy AirTran.
That is, to be polite, a bold move on Southwest's part.
Secondly, the changes
Southwest plans to make to the AirTran operation threaten to
completely zero out AirTran's profitability, while showing no
clear scope for compensatory improvements in revenue generation.
If AirTran - as a going
concern - is worth somewhere around $850 million, how much less
is it worth if a new owner takes away $210 million a year in net
revenue from a business that only makes $135 million a year in
profit (and that in a good year)?
So what is the huge
'X-factor' we don't clearly see? There seems to be only
one possible reason for Southwest's actions.
Atlanta - a Win/Win for
Southwest and Delta but a Loss for Us?
The one thing missing from
the financial analysis so far is Southwest immediately getting a
major hub and 'critical mass' in Atlanta. How much might
that be worth to Southwest?
The answer to that is
unclear, as is also the underlying imperative need to pay so
much money to get a 'turnkey' operation dumped in its lap at
Atlanta. Obviously there is great value in simultaneously
getting a major market presence in ATL and in neutralizing the
airline that might have been the more aggressive at competing
with Southwest (from the context of having the greatest
dependency on ATL as a hub and the lowest costs, allowing for
AirTran to very aggressively discount below Southwest's costs if
So does it really boil down
to Southwest spending about $1.4 billion to buy a hub in Atlanta
that is generating about $1.25 billion a year in gross revenues,
and an unknown amount of profit (possibly even a loss)?
Quite possibly so.
Delta stands to benefit too
This is an amazing thought.
If (when) Southwest takes over AirTran's operations, and when it
removes AirTran's business class seating, Delta will no longer
need to keep a lid on its own business/first class fares for
travel from Delta.
At present Delta has
undoubtedly been mildly constrained by AirTran's presence in
Atlanta, not only in terms of what it can charge for coach fares
but also what it can charge for premium fares.
Southwest's assumption of
AirTran's flights will more or less continue the pressure on
Delta for coach class fares (although note that Southwest has a
higher average fare level than AirTran), but it will remove the
pressure on Delta that had previously related to premium cabin
fares, due to Southwest abandoning the business class model.
Implication for Passengers
So what does this all mean
for us, the people who actually fly?
It is hard to see anything
good coming from this for passengers. Southwest has higher
average fares than AirTran, but doesn't offer frequent flier
benefits such as upgrades or preassigned seating.
passengers who tactically buy air tickets only when special
deals are offered are unlikely to see much change, or perhaps a
mild reduction in specials offered. But people who travel
regularly can expect less comfort/convenience.
And those Delta passengers
who have been benefitting from AirTran competing with Delta can
expect to see Delta's premium cabin fares firm, and if Delta
should win some of the people formerly flying in AirTran's
business class cabin, the availability of free upgrades will
probably diminish too.
Like all airline mergers,
there's nothing good in it for us as passengers. And
notwithstanding the claims of '$400 million in synergy', there
seems little good in it for Southwest Airlines either.
But - what do I know?!
Southwest's stock price closed up 8.7% today subsequent to this
merger announcement at the beginning of the day.
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27 Sep 2010, last update
08 Jul 2017
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