Merger For Success In The US Airline Industry - Research Paper Example

?MERGER FOR SUCCESS IN THE US AIRLINE INDUSTRY BY ID # SUPERVISOR Contents Contents 2 Introduction 3 Competition Policies Impacting the US Airline Industry 5 Deregulation and the Impact on Competition in the Airline Industry 7 Mergers and its Impact on Competition in the Airline Industry 8 Conclusion 11 References 13 MERGER FOR SUCCESS IN THE US AIRLINE INDUSTRY Introduction The airline industry has been experiencing economic difficulties ever since the terror attacks in the US on September 11, 2001. By 2007-2008, the economic difficulties in the airline industry were further compromised by price increases in fuel and the global financial crises (Ireland, Hoskisson & Hitt, 2008). Conventional wisdom dictates that mergers and acquisitions function to improve profits and “long-term financial viability” (Government Accountability Office, 2008, p. 28). Therefore US airlines looked increasingly to mergers and acquisitions as a means of responding to on-going economic difficulties impacting the industry. The incentive toward mergers and acquisition is attributed to the Airline Deregulation Act 1978 which was intended to increase competition by phasing out federal government’s control of industry ticket prices and services and to permit market forces to determine fares and services (Government Accountability Office, 2006). Competition was believed to be enhanced by the removal of the federal Civil Aeronautics Board (CAB) and its regulatory framework (Tourtellot, 1979). The Airline Deregulation Act 1978 is premised on three specific areas: competition, new entrants and fares (Airline Deregulation Act 1978). In 1978 in the US there were 36 “scheduled US airline” (Weber & Giemulla, 2011, p. 134). However, by 1984, following the implementation of the Airline Deregulation Act 1978, there were 123 scheduled US airlines operating in the US (Weber & Giemulla, 2011). Even so, within a year of the implementation of the 1978 Airline Deregulation Act, “wave of mergers commenced because” the airline industry began to realize that success depended on maintaining a “minimum size” and “a wide network of domestic routes” (Weber & Geimulla, 2011, p. 134). The wave of mergers and acquisition was predicated on the belief that purchasing the competition was a viable means of ensuring a smaller sized industry and offering broad networks of domestic routes. Needless to say, since the passage of the Airline Deregulation Act 1978, the structure of the US airline industry and its market has been altered significantly. For instance in 1979, one year after the implementation of the Airline Deregulation Act 1978, the 9 larger US airlines controlled 85% of the market. However, by 1987, the 8 larger US airlines controlled 92% of the market (Weber & Giemulla, 2011). In 1988, Texas Air, United Airlines and American Airlines controlled 53% of airline services in the US(Weber & Giemulla, 2011). Prior to regulation there were no reports of airline bankruptcy. However, since deregulation in 1978, bankruptcy has become common place. Between 1978 and 2001, nine major airlines inclusive of America West, Braniff, Continental, Eastern, Pan Am and TWA and more than 100 smaller carriers declared bankruptcy or liquidated its assets (Kaps, Hamilton & Bliss, 2012). The irony is that deregulation was thought to be appropriate on the basis that previous concerns about distorted competition and monopolies had been unfounded (Kaps et. al., 2012). As Kaps et. al. (2012) explained, government officials believed that the dynamics of the market would facilitate operations “approaching pure market competition without governmental economic regulation” (p. 7). The terror attacks of September 11, 2001 introduced greater difficulties for an already struggling airline industry (Wensveen, 2011). Losses to the US airline industry following the September 11, 2001 amounted to an estimated US$17.7 billion. However, it has been argued that the failures in the airline industry cannot be entirely attributable to September 11, 2001. Since the 1978 Airline Deregulation Act approximately 160 airlines have filed for bankruptcy protection. Even prior to the global financial crisis of 2008, it was generally accepted that the airline industry had the highest failure rate among all other industries (Morgan, 2009). In light of the fact that mergers and acquisitions have become prevalent since the late 1970s and the 1980s, the main question is whether or not mergers and acquisitions distort competition and help the airline industries to survive. This paper examines the significance of mergers in response to the need for competition in the airline industry and the effect that deregulation has had on mergers and in turn, competition. The first part of this paper will examine competition in the context of anti-trust policies in the airline industry. The second part of this paper will examine deregulation and its impact on competition and the airline industry in general. The final part of this paper will examine mergers and its impact on competition in the airline industry. Competition Policies Impacting the US Airline Industry Economist predicted that deregulation of competitive organs such as price and routes in the US airline industry would result in lowering costs of operations and reduce ticket prices for consumers. Consumers would ultimately benefit as competition would improve, giving more airlines greater shares of the market and services would improve therefore increasing demand. However, some economist warned that deregulation would not improve competition because of economies of scale relative to the airline industry would minimize the opportunities for new entrants and airlines able to compete in the market would remain quite small compared to other industries. If the market were to become concentrated, prices would increase to the detriment of consumers. In fact, it has been demonstrated that although deregulation has brought about a reduction in a majority of fairs, prices are generally at their lowest when more airlines over services to the same destination. As Mazzeo (2003) explained: The interplay between cost savings from scale and the potential threat of high fares due to the exercise of market power has informed the debate over airline competition policy since deregulation (p. 276). For instance, US policy makers have been taking note of high concentration in the airline industry and have been putting pressure on airlines to improve the quality of services. The US Department of Justice started a case against American Airlines claiming that the airline was attempting to unlawfully gain a monopoly over certain routes “to and from Dallas-Fort Worth Airport” (Mazzeo, 2003, p. 276). Moreover, the aggressive interference by US anti-trust officials put an end to a proposed merger between United Airlines and US Air. Perceptions from observers were that the merger would only exacerbate an already concentrated industry (Mazzeo, 2003). Mergers and other practices are subject to scrutiny as a result of the Sherman Act 1890 as amended by the Clayton Act 1914. Specifically, Section 1 of the Sherman Act 1890, any contract, agreement or combination of any “form of trust or otherwise” or “conspiracy” that restrains “trade or commerce” is unlawful (Sherman Act 1890, Section 1). Moreover, any person who “shall monopolise, or attempt to monopolise, or combine or conspire with any other person or persons” to control or hold a monopoly on any “part of the trade or commerce” “shall be deemed guilty of a felony” (Sherman Act 1890, Section 2). Additions to the Sherman Act by the Clayton Act involve criminalizing deliberate discriminatory pricing practices (Sherman Act 1890 as Amended by the Clayton Act 1914). Ultimately, the Sherman Act 1890 and the Clayton Act 1914 are aimed at practices, whether in terms of monopolies, conglomerates, cartels, pricing practices or other trade practices that are predatory or are such that they distort and restrict competition in the market. Deregulation and the Impact on Competition in the Airline Industry In the airline industry, smaller and new entrants have claimed that they were targeted by larger more powerful airlines. For instance, Frontier and Western Pacific claimed that United Airlines targeted them. American Airlines was alleged to have targeted Vanguard, Western Pacific and Sun Jet International. Delta was alleged to have targeted ValuJet. Northwest was alleged to have targeted Sun Country and Spirit Airlines. Whether or not this is true, Western Pacific, Vanguard, Sun Jet International, Sun Country and Spirit were out of the airline industry by 2002 or in bankruptcy indicating that competition is distorted or at the very least concentrated in the airline industry (Dempsey, 2002). The fact is, deregulation removes federal government restrictions and control of prices in the market. As a result, pricing problems are reportedly distorting competition and permitting larger airlines to maintain monopolies. For example, according to Dempsey (2002) new entrants to the airline industries offering lower fares alleged that the larger airlines lower their prices whenever a smaller more reasonable airline enters the market in which the larger airline dominates. This is particularly true when new smaller and more affordable airlines enter “dares to provide competition at their Fortress Hubs” (Dempsey, 2002, p. 689). According to Dempsey (2002) new entrants alleged that dumping capacity and lowering prices are among the main techniques used by larger airlines to “eradicate competition” (p. 689). However, there are a number of other anti-competitive behaviour such as adding more seats and increasing flights so that the competition is denied “realistic or achievable break-even load factors” (Dempsey, 2002, p.689). Competitors are often denied access to networks inclusive of “joint-fare or code-sharing agreements, or participation their frequent flyer programs” (Dempsey, 2002, p. 689). Major airlines even go so far as to rig their connecting flights by adding several hours to the connection for the competitor. Major airlines are accused of paying travel agents so that they direct business to them and not to the competition. Major airlines are also accused of getting into antitrust mergers or agreements with “corporate purchasers and regional turboprop carriers” (Dempsey, 2002, p. 690). The significance of anti-trust laws is therefore to prevent these kinds of practices. New entrants with smaller resources that offer competitive prices have a difficult time competing with larger, more successful airlines. The competition is exacerbated when major airlines engage in predatory and antitrust practices deliberately calculated to drive the competition out of the market. It can be argued however, that much of these practices are symptoms of a failing market and perceptions are therefore that, established airlines, informed by the high failure rate in the industry are loathe to share an already shrinking market with new entrants. The main question therefore is, whether or not mergers and acquisition can reduce help to improve competition and market opportunities with the result that the failure rate decreases in the airline industry. Mergers and its Impact on Competition in the Airline Industry According to the Government Accountability Office (2008), competition in the US’s airline industry increased from about 1998 to 2006. Competition is manifested by a growing number of “competitors in city-to-city (city pair) markets,” lower cost airlines in the market, lower ticket prices, a decrease in market domination and “a shrinking dominance by a single airline at some of the nation’s largest airports” (Government Accountability Office, 2008, p. 1). It would also appear that competition has improved significantly as the number of new low-cost entrants in the airline industry since 1998 have increased by 60%. Moreover, the number of dominated sectors by single large airlines was reduced by 15% (Government Accountability Office, 2008). According to the Government Accountability Office (2008): Airlines seek to merge with or acquire other airlines with the intention of increasing their profitability and financial sustainability, but must weigh these potential benefits against operational and regulatory costs and challenges (p. 1). Airlines however, in determining whether or not to merge with another airline or airlines or to acquire another airline, will take into account the opportunities for reducing operational costs. The rationale follows from the idea that if “complementary assets” are combined, “duplicate activities” are removed and capacity reduced, revenues will increase as a result of higher ticket prices in current markets and demand would increase for “more seamless travel to more destinations (Government Accountability Office, 2008, p. 1). Obviously, mergers are determined to be a key to reducing costs because it merges labor capital, air carriers and airline systems. However, mergers and acquisitions are not automatic economic resolutions for failing airline companies. These mergers are subject to scrutiny by the Department of Justice who apply the antitrust laws to safeguard against illegal dealings calculated to distort competition and advance predatory prices and practices. Moreover, the Department of Justice is also mindful of the potential for mergers to create monopolies and force other smaller airlines into bankruptcy or out of the market altogether. The Department of Justice and the Department of Transportation are involved in monitoring proposals for merging airlines as well as acquisitions to ensure that these mergers and acquisitions do not have a negative impact on competition. To this end the Department of Justice refers to the Horizontal Merger Guidelines to assist it with any decision relative to approving or refusing a proposed merger or acquisition. As the Government Accountability Office (2008) explained: Under that process, the Department of Justice assesses the extent of likely anti-competitive effects in the relevant markets, in this case, airline city-pair markets (p. 1). The Department of Justice also takes into account any possibility that a new entrant might “counteract any anti-competitive effects” (Government Accountability Office, 2008, p. 1). Likewise, the Department of Justice takes into account any benefits that the merger or acquisition might bring about such as efficiency in services or “consumer benefits from an expanded route network” (Government Accountability Office, 2008, p. 1). Since 1978 the number of airline mergers and acquisitions increased considerably. In the 1980s Delta Air Lines merged with Western Airlines, United Airlines acquired the Pacific routes of Pan Am, Republic Airlines was acquired by Northwest and Air California and American Airlines merged. However, since the transfer of the authority for review of mergers and acquisitions from the Department of Transportation to the Department of Justice in 1998, the number of mergers and acquisitions has dropped off. Of note, TWA was acquired by American Airlines in 2001 and US Airways was acquired by America West in 2005. A number of mergers and acquisitions failed either as a result of the DOJ’s objections or objections by creditors or employees or both (Government Accountability Office, 2008). For the most part, many of the bankruptcy claims came from smaller airlines. However, in more recent times, Delta, Northwest, United and US Airways’ bankruptcy claims indicate that merger and acquisitions have not helped these large companies remain competitive. As the Government Accountability Office (2008) reported, mergers and acquisitions generally have a short-term effect. It allows airlines to reduce capacity and increase airline ticket prices. However one a new entrant enters the market prices are forced back down (Government Accountability Office, 2008). Integrating labor capital can also compromise successful mergers and acquisitions as new employment contracts have to be negotiated. Moreover, labor units may make greater demands and thus support of the labor force will be necessary to ensure mergers are successful. In addition, tailoring the merger so that it accords with anti-trust policies by the Department of Justice can also be challenging (Government Accountability Office, 2008). It therefore appears that although mergers and acquisitions appear to be the solution to a struggling airline, industry, it may not be the answer in the long term. Conclusion Deregulation pursuant to the Airline Deregulation Act 1978 combined with the terror attacks of September 9, 2001 and the recent global financial crisis has changed the operational landscape of the airline industry. Deregulation was intended to improve competition by permitting market forces to regulate prices and industry practices generally. Unfortunately, market forces have not been kind to the airline industry and airline companies have had an uneasy coexistence. Mergers and acquisitions proliferated in the immediate aftermath of deregulation. However, concerns arising out of monopolies and predatory pricing practices have resulted in a restrictive approach by the Department of Justice with the result that mergers and acquisitions have slowed. This may not necessarily be a bad thing as mergers and acquisitions have proven to be more challenging and any relief it offers has been short-lived. Drawing on the fact that prior to the 1980s, no airline company had filed for bankruptcy, it may have been a mistake to deregulate the airline industry. What should have happened was a revision of the federal regulatory regime. Rather than eliminating the CAB altogether, it might have been wiser to reduce their stronghold on the industry while continuing to give the CAB oversight over the practices and pricing in the market. The Airline Deregulation Act 1978 should therefore be revised to reinstate a federal body responsible for monitoring and supervising industry practices and providing standards and guidelines for pricing, new entrants and competition policies. Informed by history, mergers and acquisitions do not resolve financial difficulties. Instead the raise concerns about monopolies and distort competition in the market. As a result competitors take anticipatory action, such as lowering prices and therefore defeats the gains involved in mergers and acquisitions. Although mergers and acquisitions can be beneficial to airline companies they should remain as they are: the exception and not the rule. As it is, mergers and acquisitions do more harm than good in the airline industry. This is particularly so, with respect to consumer interests. It is in the consumers’ best interest that small airlines offering lower fares thrive in the market. Mergers and acquisitions pose a threat to the continued success of smaller airlines. References Airline Deregulation Act 1978. Clayton Act 1914. Dempsey, P. S. (2002). “Predation, Competition & Antitrust Law: Turbulence in the Airline Industry.” Journal of Air Law and Commerce, Vol. 67: 685-840. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1814304 (Retrieved April, 2nd 2012). Government Accountability Office. (July 2008). “Potential Mergers and Acquisitions Driven by Financial and Competitive Pressures.” Report to the Subcommittee on Aviation Operations, Safety, and Security, Committee on Commerce, Science, and Transportation, U.S. Senate, 1-47. http://www.gao.gov/new.items/d08845.pdf (Retrieved April, 2nd 2012). Government Accountability Office. (June 2006). “Airline Deregulation: Regulating the Airline Industry Would Likely Reverse Consumer Benefits and Not Save Airline Pensions.” Report to Congressional Committees, 1-49. http://www.gao.gov/new.items/d06630.pdf (Retrieved April 2nd 201). Government Accountability Office. (July 2008). “Airline Industry: Potential Mergers and Acquisitions Driven by Financial and Competitive Pressures.” Report to the Subcommittee on Aviation Operations, Safety, and Security, Committee on Commerce, Science, and Transportation, U.S. Senate, 1-57. http://www.gao.gov/new.items/d08845.pdf (Retrieved April, 2nd 2012). Ireland, R. D.; Hoskisson, R. E. and Hitt, M.A. (2008). Understanding Business Strategy: Concepts and Cases. Mason, OH: South-Western Cengage Learning. Kaps, R. W.; Hamilton, J.S. and Bliss, T. J. (2012). Labor Relations in the Aviation and Aerospace Industries. Chicago, Ill: Board of Trustees, Southern Illinois University. Mazzeo, M.J. (2003). “Competition and Service Quality in the U.S. Airline Industry.” Review of Industrial Organization, Vol. 22: 275-296. http://www.kellogg.northwestern.edu/faculty/mazzeo/htm/airline_ontime.pdf (Retrieved April 2, 2012). Morgan, M. J. (2009) The Impact of 9/11 on Business and Economics: The Business of Terror. New York, NY: Palgrave MacMillan. Sherman Act 1890. Tourtellot, C. T. (1979). “Competitive Policy in Airline Deregulation.” The American University Law Review, Vol. 28: 537-576. http://www.wcl.american.edu/journal/lawrev/28/tourtellot.pdf?rd=1 (Retrieved April 2nd 2012). Weber, L. and Giemulla, E. (2011). Handbook on Aviation Law. 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