US low-costs turn to mergers

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The acquisition of AirTran Airways by Southwest Airlines sees consolidation move into the US low-cost sector, writes Lori Ranson in Washington

Maturity in the North American market continues to manifest itself rapidly with the landmark acquisition of AirTran Airways by Southwest, ushering the first true-scale consolidation in the US low-cost sector.

The acquisition allows Southwest to achieve 25% growth much faster than it would on its own, while accelerating the race to hit its 15% target of return on invested capital.

Expansion of the Southwest franchise should replace an AirTran management team "not sufficiently focused on generating acceptable returns, while susceptible to costly market share skirmishes, such as Milwaukee", declare analysts at JP Morgan. They estimate Southwest's yields on short-haul flights are as much as 30% higher than AirTran's, while Southwest's yield premium on short-haul flights is 16%.

Summarising AirTran's decision to ultimately accept Southwest's offer company chief executive Bob Fornaro says: "We're a pretty scrappy company. We've done a lot with very little in many ways. It's a tough industry. You've got to put yourself in a position where you can win."

NETWORK BUILDING

If they endorse the $1.4 billion acquisition, AirTran shareholders stand to receive a premium for their shares north of 60%, and Southwest gets cherished access to a gaping hole in its route network - Atlanta. "I think the story here is about Atlanta," says Southwest chief executive Gary Kelly. "I think it is about us bringing in more competition, bringing more low fares. We see a number of city pair opportunities to go in, lower fares and stimulate traffic in classic Southwest fashion."

But not all industry watchers are convinced Southwest will encounter ease in working its magic in Atlanta. In an extensive analysis of the deal, Denver-based consultancy The Boyd Group International concludes Atlanta has already witnessed the "AirTran effect". Its analysts argue "Southwest is replacing an existing low-fare airline, not introducing low fares to Atlanta". Its analysis sees only two markets in the top 25 origin and destination cities from Atlanta where Southwest could have a material effect - Newark and Salt Lake City.

Although Southwest pledges to grow Atlanta, Boyd Group's analysis argues that challenges exist to expansion, and Southwest will need to rely on a more traditional bank structure to profitably execute that growth.

Those analysts point to the often-publicised myth that Southwest is a point-to-point purist, arguing that at 10 of the carrier's top 19 airports, flow passengers account for more than a third of traffic. Boyd's analysts warn that in Atlanta "fast turns for the sake of utilisation won't work". They believe the levels of connecting traffic necessary to make Atlanta successful "are far in excess of what it [Southwest] is accomplishing today, even at Midway".

IS DELTA WORRIED?

Southwest's access to Atlanta gained through the AirTran acquisition has spurred speculation that Atlanta powerhouse Delta might be worried. But experts dismiss that theory, arguing that legacy-low cost competition is entrenched throughout the USA. "Network carriers already compete with the low-cost sector for nearly 85% of their domestic revenues," says Massachusetts Institute of Technology airline analyst William Swelbar. While noting there could be some new competition on the 37 markets that AirTran serves, but are not presently on Southwest's route map, "for the most part those cities already enjoy the low fares delivered via AirTran's initial entry".

In its analysis, the Boyd Group concludes that since AirTran has entered most of the largest O&D markets in Atlanta, Delta has in almost all cases been able to maintain a revenue yield premium in markets competitive with AirTran.

AirTran's passengers in Atlanta have also had product offerings that Southwest plans to dissolve including a premium class and assigned seating. "At this point in time we are not assuming that we will be open to assigning seats, charging for bags, having dual class services, anything along those lines," Kelly says.

Introduction of the Southwest brand in Atlanta could drive a small benefit for Delta, note JP Morgan's analysts. "At the margin the elimination of assigned seats and ability to upgrade may also shift some additional corporate share to Delta, though certain passengers seem to rather enjoy the more egalitarian, predictable Southwest experience."

Headlines may focus on Southwest's invasion of Delta's hub, but Swelbar of MIT believes US low-cost carriers Frontier and Spirit Airlines could be the big losers. Frontier is now confined to traffic bases at Denver and Milwaukee, "and that makes them vulnerable", he says. Fresh from unveiling plans for a $300 million initial public offering, Spirit now faces a combined Southwest-AirTran focused on carrying traffic to Spirit's Caribbean stronghold.

Despite the 20-route overlap of AirTran and Southwest being more than Delta/Northwest and Continental/United, JP Morgan's analysts see "no unique hurdles" in the deal being endorsed by US regulators. "Given Southwest's well-documented consumer benefits, it seems unlikely to us that the Department of Justice would mandate any significant divestitures," it says, adding it does not appear to pose any issue of concentration in slot-constrained, sought-after markets.