Delta's Deal: Is There a Math Problem Here?

Posted by: Justin Bachman on April 15

The early reviews on Delta’s deal for Northwest are rolling in, and investors appear unimpressed. Granted, the transaction was elucidated on the same morning that crude oil futures soared to a record $113.93, further underscoring the airlines’ premise for why the combination is necessary. Delta shares tumbled 13% on Apr. 15, while Northwest fell more than 8%. Still, the big smelly rodent crashing this engagement party – which Wall Street had eagerly anticipated – is the enormity of the proposed company. Some 1,500 airplanes, 75,000 employees, seven domestic hubs, pay scales “harmonized” so that Northwest’s former workers earn as much as the ones at Delta. These are not the kind of figures that signal deep cost savings. Wall Street wants fleet “rationalization” and much less flying to the type of towns that yield little profit. Instead, Delta and Northwest executives – with one eye on the political fight ahead over the deal’s fate – are thinking big. “It’s really a combination about addition, not subtraction,” Delta CEO Richard Anderson said Tuesday at a Manhattan press briefing, an hour after a telephone conference call on which analysts succeeded only partially in stifling their skepticism.

The airlines’ managers are thinking of it like this: The financial landscape is a shambles, crude oil will remain around $113 per barrel if not higher, the U.S. market is too fragmented to yield a decent return for anyone and every current player is far too vulnerable financially. International flying is the new gold mine. That’s why adjectives such as “durable,” “viable,” and “resilient” are among the prime talking points in this deal. “We as a country have got to have a strong airline industry,” Anderson said, even using the term “flag carrier” to describe the behemoth he would lead. The combined entity would offer service nearly anywhere to everywhere, giving it a strong bargaining position with corporate travel departments as well as the financial muscle to upgrade its first and business-class amenities to compete with global leaders in that space such as Singapore, Air France-KLM, Emirates, and British Airways. Bigger – as both companies have gleaned from watching the growth of their European partner Air France-KLM – is better in this new environment. The same logic would likely guide other deals, most notably a shotgun marriage of Continental and United. On Tuesday, Continental said it will “review our strategic alternatives and make sure we remain a strong long-term competitor.” Anderson and his team think they can easily realize $1 billion in cost savings and revenue boosts from the combination, with that number the low end of their goal.

All well and good. But if you’re sitting at a hedge fund or a major bank that holds a large and so far money-losing stake in either company, you’re worried about the high hurdles to any real cost savings. Delta and Northwest, to placate politicians and communities who are either leery or hostile to such combinations, are avoiding any notion of the slash-and-burn in their integration plans. At a minimum, it will be politically difficult to cut routes. Minnesota’s junior senator, Amy Klobuchar, is already on record as one who will be watching vigilantly about how consumers fare in the deal. “I will hold their feet to the fire to live up to their commitments and show that any merger is, in fact, in the best interest of Main Street and not just Wall Street,” she said in a statement Monday night. If you’re in Minot or Dothan, Brainerd or Pocatello, have no fear just yet – the new Delta doesn’t plan to leave town.

Additionally, no “frontline” workers such as flight attendants, ticket agents and customer service people will be fired. The only ones facing an “involuntary” dismissal are management and administrative workers, such as human resources and information tech, whose jobs would become redundant. Today, the companies employ just under 88,000, meaning about 12,000 people will be laid off to get the 75,000 people the new airline aims to employ. None of the seven domestic hubs – Atlanta, Cincinnati, Detroit, Memphis, Minneapolis, New York, and Salt Lake City – are expected to close. Northwest CEO Doug Steenland said each hub is “self-sufficient” and will contribute to the overall performance. James Higgins, an analyst with Solebury Research LLC, predicts that one of the second-tier hubs such as Memphis or Cincinnati could later be shut if fuel costs do not abate. The airlines also do not plan to park any older planes. Delta flies more than 100 MD-80s, while Northwest will still operate 82 DC-9s by year’s end. Both are heavy gas users compared to new models. The airlines fly only one similar model, the 757-200, yet Delta and Northwest view this smorgasbord-style fleet as an attribute, allowing them to size any route with a seat precision they could not achieve previously.

Combining two companies is never an easy matter. Bloggers at Reuters, with the help of its future owner Thomson, examined 45 deals since 2003 to see how shareholders fared in the aftermath. The results are mixed, with shareholders making money in fewer than half the deals. But for U.S. airlines, the M&A track record is even more dismal, a fact noted by several analysts on the conference call Tuesday. Delta and Northwest executives say they are starting from positions of strength, with decent balance sheets, and ongoing relationships as part of their SkyTeam alliance.

The deal faces review by the Depts. of Justice and Transportation. The former, especially, will weigh in on whether the combination harms competition. Delta and Northwest say they compete directly in only a dozen of more than 1,000 city pairs they both serve. Of those, eight have two or more competitors and the remaining four cities average only 500 passengers per day, Steenland told analysts. In terms of regulatory review, no one sees major issues, Higgins says. “I think this thing is going to get done and it may get done faster than anyone had expected,” he says.

What’s likely to harm consumers far more, Higgins predicts, is the continued run in fuel prices and the majors’ move to cut back domestic flying even more deeply than they have done so to date. Less supply will quickly bolster fares. Delta and Northwest have already announced combined domestic capacity cuts averaging 7.5% by year’s end, with more likely to come out of the mix if fuel prices continue to hammer the industry.