Merge or Be Purged: Will Southwest’s Aggressive Move Work?

Southwest Airlines (LUV) announced this past Monday that it would acquire AirTran Airways (AAI) for $1.4 billion in cash and stock. The details of the deal: AirTran shareholders will receive at least $3.75 in cash and 0.321 shares of Southwest stock for each share of AirTran.  On a per share basis, shareholders are looking at between $7.25 and $7.75, depending on the price movements of Southwest for a 20-day period near the completion of the merger.  Southwest will adjust the amounts and ratios of stock and cash included in the deal depending on these stock movements.  The bid is a 69% premium over AirTran’s previous Friday’s closing price.

Other than the companies’ respective press releases and a few articles here and there, the deal doesn’t seem to be garnering the attention that it should, given that it came as a surprise and that it’s a further example of the growing trend towards consolidation in the airline industry, which we’ll call “merge, or be purged.”

Many industry experts agree with airline executives, who say that consolidation will ultimately produce three or four major airlines. In the past two years alone, we’ve seen the planned merger of United Airlines (UAL) and Continental Airlines (CAL) (which closed on Friday) and the 2008 deal between Delta Airlines (DAL) and Northwest Airlines.  Analysts speculate that American Airlines (AMR) is next.  Will they tie the knot with US Airways (LCC) or even JetBlue (JBLU)?

First, a little history.  What comes to mind when thinking about Southwest? Cheaper flights, free bags, and seating frenzies!  When the company first started in 1971, it prided itself on being a discount airline, offering its customers lower fares in the airports it served, primarily in Texas.  Its initial strategy worked wonders: Southwest is a low-cost carrier, which means that it contains costs by utilizing one type of Boeing 737 plane in smaller airports where operational costs are lower, and by refusing to offer first-class and business-class seats.  As a result, it can give customers lower ticket prices and, what we all love, free checked bags.  Consequently, Southwest grabbed market share from higher-cost competitors and stayed alive when many airlines filed for bankruptcy.

On the surface, this looks like a win-win situation for Southwest and consumers: Southwest will gain access to Atlanta and limited spots in Washington DC, Boston, and New York, while consumers will be able to find cheaper flights in more airports.  After all, AirTran is also a low-cost carrier, utilizing only two types of planes.  However, a deeper look into the potential implications for this merger and similar deals suggests that market forces may eventually rain on our parade of free baggage.

What’s the rationale behind industry consolidation? Basic supply and demand.  Too many airline seats remain empty, hampering the ability of airlines to raise ticket prices, which dampens profitability. The massive costs associated with running an airline encourage many of these companies to double-up to realize the cost efficiencies in the inherent economies of scale.

Recently, Southwest has been looking for ways to jump-start growth in the face of empty airline seats, as last year alone revenue declined 6.1%: the company indicated interest in expanding in the US and possibly establishing international flights to neighboring countries as well as acquiring larger aircraft.  Purchasing AirTran is one solution to this dilemma, but it’s a risky move.  Sure, Southwest will now have access to busier airports in the US, as well as in Cancun, Mexico, and the Caribbean, but the company only has experience with two other mergers, Morris Air in 1993 and Muse Air in 1985.  Plus, we all know the merger party never starts until unions get involved.  In Southwest’s previous deals, its pilots wanted the target’s pilots kicked to the bottom of the seniority list.  This may not fly with AirTran pilots.

Ultimately, here’s the problem: Southwest’s CEO, Gary C. Kelly, claims that this merger is simply another page in the low-cost business model.  It is unclear whether the new airports it will serve, including Atlanta, Washington, and a bolstered presence at La Guardia, really fit into this model.  Atlanta, in particular, is a strategic move on the part of Southwest: AirTran is the second-largest airline at Hartsfield-Jackson International Airport, the most active airport in the US.  Operational costs won’t be as low as Southwest is accustomed to, and it now will own a greater variety of planes as a result of the acquisition.  AirTran uses services such as Expedia, which Southwest traditionally shunned as a part of its cost-saving strategy.  Plus, it remains to be seen whether Southwest will be able to drive down ticket prices at these major airports, or will simply jump on the price gauging bank wagon.  This is really an economic experiment: the big boys in the Northeast, including American and Delta, may be comfortable with the status quo, but upon Southwest’s debut on their turf, they may feel pressure to compete.

Not to worry though.  CEO Kelly himself assures us that we’ll still get free checked bags, and we’ll still be able to scramble for seats.  We’ll see. The ultimate question is: which way will ticket prices go? Will Southwest give in or muscle out the big boys?

Disclosure: No positions in the stocks mentioned.