The Merits of a Midwest Airlines/AirTran Merger

AirTran Airways made headlines today by proposing to buy Midwest Air Group, the parent company of Midwest Airlines, for $11.25 per share, causing Midwest shares to rise over 22% in Wednesday's trading. Late today, Midwest released a statement rebuffing the merger proposal, however, AirTran vows to keep up pressure to merge. Many in Milwaukee, where Midwest is headquartered, aren't happy about the announcement. This merger has been speculated on for years as AirTran and Midwest have better synergies than almost any two airlines in the United States, and a merger could benefit both carriers tremendously. That's not to say there aren't problems with a merger, but they are much smaller given the size and scope of the carriers involved than a Delta/US Airways merger or even this wacky United/Continental merger. (A United/Continental merger is so nutty and nonsensical that I don't have time to talk about it tonight, but there are simply too few synergies and too many costs to make it worthwhile.) There are two primary synergies with the AirTran/Midwest merger that would help both carriers out. First, both airlines operate sizable fleets of Boeing 717-200 aircraft, a rare occurrence given that just over 150 717 aircraft were ever made. Merging the two airlines' 717 fleets will allow the new airline to save money on maintenance, training, and other costs. Second, AirTran is looking to expand further into the Midwestern United States where Midwest Airlines has significant market share, and Midwest Airlines wants to make further inroads on the East Coast where AirTran has an extensive presence. The routes that each airline operates complement each other nicely, and would allow the new company to be strong in both regions.

While the synergies associated with the 717 help reduce costs with this merger, there are a number of other fleet-related factors that complicate matters. First, Midwest Airlines also has a fleet of 11 MD-80 aircraft, that they plan on expanding to 13 by mid-2007. These aircraft aren't compatible with AirTran's 717s, and would likely be tossed from the fleet if a merger occurred. MD-80s can be acquired cheaply by Midwest, but they are also very expensive to operate and aren't compatible with AirTran's business model, since AirTran seeks to be the lowest-cost provider of air travel in the industry by embracing newer, cheaper-to-operate aircraft such as Boeing 717s and 737s. Another issue is the compatibility of AirTran's 737s. AirTran is receiving new 737-700 aircraft from Boeing on a regular basis, but they still have a relatively small fleet of 22 aircraft. Midwest currently has no 737s and has shunned them because Midwest operates from smaller markets in the Midwest that don't require an aircraft as large as the 737. A merged airline would likely concentrate 737s on AirTran's Atlanta and Orlando hubs until the new airline received enough aircraft to start basing 737s in Midwestern cities like Milwaukee or Kansas City. This would eliminate the cost of basing the planes in Kansas City or Milwaukee, which would lead to additional personnel and maintenance costs and given that the new airline couldn't likely fill those 737s from Kansas City or Milwaukee, it makes sense to keep them in safer hubs like Atlanta and Orlando. But the main difference in fleets between the two airlines is Midwest's wholly-owned regional operation, Skyway Airlines. Skyway uses small 19- and 32-seat planes to serve smaller cities in the Midwest. Midwest has also announced interest in purchasing 50-seat aircraft to expand Skyway's operations. Ever since their failed JetExpress experiment, AirTran has been adamant about not having a regional aircraft operation. If a merger occurred, AirTran would likely phase out Skyway Airlines because it doesn't fit into AirTran's core business model of providing simplified service at affordable prices. Regional aircraft like the ones Midwest owns are too expensive, and full of reliability issues that AirTran doesn't want to get involved in. It's hard to see AirTran finding room for Skyway, but perhaps if Midwest could prove that it made fiscal sense, AirTran would be receptive to retaining at least some regional operations. But while there appear to be many dissimilarities between the two carriers' fleets, remember that the 717 makes up the bulk of their fleets. AirTran operates approximately 85 717 aircraft (compared with 22 737s) and Midwest operates 25 717 aircraft (compared with 11 MD-80s and 18 regional aircraft). Because the 717 makes up a sizable chunk of both airlines' fleets, there are significant cost synergies such as reduced maintenance, crew training, and dispatch and operational costs (such as the increased likelihood of being able to find a spare compatible aircraft if there is a mechanical breakdown) that would be very real in a merged airline.

The other major synergy in a merged AirTran/Midwest Airlines would be combined routes. AirTran already serves Milwaukee and Kansas City, Midwest's two primary hubs, and Midwest serves Atlanta and Orlando, AirTran's primary hubs. However, AirTran has struggled to grow in the Midwest. AirTran has succeeded on the East Coast in part due to Southwest's relative lack of service in that region. But Southwest has long been established in the Midwest, and has substantial market share in cities such as Chicago, Kansas City, Omaha, and Dallas. While Midwest Airlines doesn't serve Chicago, it does serve all the other listed markets, and has significant market share in both Kansas City and Omaha. In fact, Midwest used to have even greater market share in Omaha, but substantially reduced service to the city in part due to competition from Southwest and in order to reduce costs. Kansas City and Omaha are two important Southwest markets, and AirTran would love to battle Southwest in these cities given that AirTran lost a major market share battle in Chicago against Southwest a couple years ago. Midwest Airlines has struggled against Southwest, and has tried to use its more upscale brand in order to win over customers. However, with AirTran's lower costs, a merged airline could offer customers more options to the East Coast from Kansas City and Omaha. Southwest still might retain considerable market share on flights to the West Coast, but a merged AirTran/Midwest could give Southwest a run for its money in Kansas City, where Southwest offers daily nonstop flights to several cities on the East Coast, as well as Omaha, where Southwest offers convenient connecting service to many East Coast cities. AirTran would also get improved access to markets such as Minneapolis where Midwest has already made a strong push for market share. AirTran would also get its first Canadian market, albeit one operated by Skyway Airlines, Toronto. Even if AirTran scrapped Skyway, they might use the merger as an opportunity to expand into Canada, including Eastern cities such as Toronto, Montreal, and Ottawa. Through a merger, Midwest customers would receive access to a wide-ranging AirTran network on the East Coast and beyond. Midwest customers would be able to fly to many cities that aren't currently served by Midwest such as Raleigh-Durham, Charlotte, Detroit, Chicago, and dozens more. It would enable Midwest to expand Eastward and provide extensive service for its customers, something that Midwest has tried to do in vain for years. The route networks for both airlines would complement each other nicely and allow each airline's customers to fly to previously unserved cities at a lower cost.

One wild card in the merger is what kind of amenities the new airline would offer. Midwest has suffered with a split identity for several years now, offering its Signature Service with 2x2 seating on flights to business destinations while offering Saver Service with 2x3 seating on flights to leisure destinations. The airline used to offer far more amenities than it currently does, post-9/11 economics forced Midwest to cut many aspects of its product that customers weren't willing to pay extra for, such as gourmet meals served on china. But the mixed products does create a problem for AirTran, which has a standard, low-cost product. AirTran offers minimal seat pitch to most customers, even less than most legacy carriers with an average seat pitch of between 30 and 32 inches. AirTran also offers business class with several more inches of seat pitch to those who will pay for it. AirTran also offers free XM Satellite Radio on most flights, something Midwest lacks. With this simple philosophy, AirTran has one of the lowest seat mile costs in the industry. If AirTran wants to lower costs, they must reconfigure Midwest's 717s with a typical AirTran seating configuration of 12 business class seats and 105 in coach and standardize the onboard product with XM Satellite Radio and a standard array of free snacks and beverages. While AirTran may lose some Midwest Airlines customers who fly Midwest because it offers a superior product, AirTran will likely win over more customers who will fly the airline because it offers lower fares and because AirTran's product is better than Southwest's. This sounds like a challenge, but rebranding the new carrier will be much easier than reconciling some of the other differences between the two carriers.

While Midwest rejected a merger today, in the future, if AirTran sees value in pursuing Midwest, a merger will occur. This merger will be much easier to complete and makes far more sense because of the demonstrated synergies of both carriers than either the Delta/US Airways or United/Continental mergers. It's worrisome to hear that the media has now picked up on the news of merger talks at several airlines as a sign of merger frenzy occurring in the industry. While there will likely be consolidation, particularly from smaller carriers such as AirTran, Midwest, or Spirit (which appears to be a realistic takeover target by JetBlue or Frontier), consolidation will not sweep through the big six legacy carriers, and merger combinations such as Delta/US Airways or United/Continental don't make sense from a business standpoint for many reasons unless there are significant labor, operational, route, brand, and fleet changes at those companies. Simply because a merged airline can raise fares doesn't mean that there are sufficient synergies, particularly in the areas of fleets, routes, and labor agreements, between the airlines to warrant a merger. With AirTran and Midwest these synergies exist to a far greater degree than between any of the six major legacy carriers. Hopefully, if airline executives do their job and try to protect shareholder value, and not protect investment bankers who want to conduct mergers and make large commissions in the process, then the US Airways/Delta and United/Continental mergers won't occur. But mergers between smaller airlines that have simpler route networks, fleets, and labor agreements are more realistic, and allow both airlines to grow substantially in the process. If AirTran merges with Midwest and uses the merger to create an optimized airline with an extensive low-cost route network to the East of the Mississippi, then both airlines will benefit tremendously, and it will pose a major competitive threat to Southwest in certain markets. I can guarantee that we haven't seen the last of AirTran's bids, but further information on the merger might not come until after the holidays. A release of more information or a revised bid by AirTran will certainly be something to watch for over the next few weeks.