The Importance of Entry Conditions

Texas Air’s Acquisition of Eastern Airlines

By Shaoling Chen and Ling Cen

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Summary of The DealAnnouncement Date: Feb 24, 1986Completion Date: Nov 25, 1986Acquirer: Texas Air Corp. Target: Eastern Airlines Inc% Shares Acquired: 100% Mean of Payment: 62.5% Cash, 37.5% stock Deal Value at Completion: 621.1 Million Deal Attitude: FriendlyNumber of Bidders: 2Other Bidder: Eastern Airlines Workers’ Union

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PART I: Background

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Industry In 1987, the Congress passed the Airline Deregulation Act; On December 31, 1984, the authority to enforce the Act’s

antitrust provisions was transferred from the Civil Aeronautics Board (CAB) to the Department of Transportation (DOT);

In the early years after deregulation, many new carriers did enter the industry, and many existing carriers did enter new markets;

After 1985, the rate of entry declined and most of new entrants went bankrupt or were absorbed in mergers;

Major airlines all adopted “hub-and-spoke” networks.

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History Of Acquisition in Airway IndustryAcquiror Full Name Target Name Date

AnnouncedDateEffective

DateWithdrawn

% ofSharesAcq.

Value ofTransaction($mil)

Trans World Airlines Inc Trans World Airlines Inc 1985-3-13 1985-4-16 38.9

Texas Air Corp Frontier Holdings Inc 1985-4-3 1985-10-9 275

Texas Air Corp Trans World Airlines Inc 1985-6-10 1985-12-18 852.4

Texas Air Corp Eastern Air Lines Inc 1986-2-24 1986-11-25 100 621.1

Trans World Airlines Inc Ozark Holding Inc 1986-2-27 1986-9-15 100 241.4

Pan Am Corp Eastern Air Lines Inc 1986-3-7 1986-3-7

Delta Air Lines Inc Jet America Airlines 1986-8-18 1986-9-11 18.7

Delta Air Lines Inc Western Airlines Inc 1986-9-9 1986-12-19 100 860

Texas Air Corp People Express Inc 1986-9-15 1986-12-30 100 289.5

American Airlines Inc ACI Holdings Inc 1986-11-17 1987-4-30 100 221.4

Pan American WorldAirways (Pan Am Corp)

Templehof Airways 1987-1-2

AMR Corp Pan Am Corp 1987-1-16 1987-2-23

Trans World Airlines Inc US Air Group Inc 1987-3-4 1987-3-16 1,616.40

Texas Air Corp Bar Harbor Airlines 1987-4-17 1987-4-17 100

Trans World Airlines,ACFIndustries

Texaco Inc 1988-3-7 1988-6-20 13,660.00

AMR Corp Wings West Airlines Inc 1988-4-18 1988-8-10 100 41.7

AMR Eagle-East Inc(AMRCorp)

Command Airways Inc 1988-6-13 1988-9-28 100 24.5

AMR Eagle-CentralInc(AMR Corp)

Simmons Airlines Inc 1988-6-20 1988-8-8 100 75.6

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Firms

Prior to the acquisition, TAC was the eighth largest air carrier; and Eastern was the third largest carrier.

TAC was a low-cost, high-productivity carrier while Eastern was high-cost, low-productivity.

The major rivals of TAC long the same lines were Delta, People Express, Presidential, and to a lesser extent USAir and Piedmont.

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Firms (cont’d)

TAC had hubs at Denver, Houston, and Newark, while Eastern had bubs at Atlanta, Miami and Kansas City.

The direct competition between Eastern and the TAC carriers involved their hourly shuttle services in the Northeast corridor: New York (LaGuardia)—Washington (National Airport) and New York (LaGuardia)—Boston (Logan Airport), two of which were the airports covered by FAA’s high-density rule where “slots” were needed to gain entry.

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USA Airports

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PART II: Time Line

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Feb 24, 1986: Texas Airline and Eastern Airline jointly announced the merger decision, as a resolution of Eastern’s financial and labor crisis.

Mar 20, 1986: President Airway called a full evidentiary hearing on the “anti-competitive” impact from the proposed Texas-Eastern merger on shuttle service between Washington and New York.

May 13, 1986: Texas Air agreed to provide Pan Am with one gate at Logan Field, and two gates at LaGuardia, as well as nine airport takeoff and landing rights at National Airport and 23 takeoff and landing rights at LaGuardia. And Pan Am paid $65 millions for theses slots.

July 9, 1986 : The DOT tentatively approved Texas Air’s acquisition, but insisted on guarantees that Pan American World Airways can provide effective competition to Eastern's Washington-New York-Boston shuttle.

Aug 27, 1986: DOT rejected the proposed acquisition in concerning the reduce competition on the shuttle routes serving New York, Boston and Washington.

Sept 12, 1986: Texas Air Corp. Friday refiled with DOT a new agreement that provided Pan Am with enough take-off and landing slots in the Northeast shuttle markets.

Oct 1, 1986: DOT granted the final approval to the deal. Nov 25, 1986: Deal Completed.

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PART III:Was the acquisition cost efficient?

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Stock Price of the Target

Eastern Airline Inc (Jan 1985-Nov 1986)

0

5

10

15

pric

e

Announcement of acquisition

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Stock Price of Acquirer Texas Air's Stock Price (Jan 1985-Dec 1986)

01020304050

Announce to acquire Eastern Air

Announce to acquire People’s Express

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Event Study Of Announcement Effect

Event Study: Find the pricing anomaly given an information shock.

Methodology estimation window event window post event

window

-250 -30 -1 1 complete

Pricing Model: CAPM, APT or Other factor pricing model

Abnormal Return: Deviation from the expected return according to the estimated pricing model from estimation window. (Announcement changes the pricing behavior)

Announcement (day 0)

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Acquirer and Target’s Cumulative Abnormal Return (-1, 1)

-0. 10

0. 10. 20. 30. 40. 50. 60. 70. 8

CAR(Texas Ai r) CAR(Easter Ai rl i ne)

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Stock prices of competitors prior to/post acquisition announcement(announce February 24, 1986)

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Comments Arguments against “cost efficiency” by merger

opponents: the merger was perceived as anticompetitive.

The merger announcement did not cause a statistically discernible increase in all the competitors’ stock prices;

Even though some competitors’ stock prices depreciated, it only reflected the market’s realistic fear of subsequent predation after an anticompetitive merger.

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Comments (cont’d) Arguments for “cost efficiency” by merger applicants:

the merger was perceived as pro-competitive.

The stock prices of their major competitors whose performances were relatively inefficient were greatly depressed by the announcement of the merger;

Those carriers facing either little director competition from TAC or Eastern or being already in competition with TAC’s low-cost Continental were relatively unaffected.

The carriers whose stocks appreciated comprised a group whose value might be enhanced because of the enhanced prospect of their acquisition.

The economic circumstances for successful predation in this industry were largely absent.

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PART IV:Did the merger applicants have

market power?

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Market Definition and Concentration Arguments for:

From the consumers’ perspective, service between point A and point B would rarely be seen as a substitute for service between points A and C. Thus, each “city pair” should be regarded as a separate market.

Under this circumstances, the average HHI of a sample of 5053 city-pair markets in the1981, was 7780—over 4 times the DOJ “highly concentrated” threshold.

Arguments against: Provision of scheduled

airline service among “overlap city pairs” at the national level should be relevant markets when considering all kinds of “nonstop”, “single plane”, and “connecting” air services.

The proposed TAC-Eastern merger fell well within the DOJ “safe harbor” in terms of the national market, with a post-merger HHI of 839.9 and with an indicated change in the HHI of 96.7.

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(Cont’d) Arguments for:

A relevant market could be defined as airport pairs.

The other incumbents at the airport pair would be unable or unlikely to provide competitive discipline.

Entry barriers, such as “slots” especially, were sufficiently high to foreclose or substantially mitigate a discipline effect of potential competition by new entrants at the airport pair.

Arguments against: Competitive services from other airpor

ts in the cities could not be excluded from the relevant market:

Within a metropolitan area airports are much closer substitutes for many travellers.

The traffic flows between other airports over NY-Washington had increased compared to LaGuardia-National flows.

The demand elasticity for services from preferred airports would be high.

The existence of other strong incumbents could adequately discipline any attempted exercise of market power by initiating service between those airports.

Beginning on April, 1986, carriers could freely buy, sell, or trade slots at capacity-constrained airports.

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(Cont’d)

Arguments for: Significant rents yet persisted

in the form of excessive compensation for labor and management due to the strong power of labor union.

Concentration of hubs after the merger might prevent entry and injure competitiveness.

Contestability depends on free and costless entry and exit, while potential entry barriers were widespread.

Arguments against: The pervasive fare discounting and lo

w industry profits attested that no market power was exercised even in a “city pair” market.

TAC and Eastern had hubs at quite different areas. Thus, their merger would not have added effect of hub dominance on competition.

Concentration statistics such as HHI was not an appropriate mechanism to evaluate market power. Airline industry was a “perfect contestable market”, where supracompetitive pricing could not be sustained.

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Contestable market When entry is free and exit is costless, the equilibrium price would

approach the competitive price (AC), regardless of the number of actual competitors. Such a market is called “Contestable market.

The “threat of entry” has an effect on the market behavior of the incumbent firm.

Market concentration does not mean market power definitely.

Example:C(q)=f+cq, AC=c+f/q, MC=c<AC

qc

pc

MC=c

q=D(p)

AC=c+f/q

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PART V: Was the entry easy?

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Arguments for “easy entry”: The aircraft is not inherently dedicated to

produce any specific service and is by design quite mobile, firms may convert production from serving one set of points to another easily and, in most instances, at little cost.

Even for the service from capacity-controlled airports, the existence of a free market for slots transformed the slot requirement from an entry barrier to an ordinary asset requisite for production.

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Entry barriers on capacity and operation authority at airports It was difficult to build new airports to accommodate

new entry, which was mostly because of noise restrictions.

It was difficult to share or expand existing airports because:

Gates leases or building was limited by exclusive-use contracts, majority-in-interest clauses, etc.;Initiating operations was sometimes prohibited by noise restrictions, especially for several regional new entrants.

The sale of slots declined while trade between related firms increased.

Arguments against “easy entry”:

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Entry barriers due to airline marketing strategies Computerized reservation systems (CRS); Frequent flyer plans; Volume incentives

Travel agent commission overrides (TACOs);

Overbooking privileges;

Free tickets;

VIP club memberships, etc.

Code-sharing

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An Example in Our Case:

How TAC responded to the potential entry of Pan Am under different entry conditions?

Before Aug 27, 1986 when DOT rejected the proposed merger because of reduced competition: entry is neither free nor costless

TAC’s strategy: invest in excess capacity (holding quite a large number of slots) to deter entry. Such a strategy is called “Top Dog” strategy.

After the rejection, TAC was forced to create free and costless entry conditions for the approval of merger.

TAC’s strategy: reduce investment in capacity (selling enough number of slots and gates to Pan Am at acceptable price) to accommodate entry. Such a strategy is called “Puppy Dog” strategy.

--Slots buy-sell

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APPENDIX:Detailed Time Line

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January 1986: Eastern Airline fell into financial distress and the board urged a wage cut of labor cost (wage). The Eastern Airline worker (pilots) union responded with a strike threat.

Feb 24, 1986: Texas Airline and Eastern Airline jointly announced the merger decision, as a resolution of Eastern’s financial and labor crisis.

Mar 12, 1986: Pan American asked the DOT to force Texas Air Corp. to reduce its holdings in Eastern Airlines, so that other bidders for Eastern might emerge.

Mar 14, 1986: DOT gave Texas Air limited approval yesterday to acquire up to 51 percent of Eastern Airlines stock while the department reviews the proposed merger of the two airline companies.

Mar 20, 1986: President Airway called a full evidentiary hearing on the “anti-competitive” impact from the proposed Texas-Eastern merger on shuttle service between Washington and New York.

May 13, 1986: Texas Air agreed to provide Pan Am with one gate at Logan Field, and two gates at LaGuardia, as well as nine airport takeoff and landing rights at National Airport and 23 takeoff and landing rights at LaGuardia. And Pan Am paid $65 millions for theses slots.

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July 9, 1986 : The DOT tentatively approved Texas Air’s acquisition, but insisted on guarantees that Pan American World Airways can provide effective competition to Eastern's Washington-New York-Boston shuttle.

Aug 27, 1986: DOT rejected the proposed acquisition in concerning the reduce competition on the shuttle routes serving New York, Boston and Washington.

Sept 12, 1986: Texas Air Corp. Friday refiled with DOT a new agreement that provided Pan Am with enough take-off and landing slots in the Northeast shuttle markets.

Sept 15, 1986: Texas Air Corp announced to buy the financial-distressed People’s Express Inc. for 125 millions.

Sept 18, 1986: Texas Air Corp. completed the transfer of 75 slots at two airports to Pan American for $60.7 million.

Sept 19, 1986: Federal government approved a revised proposal by the Texas Air Corporation to acquire Eastern Air.

Oct 1, 1986: DOT granted the final approval to the deal. Nov 10, 1986: Eastern Air workers’ union, representing about 44,000 E

astern Air Lines employees offered to buy the Eastern Air for 600 m and filed a lawsuit seeking to block the sale of the company to Texas Air.

Nov 25, 1986: Deal Completed.