The Importance of Entry Conditions Texas Air

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The Importance of Entry ConditionsTexas Airs
Acquisition of Eastern Airlines

• By Shaoling Chen and Ling Cen

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Summary of The Deal
Announcement Date Feb 24, 1986 Completion Date Nov 25, 1986 Acquirer 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 Friendly Number of Bidders 2 Other 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 Acts 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 Industry
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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 (contd)
• 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 FAAs
  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 Easterns 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
  Airs 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 IIIWas the acquisition cost efficient?
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Stock Price of the Target
Announcement of acquisition
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Stock Price of Acquirer
Announce to acquire Peoples Express
Announce to acquire Eastern Air
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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 Targets Cumulative Abnormal Return
(-1, 1)
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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 markets
  realistic fear of subsequent predation after an
  anticompetitive merger.

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• Comments (contd)
• 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 TACs 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 IVDid 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
  7780over 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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(Contd)

• 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 airports 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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(Contd)

• 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 low 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)fcq, ACcf/q, MCcltAC
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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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Arguments against easy entry

• 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.

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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
--Slots buy-sell

• 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
• TACs 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.
• TACs 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.

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APPENDIXDetailed 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 Easterns 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
  Airs 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 Peoples 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 Eastern 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.