US Air American Airlines Merger Blocked, Implications for European Deals

The Justice department has announced that it is suing to block the USAIR-American Airlines, Merger.  We have previously written about the use of concentration ratios to ascertain the competitive impact of a merger involving Annheuser Busch and Modelo.

The arguments for and against are standard.  On the pro-merger side, the combination is expected to lower costs through economies of scale and permit lower pricing for consumers. In addition, since the service routes of the two airlines are complimentary, the merger could provide better linkage for consumers.

On the anti-merger side is the recognition that with increased market share, especially in selected 'hubs', the airlines will be able to charge higher prices with their more monopolistic standing.

In Europe, airline margins are tighter than the US.  In a very interesting article, the CAPA Center for Aviation discusses concentration ratios and margins around the world focusing on the opportunities for additional concentration in Europe.  See European Airlines, Few Deals to be Done.

All the best,

Ralph

Sex, Lies, and Firm Value

Today, two of my coauthors, Brandon Cline and Adam Yore, are featured as guest bloggers today talking about a recent paper of ours entitled, The Agency Costs of Managerial Indiscretions: Sex, Lies, and Firm Value.

All the best

Ralph

The Agency Costs of Managerial Indiscretions: Sex, Lies, and Firm Value

 Ethics and codes of conduct are frequently placed at the forefront of corporate policy. Recently, many have even argued that the integrity of management is a factor of production. The notion is that mutual trust between two economic agents reduces transactions costs as it mitigates the need for excessive contracting. However, when trust among economic agents is breached, the offending agent’s reputation is damaged. The penalties resulting from the damaged reputation are often a multiple of the actual harm associated with the offending event.

Many executives face ethical charges in their personal lives unrelated to the firm’s financial or operating decisions. Boeing’s Harry Stonecipher, RadioShack’s David Edmonson, Staples’ Martin Hanika, and Raytheon’s William Swanson were all placed under the spotlight for engaging in alleged extramarital affairs, substance abuse, domestic violence, or public displays of dishonesty.

In a paper just released we examine a sample of executives accused of indiscretions in their personal lives for actions explicitly unrelated to the operations of their firm. These include allegations of violence, substance abuse, dishonesty, and sexual misadventure. The objective of this research is to examine the corporate agency costs associated with alleged indiscretions in executive’s personal life.

The existence of alleged improprieties in an executive’s personal life raises important questions for corporate governance. First, what is the impact of these allegations (if any) on the valuation and operations of the firm, and do these allegations have the potential to signal important managerial qualities to the market? A second set of questions asks whether an executive’s alleged personal indiscretions relate to subsequent questionable or even illegal activities at the firm level including earnings management, actions provoking shareholder lawsuits, or fraud. In essence, are signals suggested by personal indiscretions borne out by successive actions in the corporate setting?

While these actions are personal in nature, we find that they signal significant agency costs for the firm. The data indicates that managerial indiscretions pose a significant risk to the company and inflict substantial agency costs upon shareholders, particularly when the CEO is involved. On average, there is an immediate 3.8% loss in shareholder value at the disclosure of a CEO indiscretion and operating performance suffers an abnormal decline of 1.5% during the same fiscal year. In addition, the firms of these executives experience a long-run abnormal decline in value of 9% to 12% during the year of an indiscretion. These firms are also more likely to be involved in shareholder-initiated lawsuits, DOJ/SEC investigations, and are significantly more likely to manage their earnings. Notably, only 25% of executives face disciplinary turnover for these offenses, despite the fact that a significant fraction of these executives are repeat offenders. In fact, the turnover rate for repeat offenders is almost identical to that of first time offenders. At best, this implies that the typical firm’s board does not feel that that management’s behavior poses a problem. At worst, it implies that boards are ineffective at preventing these events or are simply apathetic to their consequences.

The paper contains many other results. It is authored by Brandon N. Cline of Mississippi State University, Ralph Walkling of Drexel University, and Adam Yore of Northern Illinois. It can be downloaded here.

Concentration Ratios: The Case of Anheuser Busch and Modelo

On Friday, the Wall Street Journal reported that

U.S. Sues to Block $20 Billion Beer Merger

WSJ Feb 1, 2013

Picture by WSJ 

When the government thinks of opposing a merger like this, they try to discern whether an industry is overly concentrated, and thus prone to monopoly like behavior; they often use two ratios.  The first is the 4-firm concentration ratio, simply the sum of the four largest producers.  The second ratio is the Herfindahl-Hershman index, the sum of the squared market values of all firms in the industry.  The range of values for this index are close to zero for a highly populated, highly competitive industry (say 100 firms, each with 1% market share)  to a maximum of 10,000 for a case where one firm has 100% of the market.

The Department of Justice website gives more details on the HH index, noting that values in excess of 2500 are considered to have excess concentration.

So what is the HH index for the beer industry and what are the problems with the use of this method?

For the distribution of market shares noted above, the HH index would be equal 2766 before the merger and 3312 after.  The calculations are shown below.

Company	Market Share	Market Sh Squared	Mkt Sh with merger	Mkt. sh with merger sq
Ann Busch	39	1521
Modelo	7	49	46	2116
MillerCoors	26	676	26	676
Heineken	6	36	6	36
Others	22	484	22	484
Sum	100	2766	100	3312

This HH can be  a very useful ratio.  But I want to illustrate some of its problems.  First, note that when we square values, higher numbers produce more extreme values.  Note that the squares associated with, say 1, 2, 3, and 5 produce ever increasing square values of 1, 4, 9 and 25.  Larger market shares produce larger numbers.

So here is a first limitation to note:  I took all the 'other' beer distributors and grouped them in one category, resulting in a 22% market share.  That is, I artificially created a company with a 22% market share.  What is the impact of this?  Well, let's change that assumption.  Let's now assume there are 11 'other' competitors, each with a 2% market share.

Company	Market Share	Market Sh Squared	Mkt Sh with merger	Mkt. sh with merger sq
Ann Busch	39	1521
Modelo	7	49	46	2116
MillerCoors	26	676	26	676
Heineken	6	36	6	36
Others           a	2	4	2	4
b	2	4	2	4
c	2	4	2	4
d	2	4	2	4
e	2	4	2	4
f	2	4	2	4
g	2	4	2	4
h	2	4	2	4
i	2	4	2	4
j	2	4	2	4
k	2	4	2	4
Sum	100	2326	100	2872

The HH index is substantially lower, although the merger is still above the limit of 2500 set by the DOJ.

A second and more fundamental criticism of the HH index concerns the definition of 'market'.  Some natural questions arise.  What is the market?

OK, let's start with geography to define our market.  Is is just International? Domestic?  Within a state?  I'll bet more Red Hook is sold in Seattle than in Philly.  Does that make Red Hook anti-competitive in Seattle?

Perhaps more fundamental, what is a market in terms of the product?  Think of Powerade, a low or zero calorie flavored drink.  What comprises its market?  Flavored drinks?  Bottled water?  Soft Drinks?  Beer?  Okay, I'll give you that one - but other questions have less obvious answers.  Does the market for beer include wine?  How about wine spritzers, etc?

And --- if we turn to technology the answers are even more uncertain.  What is the competitive market for HP calculators?  All calculators?  All calculators and personal computers?  Hand-held personal computers?  Cell phones?  Watches with calculators?   Something not yet invented?

The point is - the HH is a useful measure - once we can agree on the market.  But defining that market sometimes requires heroic assumptions.  Think I'll open my Sierra Nevada and contemplate this some more.

Ralph