Journal of Financial Economics 43 (1997) 275-298

Privatization and efficiency: Industry effects of the sale of British Airways

Catherine Eckel, Doug Eckel, Vijay SingaP Virginia Pohechuic lrrrliarv ad Swe Wm. &c&q. VA 2UW. US.4

(Received Apill!?95; final v&on received July 1996)

We analyze the etkt 04 privatization on the performance of British Airways by examining the privatization’s impa on airfares and competitors’ stock priax We find that stodc prim of U.S. annpetil9rs fell a sigoiticant 7% up00 British Airways’ privatb tion. imply@ expectation afa more annpetitive British Airways Closcx rivals d British Aimarn~agcPlcrdrcpinstoclrpiccthanmonctiwntrivakFurthcr. airfares in markets send by British Airways kll sigdcantly upon pcivatizatioo. The results suggest that a change from gov-mamm t to private ownaship improves economic --

__

Ker nxmfx Privatization; Ownership; Airlines Eritisb Airways IEL cfass@ctuionz G32; L3k G38; L93

When a firm is privatiz& several factors change simultaneously. Firs4 the ownership changes from the government to private hands. !kcond, the firm’s

--.. ._- .--.-- l c orqmdmg author.

This paper iu.5 bcnditai fran helpful fx3inmmI.s and kalbask from workshop participeDts 81 the Unbwsity d Arizwm, University of North Cardina at Chapel fJill. lad Virginia Pdytbnic Institute and Sate University. We agqxbate the ax~.~ructivc su~kms of Jobn Chahuax Lhvc Dmis Diane Desk. Rob Hansat. Murali Jaganaatban, Greg Kadkc. Dan Lem, Nancy Lutz Michael Wcisbach, Ken Ldm (tbc I&U). a& cqkally of Jerry Waracs (tbc cditor~ Mabesh hitamani provkkd cxalkot raateh assistam. Cathcriw E&l is gratdul lbr the nrpp011 d a Gilder Foundation Fdlowsbp through the konomic Scbce L;rh Univtity of Arizona Singal ackrwwkdges support da Virginia Tech sumour grant-

0304-4OSXA76IS.00 (’ I997 Elscvitr !kknce S.A. All rights rescrval P/I SO304-405X(96)00893-8

276 C. Eckel et al. I Journal o/Financial Economics 43 (1997) 275 - 29R

objective changes to profit maximization. Third, changes in regulation designed to enhance competition in product markets are likely to take place. While previous studies of privatization (e.g, Galal, Jones, Tandon, and Vogelsang, 1994; Megginson, Nash, and van Randenborgh. 1994) find that firm perfor- mance as measured by profits improves after privatization, it is not clear whether the observed improvement in performance is due to privatization or to changes in the firm objtctive and the market environment. Further, these studies rely on accounting data, which imperfectly measure performance and an subject to manipulation by the management (see Barber and Lyon, 1996; Healy, 1985; DeFond and Jiambalvo. 1994). Because of the change in management ineen- tivex accounting data may mdicate an improvement in firm performance even if such an improvement has not occurred.

Instead of using accounting data. we employ data from the stock market and the product market because these markets are unbiased and less vulnerabk to manipulation. Examining the stock price reaction of the privatizd firm’s rivals allows us to infer the expected impact of privatization on the performaruz of the privatizd firm. To control for anv accompanying changes in regulation we lipi-it c\.*) .,~)a~> .'. id ~,~:u&~ai marker qments in whrch the regulatory pcrlicies of any one country have little or no influence. In this way, we minimize the distorting effect of changes in reporting incentives and in the competitive environment that occur concurrently with changes in ownership around privati- tations.

We examine the impact of British Airways’ privatization on U.S. airlines identified as its dose competitors in international markets. Our results indicate that the stock prices of these rivals fell significantly around announcements that signakd the likeiihood of privatization. Further, the adverse impact of privatti- tion announaments on the rival firms’ stock returns is proportional to the extent of their rivalry with British Airways. This indicates that close competitors of British Airways expect to s&r due to the emergence of a more etBcient and aggressive British Airways after privatization.

Consistent with the expecation of a more efficient British Airways. we also find that airfares in the international markets served by British Airways lell a significant 143% relative to those on other transatlantic routes around the time of the privatization. The fall in fares is accompanied by lower costs of operation aJIer privatization.

Since we mntrol for changes in the market environment, the lower fares and lower operating expenses are probably brought about by changes in the internal organization of British Airways When we examine the governance structure, we find that no significant changes took place in monitoring by large stockholders, in board characteristics, or in insider stock holding However. important changes occurred in the compensation structure of the top management. Execu- tive stock option plans were introduced soon after privatization, and the chairman’s compensation two years after privatization grew to seven times the

C. Eckel et al lJoumal n/Financial Economics 43 (1997) 275 - 298 277

pre-privatization salary. It appears that linking managerial pay to firm per- formance is a strong incentive for improving firm performance and elliciency.

Two additional checks reinforce our conclusions. First, we use industry measures of productivity to examine the performance of British Airways. Rela- tive to industry changes, British Airways became more productive and eMcicnt in the three years after privatization compared with its performance during the three years prior to privatization. Second, we study the market reactions to the privatization of Air Canada, which took pIa= in two stam the government’s share was reduced from 100% to 57% in the first stage and then to zero in the second stage. Unlike British Airways, the exposure of U.S. airlines to Air Canada’s inttmath~nal routes was small. As would be expected. we do not find a significant impact on the stock prices of U.S. competitors around any an- nouncements of the privatization of Air Canada. Airfares did not change significantly around the first sale. in which the government retained control. After the second sak. however, when control passed to private hands. there was a statistically significant decrease in airfares of 13.770.

!kction 2 discusses the selection of British Airways and the events leading to the privatization. Empulcal results based on stock market data are presented in Section 3. whik results based on product market data are in Section 4. In Scaion 5. we analyze changes in the governance structure tha: might have contributed to improved firin performance. -ions 6 and 7 extend the study to industry measures of performance and Air Canada’s privatization. Section 8 summarizes and concludes.

We study the privatization of British Airways for several reasons. First, it belongs to an industry with accessible stock market and product market data. a requirement that allows us to examine industry sectors (routes) in which &: privatiud firm competes with U.S. rivals. Second the presence of multipk. i&pendent market segments allows us to compare price changes in the a&ted markets with markets not afkcted by the privatization, a natural control group. Thitd, the control of British Airways passed fully from the government to private hands. Fourth, British Airways is typicat of many Western privatiza- tions the government ostensibly used the privatization to make the firm more efikient and to provide a source of additional government revenue. Finally. British Airways is comparable to its U.S. counterparts in size and profitability (see Table 1).

Ec~nts leoding lo the prirar izution of Brirish Airwuys Privatization of British Airways became likely with the election of the

Thatcher government in May 1979. The government announced its plan to sell

278 C’. E&l CI (II., Journa! of Finuncial Econttmics 43 (1997) 275291

Table I Comparison of British Airways with U.S. aIrlines for the year 1986: accounting dat.1 in millions of U.S. dollars unless otherwise indicated

Category

Revenue Operating mcomc Net mcomc Total aams Total debt Revenue pasongcr miles (RPM) Avadabk aeat mdes (ASM) Emp loymcnt

B~w!I Airways .-_._- __.__ -.- _... -_--.

s4.68:.95 5 X8.55 5 2I8.3l 52.991.21 s2.120.57 25.7 billion 38.4 billion 40.759

U.S. carriers bncanl

S4.162.29 S 125.80

tS25.86) S4278.00 53.19129 32.4 biuion 53 4 billion 35.664

Ratio An&is Operating kwnciRcvcnuc 5.30% 3.02% Net ~rcome/Rcvcnue 4.66% - 0.62% Net maxne0pcrating income 87.86% - 20.55% Total debl;ToIal assels 70.89% 74.60% Opclating mcomc;lotal rfuts 3.3lQ’c 2.94% NH in~.wnc~c-td we** 7 IV’ - 0 60%

IL&‘ r*m, , dkawrr.~ Load factor 67.00% 60.72% Revwwt RPM S 0.18 s PI3 Revenue Per employa SlI5.016 SI Hi.710 0Petrting incxvrne per emplnysc 5 6.09U 5 3.527 Net income per cmfloya 5 5.358 (57251

_

!kuwc Annual rqw~r fotm I&KS. Year edal March 31. 1987 for British Airways

The US tamers cauist of Amencan Airfines. Delta. Umwl. US Air. Northwcs!. Pin Am. and TWA.

a minority share in British Airways in July 1979. which became part of the Civil Aviation Bill introduced in November 19?9. Government-sponsored bills are usually passed by the British legislature. However. before the government could proceed with the sak. the oil shock of 1979 severely depressed British Airways’ profitability. (No ckar, testabk event date related to the oil shock could be identified.) In an effort to strengthen the performance of the finn the govem- ment appointed John King (later named Lord King) chairman of British Airways in September 1980. This action sign&d a postponement of the sak, and a formal annou nament delaying the sak was made the following month. King supervised the restructuring of British Aitways for about three years before the sak was again announced in December 1983. In September 1986, the government approved the sale of 100% of British Airways. The preliminary prospectus was released in early January 1987, with the final prospectus appear- ing la!er that month. Trading in the stock began on February 11, 1987. Key events are summarized in Table 2.

C. E&l et al. /Journal of h#ancia~ Economics 43 (1997) 275 -29X 279

Table 2 Events related 10 the privatwation of British Auways other than status repons -- -.--._ _ . . _ __-__ _______ ,... --- -. ..------ ------__ ._-- _-.___ -._

Press &we Event descriptitw --- .-.._. .-. _... -_---._-_- .._- -_. --_ . _ ._

5.4 79 Election d Margaret Tbatcber. a proponcnl of privalization. announaxi. Soura: Financial Thus.

7.21 79

1 I ‘5 79

9’26,80

12 I3 a3

Govemmcnl announces its intcation to sell a minority stake in British Amways to private invaton Soutw New Yor& firm (!ktw&yC

UK Conmatim ti plan to sdl par~ d Britid~ Airways (Civil Aviati Bill pubtistKd providiag go vemmml ptans to go pubiiq anfi chang tk Civil Aviation Authoriry~ Source: Wdl Strcci Jcmmzl

K.ngw,wd;rsacuctuirmnaclbaive2~l,gt.Chrgcdwiththcrrrpons~~t) d making British Airways mocc &cies~ for its eventual sale. lnwrpmal as a po+onement d sale Sourw Wafl Strcvr land.

100% (*I Bcilisb Airways to bc sold ariy MIS. Aanounabcn I in tk Par+& mtnt by Tnnspos~ Sccmtary Ridky. Not fdlowsi up wth gowrmwrtt actton Soura: Fmancid Tim,.

9 1286

1~9 a7

1,2g a7

Gowramear approves de d Briksb Airway% likely IO be III the arJy treks of 19%7. SouruJ: Finawal Timn, Wall Strcei Jownd.

R&au d prebninary prospcras and SEC tiliag dare. !kwra: U’all Slrecr JolUlUd.

Eax~ * dale and hnal pna sei Sourer Wdl Strtw Jamd. _

Not all events are likely to generare the same magnitude of stock market reaction. Generally. financial markets would be expected to attach greater importance to unexpected actions and to crediMc announamen Is. The first concrete action taken by the government was the appointment of John King to head the airline. The appointment indicated that the gosemment wanted to strengthen the airline linanclaiky &ore its sale to the public. and thereby signaled the government’s intention to delay the sale. The government’s second action was to release the preliminary prospectus Release of the prospec- tus is a point of no return in the security issuance prooess except under extraordinary circumstances. We also consider the government approval of sale (reported on 9/l2,36) a credibk signal. Financial ?r.zrhets may not attach much

importance to government announaments or approvals However, this ap proval is particularly credible because it was preceded by similar announce- ments by the same government about British Petroleum, British Aerospace, Britoil. and British Telecom which were followed by actual pribatizatioo of the firms. Events other than the three events identified above are not consider4 important because either they are not real actions or they are not credible announaments.

280 C. E&l et al. /;lounwl ofhuzncial Economics 43 (1907) 275-298

3. Effect on stock prices

3. I. Hypotheses

The reaction of rival firms’ stock prices depends on the market setting and expected behavior of the privatized firm. The rival airlines will earn positive abnormal stock returns if the newly privatized firm exploits market power to raise prices. On the other hand, if privatization improves productive efB&ncy and lowers costs, then a more efficient competitor will hurt rivals through increased competition and the rival fitms stock prices will fall abnormally. In addition, the impact on the rival airlines should depend on each rival airline’s exposure to British Airways; airlines with a greater route overlap with British Airways should be a&ted more than airlines with a smaller overlap.

3.2. Fri~wtization as a wgulafory event

We treat privatization as a ‘regulatory event’ because of both its impact on many firms at once and its source in government decision-making. Studying tbe rfic,; 3: SCL-I: IVCT~. i; cumyliacd by sueral factors. First, since an entire industry or a set of related firms is affected simultaneously. it is inappropriate to aggregate firm-specific stock market reactions from ordinary kast squares estimates. Binder (1985) and scbipper and Thompson (1985) employ a simulta- neous equations multivariate qression apjtro& based on Z&te?s (1962) sceminJ#yluuelalcd reqpssh (SUR) This procedure allows contemporanants covtianas ofnsiduak to be nonaeroandprovi&sunbiasedstattdarderrorsFor lber-leslsonlhe promtl#oforindividualrivalBnnsorforasampleolfirms

Second it is diflkttlt to accurately identify precise regulatory event dates. Changes in regulation occur in many stages over time, and multiple events convey marginal news about tbe impending change. As a conseq~ them is

a bias against finding evkknce of a price reaction, Brown and Warner (1980) emphasize the importaacc of the correct event date for traditional event studies. Studies of regulatory events have to cope with the more serious problem of multiple events. To address this issue. we analyze the mums to a portfolio of rival firms for each event We sdect only tbe most important events for a detailed firm-by-firm analysis Tbe important events identified in Table2 (King’s ap@tttttent, government approval of British Airways’ sale, and release of the preliminary prospectus) are also the events that significantly afkct rival firms’ stock price&

Finally, spurious abnormal performance can be observed wben events other than the regulatory process simuhaneously affect the entire industry’s valuation. Although we report abnormal returns relative to a market index for comptete- ness, much of the discussion is based on industry-adjusted returns. as explained hdOW.

C. Eckel et al. IJownal o/Financial Ecomotnics 43 (1997) 275 2YW Bl

3.3. Measurement of abnormal returns

The abnormal returns to sharehoiderr of firm j in response to an event are computed by estime!ing a SUR model given by

Ra = zj + PjT- + Sjd# + Ea s (1)

where Rj; is the rate of stock return of firm j, r, is the rate of return on the rekvant index (the industry index or the equally weighted market index) over period I, and &, is a random error term. The dummy variabk, d,,, cakes the value of one during the event period for which the abnormal return is being deter- mined and zero otherwise.

Since both tile industry index and the market index can be important. we also use the following two-index model to generate abnormal returns:

R# = 2,s + /?jR, + yjtk,, + 6td# + i# _ (2)

For ease in defining parameters, the same symbols are used in Eqs. (I) and (2). -

The tturd term, nLI,, captures the movements in the industry index apart from any changes in the overall market index. These changes are &ntilial by hypothesizing that the return on the industry index. &,. is linearly associated with the return on the market index. Note that the return on the industry index has a subscript k because a different industry index is constructed for each event. & The industry index is an equally weighted index of ail airlines exduding rival firms and firms with conhrrnding eventx within five trading days on either side of the event date. The disturbance term, &,, from a regression 0&,on &+iil be orthogonai to the market index and represents that part oftbe induxtry iadex not explained by the market index. TIE daily abnormal stock return for firm j over the event peti Sj, is an estimate of 6, The cumulative abnormal mtum for firm j is CA&j = 8j x T,, where T. is the number &days in event @od U. Three dimerent event periods are used for estimation of Eqs. (1) and (2): - 1 to 0, -It0 +i,and - 5 to + I relative to the press date of the announcement as

given in Table 2. The regressions are estimated for the period from t = - 270 to t = + I where day 0 is the event date. Since the airlines are large, closely followed, and trade frequently, we expazt the shorter event windows IO provide better information about the events.

3.4. Identijcation of rirx11 Jirms

The Department of Transportation’s (DOT’s) Ticket Dollar Value Origin and Destination data bank provides comprehensive data on airfares by carriers and routes based on actual transadidns. We utiide these data to identify rival firms and to compute fare changes. Each record (or ticket) in the DOT database identifies the point of origin, the airline carrier codc($ intermediate airports, the point of destination, the dollar fare, the distance(s), and the fare class@). The

282 C. Eckei et al. ~Joumal of hancial Economics 43 (1997) 275. 208

database is a 10% sample of all tickets used for travel during a particular quarter.

Rival firms are airlines that earned a significant portion of their revenues from the routes served by British Airways. The remaining airlines, excluding those with confounding events, are used to construct the industry reference index (R,,,). We compute a riwlry index. defined as the percentage of an airline’s revenue passenger miles (RPMs) derived from the routes that are also served by the airline being privatized for the quarter prior to the quarter of the event announccmcnt. For example, the rivalry index for the announcement of King’s appointment (9/26/80) is calculated for the second quarter of 1980, the quarter prior to the quarter containing the announcement. The total RPMs for each U.S. airline during this quarter are computed by multiplying the distance and the number of passengers for each Right segment on a given carrier and then summing across routes for the quarter. The next step is to estimate the RPMs of each U.S. airline on routes that were serve4 by British Airways during the second quarter of 1980. We identify all such routes based on the Department of Transportation’s data. NYC that these routes are narssarily international !~~~rse cn’w~aw probibits Ir.S. airlin‘ from transporting pa=sengers within duty country other &an the ML, and prohibits foreign airlines (including British Airways) from transporting passengers within the U.S. The &partment of Transportation’s data contain all tickets iawed by U.S. airlines and any tickets issued by foreign airlines that connect with domestic flights. However, it does not contain tickets issued by foreign airlines for which the travel ends at the first point in the US. There&r-e+ the rivalry index will not include any routes on which British Airways provided service but did not connect with dome& flights even ona during the qnarter.

The ratio of the RPM in competition with British Airways and the total RPMs of an airline is the rivalry index for that airline. We include all airlines with a rivalry index of at least 0.1% in the sample of rivals The number of rival firms varies from three to seven. with rivalry indexes ranging from 0.6% to 15.8% for various events.’

C. E&l et al. IJozmd of t%tancid Economics 43 (15’97) 275-298 283

3.5. Portfolio results - By ewnt

For each event listed in Table 2 we first form a portfolio of all rival firms. We obtain the ordinary least squares estimates of portfolio abnormal returns using Eqs. fl) and (2). Stock return data are from the daily Center for Research in Security Prices (CRSP) fiks. These results, along with raw portfolio returns, are presented in Tabk 3.

The abnormal returns around the events are not surprising positive around King’s appoiatment, negative around government approval of tbe sak and the release d the preliminary prospectus, and insigniRcantly d&rent from zero for the remaining events The abnormal returns for the important events measured over a seven-day evelrt window. not presented here, are kss significant statis- tically. possibly because the longer window is noisier than the shoner event windows

Relative to en industry index. the first important event (King’s appointment) generated an insignificant 0.88% gain over a two-day window and a 3.66% (significant at the 10% kvel) gain over a three-day window for an equally weighted portfolio of rival firms. For the second event (government approval of sak), the rival firms lost 1.99% (significant at the 5% kvel) over a two-day window and ao insignificant 237% over a threeday window. Rckase of the preliminary prospectus is imwrtant because it indicated that British Airways would be privatizai in about a mootb’s time. The importana of this event is borne out by the stock price rezutitin of rival firmr relative to an industry index. rival fims lost 3.86% (signifiornt at tbe 5% level) over a twoday window and 5.85% (signifkant at the 5% kvd) over a threcday window.

To measure the overall impact of privatization announcemen ts on U.S. competitors we combine the two important events closest to the privatization into a siogk occurrence (not shown iu the tabk). We do not include King’s appointment because it occurred almost six years before the other two events The average industry adjusted loss incurred by the rivals around the two CVCIIL.

is 7.37% (significant at the 1% kvel) over a twoday window and 7.73% (sign&cant at the 5% keel) over a three-day window. These results indicate that the rival airlines are signiticantly affected by the changes taking place in one of their competitors

3.6. hdiridual riral firm results Jor iuaprtu~~t C’~LS

Eqs. (1) and (2) are estimated using SUR for the three important events identified in the previous subsection. The results for the three events are in panels A, B, and C of Table 4. Pan Am had the highest rivalry indexes around the three event dates (15.8%. 14.6%. and 13.3%). For day - 1 to day + 1 (the threeday) window and relative to the industry index, Pan Am gained an insignificant 7.53% around King announcement. lost an insignitkant 5.94% of

284 C. E&l et al. ~Journal of Finoncid Economics 43 (1997) 275- 298

Tabk 3 Portfolio returns around events related to privatization

Portfoiio rctums for each event related to tk privatization (w listed in Table 1) a~ given kiow. The portblio consists of rival U.S. airlines prowdmg service in competition with British Airways. To k inch&d. at kast 0.10% of tk airline’s RPMs must come from such routes The ordinary kast squanx estimates dabnormal returns to a portldio of firms for art event. based on a sin&-index model ftk industry index or tk market indcxl arc obtained using tk following equationz

wh RB is tk ntr ofstock lrctum lo a porlldio of firms and I, is the rate 0fRtum on tk fekvaot index lot pried r. The dummy variabk. d,. taka tk value ofo~ during tk event pcrind tOr wl&h tkakrormJmusairbciagdatnnirwdudanoothenmcf&induJtryiadcr~~ep~ w&hlcd mlum iodU of88 irtia~ exduding rival fiIlQx attd htna with c&blUXb8 CWatx WithiD

~5trding&~uouDdIbtmot~lcTbustkeomporitior,oCIheiadustr),portcdiocbrsgs with each CVCOL Tbt market in&x is tk NYSE/AMEX quaily wzightaJ index.

Atmomul mums arc also cmptai usmg a tweindcx model gi\m by

R,=l,+$,k+7,iliu,+6,r*+r,. 01

where iu, rdkcts tk msidut’ industry ctTcct This is tk d&Urbana term obtauud from a e d tk industry in% retcr;u on the market mdex mums Tk daily abnormal stock mum to r~~‘indri~lfirms~n.nthcrn~nr~~ disqiwnbyb,lkcumub*~nabnonnalmumlor ; , i:fdwj, I, Ak, ,a -&I; d 6,) (imes the numkr d days in tk event period. Throw dil’bttt cvcatpcriodsarcwefJ6uc8tiautiond(t)and(2t - ItoO. - I to + I.and - St0 + Itdativcto tkprcxx&tco(tkanwwtcumt t as given in Tabk 2. The equations arc cstinutcd fur tk pried I= - 270 to + 1.

r-statiuhs arc Miciacd and &VII bdow tk portfdio mums __-_. . . .-..- _ ..-.

E-1 anMnoKr- PoMolio raw Pordohmafkcl PortWioituiuxtry Pordoliomarkel& aunIx mum adj. mum adj. mum industry * mum

-_ . . _ _ - . _ _. . Eventwindow (-1.0, l-1.1) t--1.0! t-l.!) (-1.0: ( I. I) 4 - 1.0) ( - 1.1)

I. Ekctimd -0.m7 -0.0224 0.0102 0.0307 - 0.0144 - o.an6 - om13 0.0184 Tlnldw 0.47 1. I4 - 0.66 - 0.14 - 0.06 0.73

2.loscBdl o.aM9 0.02a2 a0071 0.0177 - 0.01 I2 - 0.0092 - o.am6 -0.0027 PurdM 034 0.70 - 0.61 - n.rt - 037 - 0.12

3.6iutonil - 0.0260 -0.0226 - (Lo221 -0.0120 - 0.0137 0.0010 -0.Ol70 -0.0034 PndM -120 - d5J - 0.76 0.05 - 0.97 - 0.16

IK@k -..@239 -urn UlII uQ)I a6.a W-WI3 6B4u as6 I.18 as8 I.49 - R.7 I.&4

5.ToeIlolT 0.0006 -0.0252 O.OOUl - 0.0126 0.0124 0.0107 0.0124 0.0106 88dBA 0. I4 - 0.35 0.52 0.37 o.s3 0.37

4- -(LIs14-aa36-ou u123-uu8-@#237-u131 oauo wP-=* -a39 a48 - I.99 -8.9S --Mb a24

7.m -UlS -m -am64 -u637 -u3B6 -u!B!l -aouz -m - I.% - 281 -2.2 -w -249 -3.25

8. Fii 0.0416 CUR352 0.0267 - 0.0118 QOII8 - 0.0141 0.01w - 0.0168 P-P-~ I.40 - n.H, n 73 -0.w o.no .- 0.73

C. &&I ef al. lJmwnaI of Financial Economics 43 (1997) 275-298

286 C E&i et 01. JJoumol of Finonciol Economics 43 (I9971 275-29X

t I I I

c‘. E&l er al. fJoumal o/Financial Ecotwmics 43 (1997) 275 -298 287

s, 8s d k I I

B 2 2 e d ; :

$s 00

I I

I I

288 C. E&i er al. JJoumal of f%wtciai Economics 43 (1997) 275.-298

its value when the government’s approval of the sale was announced, and lost a statistically significant 12.19% upon issue of the preliminary prospectus. TWA, with the second largest rivalry indexes, gained 4.02% in the three days around King’s announcement relative to an industry index, but lost 2.13% and 2.83% around the two other events that signaled the privatization (none of TWA’s abnormal rctums are statistically significant). The abnormal returns are generally of the expected sign for the other rival airlines relative to an industry index (positive aronnd King’s appointment and negative around the other two events), except for Delta Airlines around King’s appointment and for Eastern Airlines around government approval of the sale.* These two airlines had the s.nallest rivalry indexes.

The abnormal returns using the market index are somewhat weaker. Around the issue of the preliminary prospectus, however, the abnormal returns are consistently negative irrespective of the reference index Around King’s appoiot- merit, the two-day and thteeday abnormal tetums are always positive except for Delta Airlines. althat!& the positive abnormal returns are statistically :n+rific 1t. Around 5ovemmert31 . . .:proval of the sale, tCz two-day and ~hr~-day aonormat returns relative to the market index are generally negative except for America0 Airlines and Eastern Airlines. The general trend in loxses of individual airlines for the two events seems to be io accordance with the importance of the tmnxatlantic market to their revenges

To assess the joint impact of the last two events, we combine the returns around these events into a single event. This analysis ix conducted for the four rival airtines (Pan Am, TWA Northwest Airlines, and An&can) that are common to the two events; three out of the four airlines are also the most important airlines in terms of their rivalry indexes The industry-adjusted impact over a tw&y wiodow is a statistically and ecooomically signScant - 14.6% for Pan Am, a significant - 8.0% for Northwest, a significant - 7.5% for American, and a statistically insignificant - 7.4% for TWA. Thus,

rival airlines are greatly a&cted by events related to British Airways’ privatita- tioo.

To further examine this relationship, we regress the abnormal stock returns of each rival firm, A& against that firm’s rivalry index, Rli as given by

ARi=Zo+~1RI~+tTi. (3)

where 2, is the random error term. Since the relationship between AR* and Rli may be nonlinear (tapering ofi) because firms will continue to expand in the market until the marginal profit is driven to xero, we estimate Eq. (3) with alternate functional forms. Tbe results are similar when either the square root of

C: E&l et al.;Jownal of Financial Econmnics I.3 fI991) 275 -298 289

the rivalry index or the log of the rivalry index is used as the independent variable.

Results for the three events are presented in Table 5. Relative to the industry index, an increase of one percentage point in a firm’s rivalry index helps the rival airline by an insignificant 0.20% over the two-day window around King’s appointment. When the two events close to the privatization are considemd to@er. the rival firms lose a statistically and economically Jgnihcant 0.44% over a twoday window for every percentage point increase in the rivalry index The results relative to other &reoce indexes are similar, while the test&s for longer event windows are in the same direction but weaker.

Overall, we fmd that the rivalry index is important in explaining the abnormal stock returns to competing airlines: rival firms gain when a postponement is likely and lose when there is progress in the sak. The abnorma! stock price reaction is propontonal to their presence in the markets served by British Airways.

4. I. Hypotheses

In this section. we examine vhetber product pr&s, i.e., airfares, ate a&ted by the privatization of British Zirways. We note that a change in British Airways’ objective to profit maximization cannot result in lower f&es. In fact. a change to prolit maximization would generally lead to higher prices: holding all else equal the profit-maximizing price is always greater than or equal to the equilibrium price under alternative firrr objectives(sec Eckel, 1995). Lower iares must arise from more efhcient operations of British Airways. unless the tower lhs are temporary rather than permanert. However. this exception is unlikerr for three reasons. First rivals’ stock price changes imply an expected permanent drop in fares. Second. there is no news of fare wars after privrtization that would sqgest a short-term reduction in fares. Finally. other petformana measures indicate that British Airways realized efh&ncy gainsconsistent with lower fares.

4.2. &fa

We utilize the Department of Transportation’ Origin and Destination data to examine changes in airfares. From these dat:, we select only tickets that originate or terminate in the U.S. and that originate or terminate at a European airport. The processing of data and other controls are srmilar to those used by other studies of airline markets (see Borenstein, 1989; Ktm and Singal, 1993; Singal, 1996). This pmcessing of data cxdudes first class tickets, tickets with more than two changes of plane, tickets with missing carrier codes, and tickets with

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C. Eckei et al. ;Journal of Financial Emmmics 43 (1997) 275-298 291

abnormally high fares as identified by the Department of Transportation. The sample of routes contains all routes on which B&is!- Airways provided service on the transatlantic portion in the two quarters selecuxi for comparison.

Since fares might change for reasons unrelated to privatization, such as changes in cost, economic conditions, etc., the fare changes on the sample routes are computed relative to a control group consisting of other routes on which British Airways did not provide service but which are similar in distance to the sample route ( f 7.5%). Measuring far-e changes relative to a control group has the advantage that any data problems tbat affect the whole data bank are unlikely to significxttly affect our results. In addition, this methodology controls for trends in the data. If airfares are falling due to improvements io technology or deterioration in quality, measuring changes relative to other similar routes will remove such effects if similar routes are affected in a similar manner.

The change in fares is computed as

dYld = log Y&f, uldy:

fid:e ’ 1 (4)

where Y/d is the fan yield in USS per mik for all firms operating on that route aod dYld is the change in jields. Subscripts in the equation identify the quarter, and the superscript identitks the control group. The farr on a route is computed as am average weighted by the number of passengers paying a given fart; the yield is then calculated ;s the atio of the average fare to the distance.

4.3. Ruadts

The changes in yields given by E+ (4) are reported in Table 6. The sample coosists of 12 transatlantic routes on which British Airways provided service during the second quarter of 1986 (befoir privatization) and during the sccc?d quarter of 1987 (after privatization). We ux the second quarter in each case to remove seasonal variations. On avw for each of the sample routes, there are 7.7 routes in the control group.

Tbe change in fares on British Aiirways’ routes, relative to the control group, ranlgcs from + 25.4% to - 33.0%. Weighted by the number of passenm carried oo each sample route, there is an average- in fares of 14.3%. This decreax is statistically significant at the 1% levtc. We include the tutweighted oleilo(- 126%. significant at the 5% kvel) in the table for completeness, although it provides a difkrent measure of the chaogc in fares We think that the weighted mean is a more appropriate measure became it refkcts the economic importance of the change in fares: less traveled routes should have a lower weight in the mean. As a further check of robustness, we consider only routes with at least 20 passengers a day in our data. The results. reported in row 3.b. again show lower pfices in the markets served by British Airways.

292 C. E&l et crl./Jounwl o/Fimzncial Economic 43 (1997) 275-298

Tabk 6 Cbonga in hrs around British Airways’ privatization

The change in fares is cutnputcd as below:

whem ru is the krc yield in US per mik for all the firm5 opcmting on thrt route and dYLI is tbc change in yiddr The superscript idcntifks the control group Car cacb sampk route. Control groups consist of intcmational routes d similar distance from the U.S. to Europ on which the British Airways did not provide mioe. SuMpt I refers to the oocond qwnn of 1987 whik the subscrip I-Ire&tothcsazondqwrterdl9%.

_-___-- _.-.---___ _----.

Routes with P 20 m All routes I= day

.--._.--_-______._--_-__---__- -_---

I. Numtur d sampk routes I’ - IO

2, Routes pn amtrd group 7.7 7.7

7 change in farcr .a wQ+ 0 -04 : ,(‘.I .. -. ‘+;p. 1, - 7 30) - IQ.27% (I = - 2.65) b. Uamghtcd mean - 12.60~. (1 2 - 3.041 - 11.16’4 (I = - 1.0s)

-- -__- -_ ____I-__--___-_--_.-- _ .-_ - . ---.- _- _._-_. -._..- ---

Evidence d lower fares in conjunction with an assumed post-privatization profit maximization objective for British Airways imply that the lower product prices must be tbe Roult d lower productioa costs. Another explanation for the lower prices is adactive fate w8rs in which airlines reduce fares 00 sekcted routes to very low kvek tbat cover the marginal costs but not the fixed costs. An cxaminatlon d press reports does not reveal any news d fare wars on any d the sampk routes during the period dstudy. Our resuJts would be a&&d by fare wars only if tbey occurred on our sample routes during tbc post-privatization period but not during Ibe pre-privatiution paiod ord the fare wars occurred only on routes saved by British Airways but not on any dcoatrol routes. There is no evidet~ that this happened. in the next sectioa we examine whether a change in managerial incentives causes the firm to become mofz cost-e&tive after privatization. A govemmentsmKd firm has littk incentive to minimize costs, and inda5d gomnmen t-imposed social objectives may require productive ine&iency (E&L 1988, Eckcl and Vermaekn, 1986).

Since the foregoing analysis controls for changes in both the market environ- ment and the firm obwive, the results thus far suggest that the privatization of

C. E&l et al. ~Joumal of Financial t?hnvmics 4.3 (1997) 275- 298 293

British Airways affected its internal organization in ways that improved its &‘iciency and profitability. Consistent with this improvement, we find that the compensation structure of the top management changed considerably. Prior to privatization, there was no performance-based incentive scheme. The chairman’s compensation for the fiscal year coded March 1987. the year of privatization. was f 52,740. For the first full year as a private firm, the chairman’s compensation more than tripled to f 178450. For the following year ended March 31, 1989, while the British governmen t attempted to restrict salary increases to IO%, the chairman’s compensation more than doubled again to f385.791, including Sonrtses related to performance (see Reed, 1990. p. 41). Thus, within two years of Grivatization. the chairman’s compensation bad grown to seven times its previous level, and it now included a bonus besed on firm performance. While we do not have information regarding the size of the bonus included in the 1988-89compensation. the 1991-92 salary off669.350 included f220.000 (or about 0%~third) as a bonus.

lo another e&t to eiign management objeuives with stodchokier objectives. British Airways introduced an Executive Share Option Scheme in 1987 to provide an incentive related to the growth and profitability of the company for key employees and executive directon. Within about a year. King had been granted options on 294.a sharts and Chief Executive Colio Marshall on SlS.ooO sham As of April 1, 1991. King had options on 853.ooO shares and Marsball had options on 710,Gw) sham

Gains might have resulted from several other factors. but the evidence is weak.

ExtemaJ disciplining of management can also be achieved by the market for corporate control (see Jensen and Ruback. 1983; Jarrell, &kirk>. and Netter. 1988) and through monitoring by Mockholders or institutional aockhokkrs (see Brickky, L.ease, and Smith, 1988). However. conditions governing privatizations usually pm&de a group of stockholders from holding a substantial stake in the company. In the case of British Airways, the maximum proportion of shares held by any person or connected persons was limited to 15% until January 31. 199% that is for about five years after privatization. Thus, neither the market for corporate control nor enhanced monitoring by Mockhokien could contribute significantly to the improved performance of British Airways.

5.2.2. Baud monitorfng Better monitoring by a changed board of directors can ako influence the im-

provement in performance. There is empirical evidence to suggest that smaller

294 C. Eckel et al. ~Joumal of humcial Economic? 43 (1997) 275-298

board sizes (Yermack, 1996). a greater fraction of cutside directors (Byrd and Hickman, 1992; Rosenstein and Wyatt, 1990, Weisbach, 1988). and separation of the chairman and chief executive functions (Pi and Timme, 1993) can improve firm performance. However, none of these board characteristics changed after British Airways’ privatization. The board consisted of nine directors for the entire penod from 1986 until 1991. Only three of the nine directors could be conrideted ins&n responsible for the day-today operations of Britirb Airways. Separate positions of chairman and chief executive bad existed hefore privatiza- tion and continued after privatization. In fact, during this period, no major changes in the top management took place. The team of John King as chairman (from February 1981) and Cohn Marshall as chief executive (from February 1983) continued until February 1993. six years after privatization. Marsha4 succe4ed King as chairman in 1993 when King retired.

X2.3. insider ownership Finally, higher insider u lvnership IS also associated with better firm perform-

.,rpe due : 7 n rducric~~ i.1 aaenc:’ co:. and better alignment df management objectives with stockholder objectives (McConnell and Servaes. 1990; Merck. Shkifer. and Vishny. 1988). After privatization, as of July I. 1987. the directors owned 88@0 shares (v&red at approximately 5200400) representing 0.01% of tbe outstanding capital. Even after five years, the directors owned only 188,OMJ shares mpresenting an insignificant 0.025% of the outstanding capital. These kvels of ownershin are too small to reduce agency costs.

In this section, we examine the effects of privatization using other industry measures of performance. The results are similar. Following Megginson et al. (19!M), we compare firm performance for the three years before and the three years after privatization, cxduding the year of privatization.

Results arr reported in Table 7. The unadjusted change in British Airways is given in cohrmn (3). whik changes adjusted for changes in the industry are given column (5). The firat three meaaurea are related to aixe. For example, Boycko. Shkifer. and Vishny (1996) note that governments generally require a state cntqprisc to maintain excessive employment at the cost of profitability. There- fore, as a conqucnce of privatization, we expect British Airways to dazrease in size. From column (5). we find a decrca~ in size relative to the industry, with the largest change (a decrease of 17%) occurring in the number of employees.

The next three measures relate to productivity. The load factor, calculated as tbe ratio of revenue passenger miles to availabk scat miks (MM@, measures capital productivity whik employees per ASM and employees per RPM measure labor productivity. We expea the productivity measures to show an

C. Eckei d al. 1 Journal of Financial Economics 43 (1997) 275 298 295

Tabk 7 Operating performance around British Airways’ privatitatwn

Three-year aw-agc % change

British Change klfOl7llilllU Bcbrc After Airways rdatlw to masure privatization privatization (u&j.) industry industry

(1) (2) (3) (4) (51 - --- --

Availabk scat miks (AShIs) 3.T.453 49.901 40.77% 47.4?~; - 6.51% in millions

R-upasscntm miks (RPM) in miltions

tipbY= Load tactor

cfNJw= w million ASMr

Emplow=pcr miltion RPMs

-N Rcunu pr RPM

(in 19uZf~ cost pu RPM

(in 1982 f)

$3.734

I.620

0.074 0.109

0.099

?5. I74 4&r)%

48.74? 26.43% 43.91’L - 17.48% 0.704 5.35% ?.76% w??; 0.978 - 10.13% - ‘51% - 7.63

I.-W9 - I4.80%

0.08% I P 08% 0.090 - 17.05%

0.084 - IS.lC%

so.%%

- 4.u4%

IaIR% - 13.14%

- 13.20%

- z.rm

- 9.95%

7.90?; - 3.9z;

- 1.95:.

----- l. The analysis is antered around 1986. tbc bear of British Airways privatization Sinr BntisJ~

Airwa$ tiszal yar ends on March 31. data for any year are obtaitwd from the annual report tbr the lid year ending the lollo*iinp March. e.g *986 data arx &air& from tbc annual report Car tbeyarcndiqtonM8rch31.1987.

2. Revenu pamlgcrrniksrdcrtoYatIrrtikslt5cdhy~uc-gulcTacnypusmgus 3. ~~s~rrvm~hPve~djurtadburdor,domcaiciofl~ncaChn~intheCPI

are otnainai from Immuriod Finanriai Slatisticr on CD-ROM lbac 64). 4. The industry includes largz U.S. airtines A mcrican ArIina, Unital Airlim Delta. US Air. Pan

Am. and TWA.

improvement if the firm becomes more efkien;. As expected. we find an improvement of about 3% in capital productivity and 8% and 10% in the two measures of labor productivity, respectively.

The last three rows measure the firm’s overall efficiency. Sales efficiency Wes per employee) irises after privatization because d a larger reduction in employees than in RPMs Both the revenue per RPM and the cost per RPM decrea~ after privatization by 4% and 2%. respectively. with industry adjust- ment, The lower revenue per RPM confirms the lower prices paid by consumers after privatization, and the lower cost per RPM indicates that British Airways has become more costeffective after privatization.

296 C Eckel er al. lJoumal of Financial Econmnics 43 (1997) 275-298

Further, overall improvement in British Airways’ efficiency is indicated by an increase in its worldwide market share after privatization. For the three years prior to privatization, British Airways’ market share was 3.0%. in the three years after privatization, its average market share was 3.3%. rising to 3.5% for the year ended March 31, 1990. These resu!ts, hased on industry measures of productivity, are consistent with our findings based on market reactions that indicate a more efficient and aggressive British Airways after privatization.

7. Pdvatintiom of Air Cads

As an extension and a further check on our results, we examine the market reactions to Air Canada-s privatization, which is somewhat different from British Airways’ privatization. First. U.S. airlines do not compete significantly with Air Canada The rival U.S. airlines derive only 0.4% to 1.3% (with a mean 0fO.8%t oftbeir revenue from routec served by Air Canada compared with the O’,“: [a :_C.ti’:, th:th ir SLUI 01 S.S%) from routes served by British Aimayr. The small exposure implies that news about the privatization of Air Canada should not significantly affect tahe stock p&es of the American rivals. Indeed, we do not find any significant stock price tea&on upon annou- t of Air Cads privatization to any of the events either for a portfolio of rival firms or for individual rival firms. The abnormal returns are insignificant imqective of the event windows and the r&rencc indexes

Second the privatization of Air Canada took pJace in two stages: the govem- merit’s share was reduced from 100% to 57% in tbe first stage and then to otfo in the second stage. We find tbat airfares did not change significantly around the first sak when the government continued to control Air Canada with its majority stake. However, when control paxsed to private hands after the second sak, there was a statisti4ly sign&ant dartasc in airfares of 13.7% relative to fares on a control group of routes. The results for Air Canada show that tram&r of control is necessary to achieve gains in productive etEciency. !kcond they reaf6rm our results for British Airways.

Prior studies have found that firms arc more profitable and efticient after privatization. However, changes in both the competitive environment and firm objectives usually occur simultaneously with a change in ownership. These studies of privatization thus measure the joint e&t of changes in ownership market structure, and firm objectives, hut assume that the primary effect is due to a change in ownership.

C. E&l et al. Noumai o/Financial Economics 43 (1997) 275 -298 297

In our study of the privatization of British Airways, we attempt to isolate the effect 01’ a change in ownership on firm efiiciency. We control for changes in the environment by studying international routes where the direct control of any one government is limited. Further, all of our results are based on market data. stock prices, and airfares, which are less subject to manipulation than accounting earnings. This methodology can be used for examining the effect of other regulatory changes.

Based on our analysis, we find that the stock prices of British Airways’ aqtetitors fizlf abnormally, depending on the degree to which they competed with British Airways. This indicates that privatization leads to an i- in &ciency. erodirrg the profitability of rival fimxs Further, relative to control groups, the airfares on routes served by British Airways duzased significantly. A d- in airfares implies improvement in firm productivity irrespective oft& change in firm objectives. Lower fares 00 sample markets after privatization are also consistertit with tbe hypothesis that the privatization of British Airways resulted in greater efI&ncy as a result of the change in ownership. The drop in stock prices of rival firms combined with tbe lower fares suggest that privatization benefits the consumer in a consistent and sustained fnallmr.

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