InTheSpotlight: UAL’s Deal Could Touch Off a New Round of Much-Needed Consolidation

A new wave of consolidation is widely expected to sweep through the airline industry in the wake of UAL Corp.’s announcement to buy rival U.S. Airways Group Inc. for $4.3 billion. The transaction, which undoubtedly would have far-reaching implications for the industry, triggered much speculation about rival bids and other airline deals. A UAL/U.S. Airways combination would create a global airline with $26 billion in revenues and 145,000 employees, widening the gap between it and the second-biggest carrier, American Airlines Inc. U.S. Airways is the country’s sixth-largest airline, with revenues of about $8 billion. UAL is the parent of United Air Lines Inc., the largest carrier in the nation, which had $18 billion in revenues last year. The deal is expected to draw tough scrutiny from federal regulators. Yet, executives of UAL and U.S. Airways have been downplaying speculation about regulatory roadblocks, saying that they are confident that their deal would not reduce competition in the market. United and U.S. Airways overlap on only 17% of their routes, UAL has said. To alleviate antitrust concerns, the deal calls for United to sell some of its assets to Robert Johnson, chairman of BET Holdings Inc. and a member of U.S. Airways’ board, who intends to start an airline called DC Air, which would fly out of Washington’s Reagan National Airport. Many airline analysts believe that deal has only a 50/50 chance of getting past federal regulators, but union negotiations could be a sticking point as well. The first time United tried to buy U.S. Airways several years ago, the unions couldn’t work out a deal, so the transaction was scrubbed. Generally, one of the biggest issues in a merger for unions to negotiate is seniority, says Michael Zea, a V.P. and aviation expert at Mercer Management Consulting. He points to the example of Air Canada and Canadian Air, which are currently integrating their operations. “Air Canada has grown more quickly than Canadian Air has over the past five years and, therefore, Air Canada’s pilots, on average, are younger. Yet, they don’t want to be ranked behind Canadian Air pilots. Those are the kinds of issues that you run into in an airline merger,” he explains. “In a deal this size, union negotiations will be tough. American/Reno was a very small but very bloody deal because of the union negotiations,” adds Allan Tamm, president of Avicor Aviation Inc., an aviation business consulting, aircraft sales, and aircraft leasing firm based in Beaverton, Ore. Additionally, Robert Mann, president of R.W. Mann & Co. Inc., an airline industry analysis and consulting firm based in Port Washington, N.Y., remarks, “Even though the pilots of both U.S. Air and United are represented by the ALPA National union, and ALPA has a merger policy in place, in my experience, the policy’s application has been fraught with peril.” Despite widespread opinions that consolidation would greatly benefit the industry, most airlines have been stalled in their acquisition attempts by antitrust concerns. One of the key deterrents to consolidation so far, says Mann, has been the presumption that any deal that ends up with more than a 20% market share would not be permitted. “United/U.S. Air would end up with about 25%, perhaps up to 30% with the kinds of synergies that the companies are alluding to. If a 30% share is permitted, how many resulting carriers are created by shares at 30% each? Obviously, it would be not more than four,” he says. In the event that regulators permit the United/U.S. Airways combination, and thus open the door to consolidation down to a handful of megacarriers, many airlines are now exploring how best to position themselves in the new competitive environment. American Airlines and Delta Air Lines Inc. held talks on industry consolidation in early June, and even discussed the possibility of a merger. At the same time, American also seems to be considering an acquisition of Northwest Airlines Corp. And setting the stage for what could be a consolidation push by European airlines trying to keep up with their larger American competitors, British Airways PLC and KLM Royal Dutch Airlines are talking about a possible deal. While in the past antitrust concerns have stymied domestic airline consolidation, the regulatory hurdles are even higher in cross-border deals. Restrictions are that the U.S. government – and other governments around the world – limits the extent to which a non-U.S. citizen or non-resident company can control a U.S. airline. In this country, a non-U.S. resident or company can control no more than 25% of a U.S. airline. Mann says that rule in part grows out of the perception of aviation as a national defense asset. “It has limited the ability of capital to flow freely in the market, and what that has caused is a couple of bastardized structures, which we know as code-sharing and alliances, which don’t seem to work well from a customer’s perspective,” he adds. Under code-sharing agreements, carriers sell seats on each other’s flights and provide flight connections for passengers who transfer from one airline to another. Making a play in a less-restricted market About two years ago, Richard Branson of the U.K., chairman of Virgin Express Holdings, expressed interest in owning and operating an airline in the U.S. but decided that he would not risk his capital if he couldn’t control the airline, says Mann. “So, he took his play to Australia.” Branson’s Virgin Blue Airlines is launching its low-fare service Down Under, and is scheduled to begin operations before the start of the Sydney 2000 Olympics in mid-September, pending approval from the Civil Aviation Safety Authority. The inability of carriers to engage in out-and-out m&a activity has fueled the popularity of global code-sharing and alliance arrangements. In Mann’s opinion, code-sharing has resulted in better financial results – less leverage on the balance sheet, less off-balance-sheet leverage, and better cash flow performance on invested capital. Additionally, the risks of these types of ventures have been low: there’s no need to invest in airplanes or crew training. On the down side, though, he notes that “code-sharing and alliances have caused more U.S. flag services to be cancelled in international markets than the last recession or the Gulf War did, so there is a real negative to it as well.” Alliances have become a very powerful strategic force because of the network economics of the airline industry, remarks Zea. “There is such a big infrastructure cost, like there is with telecommunications.” Filling a plane with people is similar to filling the phone lines with calls or data, he says. In both industries, companies must invest a huge amount of capital in order to build their networks, so using those assets effectively becomes the key to making a profit, he adds. Impediments to internal growth have frustrated carriers as well, the experts note. The Fed will not permit – or it certainly can deny – a total monopoly in a market, says Tamm. Airlines first must bid for routes and get the regulatory green light to schedule service into their desired markets. Next, a carrier must make sure that crews at the airports along those routes can service their flights, he adds. Additionally, once a carrier publishes a flight schedule, it has committed to flying it and has invested time and money in training personnel to operate those flights, “so the risks to internal growth can be pretty extreme,” Mann says. Mann says that Robert Crandall, former chairman and CEO of AMR Corp., the parent company of American Airlines, had believed that internal growth was the best way to expand. “American is now a partner in several code-sharing ventures, but Crandall had said that he would have preferred to grow internally. He thought that code-sharing essentially is a fraud, because what happens in those deals is that you put your name on a product – a plane – that is operated by another company.” While growth options for airlines in the past may have been few, the experts agree that if regulators OK United’s deal, a consolidation down to a few huge players is very likely. If that were to happen, Tamm believes that regulators would encourage U.S. residents and companies to start airlines to create competition to the megacarriers. “After that, they would probably open up the market to international players,” he adds. Zea, who also thinks there’s a possibility that the airline industry could become a truly global market some day, says, “The government’s job is to protect competition and if its feels that the only way to do that is by opening up the market to foreign companies, then it will have to trade that for the specter of loss of local control,” he says. U.S. airlines are among the best-run in the business Mann notes that growth prospects for foreign carriers buying U.S. companies would probably be more attractive than those for U.S. carriers looking to pick up a foreign airline, because more than 60% of worldwide air transportation revenues come from the U.S. market. “You have a lot of companies looking inward to have aviation regulations relaxed. There are very few places in the world where the air transportation business is run as efficiently as it is here.” The operating costs generated by European carriers are 30% or more higher than unit costs achieved by U.S. carriers, even among the most efficient airlines, such as British Airways and Lufthansa, he notes. “For U.S. companies, it’s not a situation like finding a cheaper place than the U.S. to make sneakers.”