Survival of the Biggest

With the dollar down and oil up, U.S. airlines are talking merger. But will consolidation be enough to fend off powerful European carriers?

By Dean Foust, with Kerry Capell in London

Arthur Giron

The long-anticipated consolidation of the U.S. airline industry appears to be finally on the horizon. Barring the unexpected, Delta Air Lines (DAL)and Northwest Airlines (NWA) will soon announce they are joining forces to create the nation's largest carrier. When that happens, it's likely United Airlines (UAUA) and Continental Airlines (CAL) will strike their own deal, and it raises the odds that American Airlines (AMR) will follow suit—perhaps linking with a smaller player like Alaska Airlines (ALK) or Frontier Airlines (FRNT), industry sources say.

The immediate pressure driving these pacts is high oil prices. Even with all the wrenching cost-cutting that Delta, Northwest, United, and others endured in bankruptcy, most U.S. carriers are back in the red. But the mergers are also being driven by a competitive threat that could be as onerous as $90-per-barrel oil: the imminent assault by European airlines on the lucrative transatlantic routes that have been the U.S. carriers' few big profit centers. And the European carriers don't plan to stop there. Spurred by the weak dollar, European carriers are publicly agitating to expand a new bilateral aviation treaty to gain the right to acquire or buy controlling stakes in the enfeebled U.S. airlines. The European carriers "are going to trash the profitability of the international routes, which are the only thing the major [U.S.] carriers make money on," says former Continental CEO Gordon Bethune. "They've got to come together and combine their own international networks or get chewed up by the Europeans." (Executives at Delta, United, and Northwest all declined to comment on the state of merger talks or the long-term competitive implications of any deals. Continental did not respond.)

GLOBAL MEGACARRIERS

The initial steps toward this future of global megacarriers may already be taking place. In December, Germany's biggest airline, Lufthansa (DLKAY), bought a 19% stake in JetBlue Airways (JBLU). The move ensures Lufthansa access to the crowded New York market via JetBlue's slots at John F. Kennedy International Airport and gives it an effective right of first refusal on any offer for JetBlue. Virgin Atlantic Airways, after years of legal wrangling, won approval to launch Virgin America. The U.S. affiliate, in which Virgin owns a minority stake, flies coast-to-coast routes. And many of the European carriers are devoting more of their fleets to transatlantic routes at a time when cash-strapped U.S. rivals lack the resources to respond. In January, British Airways (BAIRY) announced plans to launch OpenSkies, a new brand that will focus on routes across the Atlantic. "U.S. carriers are not in a position to create new entities like British Airways. They're simply struggling to stay alive," notes Peter Morris, chief economist for Ascend, a London consultancy.

The European carriers could also invest in some of the prospective U.S. mergers. According to industry sources, Delta and Northwest may bring aboard Air France-KLM as a minority investor. Reason? With more than $6 billion in cash, the Paris-based carrier may be their best source for some of the roughly $3 billion the carriers would need to cover the costs of integrating their route structures. "I think a Delta-Northwest merger would be the first step toward a global airline controlled by Air France," says Stuart Klaskin, a Miami-based strategic aviation consultant. "Everyone in this round of U.S. consolidation will have some financing from foreign carriers, and that will be an intermediate step toward consolidation."