Magazine

Airline Mergers Aren't Storybook Romances


The Continental-United tie-up makes sense in a bloated industry, but history shows that big airline mergers yield mediocre results at best

On May 3, Continental Airlines (CAL) Chief Executive Officer Jeff Smisek, a guy known for driving around Houston at 130 miles per hour, boasted how he'd telephoned his counterpart at United Airlines (UAUA), Glenn Tilton, to break up the potential marriage of United and US Airways (LCC). "I gave Glenn a call and told him I was a much prettier girl," Smisek told Bloomberg News.

It would be unsporting to deny Smisek, 55, his Broadway turn as Maria in West Side Story. Yet the reality of the airline industry is anything but pretty. The vital function of flying passengers for work and pleasure remains a terrible business, and the merger of Continental and United won't do much to solve the problem.

Over the past decade, the domestic airline industry has amassed no less than $60 billion in red ink and shed 160,000 jobs, according to the Air Transport Assn., a Washington trade group. United and Continental each suffered losses for the past two years, and as borrowers they receive miserable credit ratings. On average, journeys between clogged airports take longer than they did years ago because of tarmac delays, circling before landing, and other factors, the ATA says.

Warren Buffett, as usual, has pithily summarized the situation. "You've got huge fixed costs, you've got strong labor unions, and you've got commodity pricing," he told The Telegraph back in 2002. Buffett learned his lesson after a disastrous investment in US Airways in 1989: "I have an 800 number now that I call if I get the urge to buy an airline stock," he said. "I call at two in the morning, and I say: 'My name is Warren, and I'm an aeroholic.' And they talk me down."

Bankruptcy Knack

The one skill the carriers have consistently demonstrated, says Adam Epstein, a consultant and tech financier who flies frequently from his base in San Francisco, is using the Bankruptcy Code to rearrange their money-losing operations. Thirty-seven airlines, including United, have filed for Chapter 11 protection from creditors since 2000, according to the ATA; nine have been liquidated. "Maybe more should have just gone away, rather than reorganize," Epstein says.

Mergers are another way to thin a bloated industry, but the streamlining has been painfully slow and uneven. The trouble with commercial air travel traces to 40 years of government fare and route regulation, which ended in 1978. Unable to compete on prices, the carriers tried to outdo each other on services. The complimentary booze flowed. Federal rules protected profits, so the companies had little incentive to contain costs. Salaries for pilots, flight attendants, and mechanics soared. Labor concessions in recent years have corrected some of the wage distortion, but not all of it.

In the 1980s and 1990s, upstarts such as Southwest Airlines (LUV) challenged the longtime carriers, setting off intermittent price wars, strikes, and egotistical overexpansion. To this day, the industry hasn't gotten control of its crippling fixed costs. Even with sophisticated financial hedging techniques, it has suffered from high and volatile fuel prices. Freak storms, not to mention Icelandic volcanoes, can gouge millions from collective revenues.

After three decades of turbulence and the disappearance of PanAm, Eastern, TWA, and other hallowed brands, the airlines still have too many seats in the air. The dominant system of hub airports—Continental has them in Houston and Newark, N.J.; United in Chicago and Los Angeles—has proven to be expensive to maintain and prone to infuriating travel snags.

History Not Encouraging

The only airlines that seem to have a winning formula are Southwest, JetBlue (JBLU), and a handful of others that fly from point-to-point, keep expenses and fares low, and generally enjoy decent relations with their employees.

Though combining United and Continental makes plenty of sense on paper, history isn't encouraging. Most big airline mergers have yielded mediocre to poor results, not because the particular mix was a terrible idea, but because the entire business is hexed. US Air still juggles two sets of employees five years after merging with America West—and their lowly customer service ranking from J.D. Power & Associates (MHP) reflects the confusion. The two lowest-rated full-fare carriers in the quality-assessment firm's 2009 survey were US Air and United. Delta Air Lines' (DAL) 2008 hook-up with Northwest Airlines has gone more smoothly. The new Delta reported that it narrowed its loss in the first quarter to $256 million, down from $794 million in the quarter a year earlier. That passes for good news in the airline trade.

Given the alternative of struggling independently, United's deal with Continental seems smart, says Vicki Bryan, a senior analyst with GimmeCredit, a bond research firm in New York. Annual cost savings and new revenue could reach $1.2 billion by 2013, the companies project. They promise "improved profitability and sustainable long-term value for shareholders." The combined carrier should benefit from greater reach on the most lucrative international routes. "The airline industry has long been oversupplied, and that has kept airfares essentially unchanged for the past 20 years," says Bryan. "Without pricing power, there are only two ways that airlines can address this: higher-quality revenue [such as that from profit-rich routes to Asia and Europe] and lower costs." The United-Continental deal could produce both.

Consolidation: How Far?

How much real consolidation occurs remains an open question. Seeking to buy peace with their unions, United and Continental emphasized that job reductions would be limited primarily to retirements and attrition. Some savings might come from further trims to amenities. Smisek, in his short four months as CEO of Continental, has curbed customer incidentals, which until recently were generous by air-travel standards. Catching up to its rivals, Continental has eliminated free food in economy class on most domestic flights. It also started charging extra for roomier exit-row seats and matching those annoying bag fees. "The merger looks like win-win for the two airlines," says consultant Epstein, "but I don't think passengers are going to feel better treated."

The modest-priced carriers notwithstanding, it's a mystery how the American airline business continues to attract capital with very little hope of a decent return. One explanation comes from Tom Petzinger Jr., who runs Launchcyte, a biotech-financing company in Pittsburgh. Earlier in his career, Petzinger wrote about airlines for The Wall Street Journal and in 1995 published a book on the topic called Hard Landing. "I hate to use the word 'romance,' in a business context," he says, "but I think that's what it is. There are naive investors who refuse to believe you cannot make good money delivering human beings over the surface of the planet. The assumption makes sense. The economic realities say otherwise. There are just too many other people with the same investment view, and too many planes flown by too many pilots.… The lesson keeps getting learned the hard way."


Reviving Keynes
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