Airline mergers take off

America's biggest airlines have for years struggled to turn a profit. Could a round of consolidation be the solution to all their problems? By Stephen Foley

Friday 08 February 2008 01:00

Anyone who has taken a domestic flight in the US will be well used to delays, but nothing compares to the length of time that investors have been kept on the tarmac, waiting for the take-off of much-needed consolidation among US airlines.

But word from the cockpit: not much longer now.

Delta, the third-largest passenger carrier in the US, is in the final stages of merger talks with NorthWest, the sixth-largest, in a deal that would turn it into the world's No 1 carrier and – investors hope – create a financially sustainable business for the first time in a generation.

It could also trigger a round of other merger deals among worried competitors, and might finally mean that US airlines do not have to swing, as they have done, between bankruptcy, meagre profitability and then back to bankruptcy.

Both Delta and NorthWest only emerged from their post-9/11 bankruptcy last year; United Airlines, whose preliminary merger talks with Continental are believed to be advancing quickly, emerged in 2006; even Continental itself filed for bankruptcy protection during the recessions of the early Eighties and Nineties.

"The question is often asked, how come airlines lose money when the planes are so full?" said Ray Neidl, analyst at Calyon Securities in New York. "The airlines are pricing their product below their cost, largely due to industry fragmentation and too much product being offered. In the long-term this will not work."

Combining some of the biggest players in a fractured market, where even the leader, American Airlines, carries barely 15 per cent of domestic passengers, could finally give the airlines a chance to rationalise routes, end a perennial fare war, and drive down costs. The question is, will it really happen?

Less than a year ago, Atlanta-based Delta spurned a merger approach from smaller rival US Airways, but that was the final straw for Wall Street. A hedge fund, Pardus Capital, built up a stake in several airlines and began to bang executive heads together. By November, Delta was agreeing to hunt for a partner. A combination with NorthWest was the most obvious, adding that company's business in the Western US and across the Pacific to Delta's East Coast and transatlantic strength.

No one at Delta or NorthWest was commenting yesterday, but talks between the two sides are believed to have overcome the tricky business of assigning management roles, and there is agreement that it would be structured as a nil-premium all-share merger.

American Airlines will no doubt be examining a counter-bid, but it will have to weigh the obvious attractions of bulking up its trans-Pacific business against the need to divert cash into a bidding war at a time when fuel costs are sky-high and business travel may well be about to turn down.

Next, if NorthWest agrees to merge, then its "golden share" in Continental – a hangover from a relationship between the two that was ended by regulators in 2001 – becomes worthless, and Continental is free to join the party, too. UAL, parent company of United, looks the best fit, another East-West combination that will create a better range of options for cross-country travellers. Shares in both were higher yesterday in all the excitement.

But if those in the executive suites have finally come round to Wall Street's view that consolidation is necessary, it is worth noting that not everybody thinks it is a good idea. Passengers, for starters, have done very nicely thank you out of the mutually assured destruction of airline price wars, so any merger deals that threaten to weaken competition can expect a very tough review from the Department of Justice and other regulators.

Any airlines left out of the consolidation could also be expected to complain vociferously if they believe a strong competitor would do them harm and – as Richard Branson discovered as he was battling to launch Virgin America – airlines are pros at gumming up the regulator process for rivals. And then there are political obstacles, too.

Already yesterday, the powerful chairman of the House of Representatives transportation committee was warning he would fight consolidation. Even if one merger looks benign, the others that may follow should also be taken into account, he told a Reuters summit on regulation. A series of mergers could hit services, fares and consumer choice, James Obester warned.

"I am concerned the Transportation Department willnot raise its voice here andthey should," he said. "For the Justice Department, I think we have to give them the longer view while they consider one proposal... If we allow the creation of a global mega-carrier, the others cannot stand still to defend their market share, to defend their market interests. They too will have to undertake merger talks and ventures."

There are those who fear that even a consolidated industry will be unable to break out of its financial malaise, since cost savings could be swallowed up. There might be no end to the downward pressure on ticket prices, since low-cost airlines are still proliferating. And employees may also want more. Already, NorthWest's pilots' union has said it will support a merger with Delta only if it gets equity in the deal and its members get an improved contract out of it. "If you combine the two companies without any or only limited cost and revenue benefit assumptions, the only benefit to stockholders is that the market might assign a higher multiple to the combined company's stock price," Mr Neidl told clients. "That does not present enough upside potential from current stock prices to justify the expense and risks of a merger. Revenue and cost benefits would have to be achieved."

If executives decide in the coming days that they can meet that imperative, and a merger proposal by Delta and NorthWest really does emerge, industry consolidation in the US might be cleared for take-off. But even if it gets into the air, don't expect a smooth flight.

The outlook for Europe

The industrial logic that drives airlines to merge, or try to, is close to irresistible. Fixed costs are massive; customers pay for convenience and frequency. The bigger you are, in theory, the better able to deliver both.

Yet, the European market has a few wrinkles that make mashing two companies together difficult. Politics, for one. Governments get tetchy about letting flag carriers be gobbled up by a foreign rival. It has happened, of course: Air France and KLM got together; Lufthansa bought Swissair. Yet those are exceptions. Witness British Airways' recent failure to buy its long-time partner Iberia: after months of talks, a consortium of Spanish billionaires swooped in to see off any deal. Alitalia, the farcical Italian carrier, continues to trundle along in bankruptcy after the government nixed offers from Russia and US private equity group TPG.

Yet, with just a couple months left before Open Skies, the new regime under which transatlantic routes will be throw open to competition for the first time, Europe's airline heavies may be goosed in to new talks. The focus on long-haul, premium passengers by the major legacy carriers is now nearly absolute, as low-cost carriers have chipped away at the domestic and short-haul business. Consider BA: it plans a business-class-only service to New York, and has sold its subsidiary GB Airways to easyJet.

Danny Fortson

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