History Sheds Light On Proposed United, US Airways Merger

World Airline News, June 9, 2000

History often assists well when modern dilemmas have to be resolved. Steve Jaffe, an analyst at Silver Spring, Md.-based consultancy Avitas, Inc., reflects on how the past can demonstrate the pros and cons of the potential merger of United Airlines and US Airways, and how this age old strategy for growth and consolidation can sully even the brightest futures. This editorial was written before American Airlines confirmed June 5 that it had approached Northwest Airlines with a buyout bid.

A friend recently confided that this person's respective partner was pestering this friend to buy a house in the new neighborhood where all their friends were moving to. Although they could not afford it, the partner urged my friend nonetheless to buy "before all the houses are bought up." The rational friend assured the partner that whatever unpredictable future market conditions may prevail - there will always be houses available for sale.

In the aftermath of the United Airlines [UAL] - US Airways [U] proposed merger, are the major airlines scrambling like the irrational partner, to buy up other airlines "while there are still some left?"

The prevailing opinion is that American Airlines [AMR] and Delta Air Lines [DAL] "can't stand still", and must respond to United's move. Is this a rational analytical process, or a knee-jerk reaction?

Market dominance is a critical factor in an airline's success. Aside from sheer market presence, dominance alone contributes to "economies of density" in which dominant airlines benefit both on the revenue and cost side. On the revenue side, additional flights and city pairs translate into proportionately more passengers (the "share gap", or "S Curve"). The additional flights create yield premium which passengers are willing - or are forced to - pay higher fares for more or better service. Additionally, a strong public business and civic presence with the community, corporations, and travel agents result in higher demand.

This dominance also translates benefits on the cost side. A hub carrier can operate larger aircraft which are less costly per seat mile to operate, the labor force is used more productively at a hub than a spoke, and the connectivity with outlying spoke cities and other hubs is generally more cost effective than point to point operations.

All this is well established, but the question is, do economies of density keep growing as an airline gets bigger and bigger? If so, Harding Lawrence - not Herb Kelleher - might have been our airline poster boy of postderegulation success. But Lawrence found out that expanding an airline was a lot easier than managing its growth. Flying empty Boeing [BA] 747s across the Pacific, Braniff Airlines burned up cash long before the carrier could establish any sort of market presence, let alone dominance. Pan Am believed its quest for domestic feed would finally be answered by its acquisition of National Airlines. But labor acrimony scuttled the chances for any quick benefit of a domestic route structure.

History Does Not Reflect Well

Following a spate of mergers, Republic in 1981 could actually boast of "joining more of America than any other airline". But the route structure was more a dysfunctional amalgam of three separate carriers in three separate regions - North Central, Southern, and Hughes Airwest. It took two full years to integrate the three carriers, at the cost of a greatly reduced and rationalized route network.

And as far back as 1984, United won the bragging rights to "first to fly to all 50 states." Of course, they soon found out that flying 737s to Fargo was not a profitable venture. Apparently, there are mitigating factors to the benefits of size.

Can we have the best of both worlds? Is it possible for an airline to focus on its strengths - and grow its capacity at the same time? Yes, and it's called alliances.

Northwest Airlines [NWAC] is a good example. Recovering from the malaise of the early 1990s, Northwest charted a new course toward long term success. The carrier would focus only on its strategic strengths, fly only where it could make money, and, in the words of CEO John Dasburg, abandon the concept of "ubiquity". Northwest shut down its mini hubs in Washington, Seoul, and Boston, and redeployed its fleet to turn Detroit into a truly competitive hub. The alliances, first with KLM Royal Dutch Airlines, and later with Continental Airlines [CAL], provided breadth of coverage - effectively a global route structure, at a minimal investment. According to Northwest, the KLM alliance contributes about US$50 million in profits annually, and its 1999 pre-tax earnings from its alliance with Continental were around US$80 million. Through alliances, Northwest has attained a degree of dominance while avoiding the downside of mergers.

Is all this to suggest that the United/US Airways proposed merger is simply too big to work? Emphatically not. There are many synergies to these two companies combining forces. The route structures meld nicely with little overlap and provide United with a strong East Coast presence to feed its transcontinental and European flights. Except for the newly ordered Airbus Industrie A330s at USAir, the fleet match is a good one. The executives at both airlines know each other well, having worked for and with each other for years in Chicago - avoiding a clash in the executive suite. And the regulatory hurdles are less with a United/US Air combination than with other potential mergers, as the two airlines combined would not exert an overwhelming dominance, as measured by origin and destination traffic, at any of the nation's top 15 airports.