It's All Up in the Air: M&A Deals in the Airline Industry

Weekly Corporate Growth Report, Jun 9, 2008 by Dolbeck, Andrew

Analysts and airline industry executives have stated that merger deals in the airline sector are inevitable. The industry is facing a number of challenges, such as stiff competition and rising operational expenses, particularly the rising cost of jet fuel. Industry consolidation would help airlines face these challenges by combining resources, cutting costs, and reducing competition.

According to an estimate from Jamie Baker, an analyst with JPMorgan Chase, airline industry losses could top $7.2 billion in 2008. Some analysts estimate that airlines will have to raise fares on all routes by about $60 to offset the impact of rising fuel prices, which are up 82.5 percent over last year. But many airlines have already instituted fare increases, along with new fees and surcharges in an attempt to bolster revenues.

The costs of fuel also impact the potential success or failure of mergers. If the price of oil rises too high, it can limit the cost benefits provided by the merger. And if the price of oil falls sharply, which doesn't seem likely, it undercuts the need for costly merger transactions.

With operating expenses high and competition fierce, airlines have considerable motivation for merging. But airline consolidation doesn't seem to be going that well, at least not for United Airways.

United and US Airways

United Airlines has dropped out of its recent merger negotiations with US Airways. The discussions appear to have stalled over the difficulty of combining the two airlines' various labor contracts. US Airways, which merged with America West in 2005, could face additional charges under its pilots' contract for merging again so soon.

The Air Line Pilots Association and the International Association of Machinists and Aerospace Workers were both expected to oppose the merger. Both unions have representation on United's board of directors, making it difficult to rely on full board support for the deal. It is possible that the unions, along with the Association of Flight Attendants, might have lobbied against the deal, making federal approval of the transaction less likely.

United and Continental

The US Airways deal is the second recent merger plan to fall through for United. The airline had been in discussions with Continental Airlines, but Continental's board decided on April 27 to discontinue negotiations. Continental stated that the deal would not be in the company's best interest.

While the two airlines will not merge, the companies are discussing a possible alliance. Continental is currently part of an airline alliance called SkyTeam, which also includes Delta, Northwest, and Air France/KLM. Continental has expressed a willingness to discuss leaving SkyTeam for another partnership and United hopes to lure the carrier into its Star Alliance, which includes Lufthansa and about two dozen other carriers. Continental has also talked to British Airways and American Airlines about joining them in the oneworld alliance.

Delta and Northwest

The success story in the realm of airline mergers appears to be the proposed merger of Delta Air Lines and Northwest Airlines. The companies agreed in April to merge in an all-stock transaction with an estimated enterprise value of $17.7 billion. If successfully closed, the deal would create the world's largest airline company.

The deal appears likely to win the necessary approvals. Representative John Mica, a Florida Republican and former chairman of the House of Representatives aviation subcommittee, stated at a hearing on the merger that the deal did not appear anti-competitive. Rep. Mica also stated that it was likely that the deal would be approved by officials at the departments of Justice and Transportation. Antitrust and industry experts have also stated that the proposed merger stands a good chance of winning regulatory approval.

In addition, Delta's pilots voted overwhelmingly in favor of changes to their contract that will give them pay raises, an equity stake, and other benefits, but also will give management more leeway as part of a proposed combination with Northwest.

While the rising cost of fuel is clearly a factor in airline mergers, Delta and Northwest claim that it will not impact the completion of their merger. Delta Air Lines President Ed Bastian stated that the company's executives and board members looked at merger models that assumed oil at $135 per barrel and higher and confirmed that the merger deal still made sense under those conditions. It was good planning, since oil reached $135 per barrel near the end of May.

Other Survival Measures

Consolidation isn't the only option available to struggling airlines, of course. A number of carriers have announced cost cutting measures, such as eliminating routes, retiring aircraft, and raising travel fares. But more extreme measures, such as cutbacks in service and staff, would be more palatable as the result of a merger, where the elimination of redundant. operations and staff positions is expected. According to Rick Seaney, chief executive officer of Farecompare.com, a consumer airline ticket research site, it is not uncommon for airlines to trim between 8 percent and 15 percent of routes when they merge.