Deal with Continental ignites US consolidation as carriers hope the combination leads to elusive profitability, writes Lori Ranson

Forced into merger talks by the prospect of its major US Star Alliance partner United Airlines merging with US Airways, Continental has now agreed to merge with United after walking away from talks prior to the economic freefall that occurred in 2008.

United has long tempted bullish consolidation advocate US Airways with a merger, but in the end Continental, in the span of about three weeks, engaged in a bit of alter robbing to broker a stock swap agreement with United to create a combined equity value of roughly $8 billion. The swiftness with which Continental and Untied moved to reach a merger agreement is a testament to the pressures US airlines face in attempting to create a business model that sustains long-term profitability.

Continental chief executive Jeff Smisek offers a candid assessment of its motives in pursuing United. "What happened here is very simple. I found out through the news media that Glenn [United chief Glenn Tilton] was looking at a potential other combination. I recognised that United is the best possible partner for Continental. I am very interested in providing a foundation of profitability and sustainable profitability for both our shareholders and our co-workers."

Based on estimates from Barclays Capital that foundation rests in $465 million in overall synergies. The investment bank calculates a $248 million expense to harmonise labour rates across all work groups and $195 million in labour incentives. The modelling used by Barclays is based on a 9% US domestic capacity rationalisation ushered in by the merger of the two carriers.

Barclays suggests that the $1 billion estimate in annual merger syngeries offered by executives of Continental and United is a bit more "aggressive". Continental and United are likely including international revenue synergies in their targets, says Barclays, and possibly a bolstered market share, "which we believe will ultimately be competed away". The $1 billion estimate offered by Continental and United also inherently includes some fleet rationalisation, Barclays notes. But until the carriers offer specific capacity allocations, "we cannot reasonably estimate without further details".

What is known is the Continental-United tie-up does create a powerhouse global network with few geographic holes. "We have no international route overlaps," says Smisek, who will become chief executive of the new carrier. "Across the pacific and the Atlantic as well as Latin America and the Caribbean, we will offer customers increased access to a greater number of destinations, countries served and daily departures."

If the carriers ultimately succeed in gaining approval for their merger it would combine Continental's strength in New York and Latin America with United's concentration on the US west coast and across the pacific. "Put simply," says Smisek, "Continental is strong where United is weak, and United is strong where Continental is weak."

Using current levels of operations as a baseline, United and Continental estimate offering service to 370 destinations in 59 countries. Domestic routes would account for 57% of the carrier's capacity, while 20% would be deployed across the Atlantic, 15% in the pacific and 8% in Latin America. Analysts at JP Morgan estimate the merged carrier would have 13 US domestic nonstop overlaps, and 11 of those routes could transition to monopoly or duopoly status.

Smisek and Tilton are striving to close the merger by year-end and receive a single operating certificate from the FAA by mid-2012. But the typical competition hawks have already surfaced. US Representative James Oberstar, who adamantly opposed Delta's merger with Northwest, has already sent the US Department of Justice a letter expressing opposition to the merger.

Oberstar sees a "different spirit" in the current US Department of Justice staffed by the administration of US President Barack Obama compared with the previous administration that endorsed the merger between SkyTeam carriers Delta and Northwest Airlines.

Delta chief Anderson explains the carrier's transaction with Northwest was probably the quickest of its size to ever clear the Justice Department, adding, "I don't think this environment is the same." The analysts at JP Morgan believe the odds of the Continental-Untied merger gaining regulatory approval are 75%, while Barclays says its analysis raises few red flags based on a model using guidelines from previous merger reviews.

THE MAGIC OF THREE

Dust has barely settled on the Continental and United deal before a flurry of speculation emerged that spurned US Airways would be driven into a merger with American Airlines as a means for both carriers to survive. Even before Continental and United solidified their decision to merge American management was hammered by analysts about exactly how the carrier plans to achieve profitability. "You have the highest costs. You have the lowest margins. You are the only major airline expected to lose money this year," says JP Morgan analyst Jamie Baker.

American chief executive Gerard Arpey acknowledges it is no secret the oneworld carrier has higher labour costs than its peers since it has never filed for US Chapter 11 bankruptcy protection. But Arpey argues that roughly 19 major contracts are currently being mediated or negotiated across the industry. "I think the gap you are describing on the cost side is going to be mitigated and there is going to be a convergence," he says.

Arpey also tells American's employees that even though the carrier has a labour cost disadvantage relative to Continental and United, "the history of airline merger suggests that in the process of merging, their labour costs will rise and move toward ours". Arpey believes it is "fair to say that a combined United-Continental has the potential to change the industry landscape in a number of ways, some positive, some negative".

Few industry watchers see any repercussions from the Continental-United merger, and despite being shunned in this round of consolidation US Airways chief executive Doug Parker says ultimately the US industry can only support three large hub-and-spoke airlines. Analysts at US consultancy AirlineForecasts profess strong views about three large network carriers being the ideal number to sustain long-awaited profitability. "If the industry is not allowed to consolidate in the most rational manner, the result will be a continuation of the slow liquidation of US Airways and American, the two remaining network airlines in need of restructuring," says AirlineForecasts.

But despite this, Wall Street is not ringing a siren for additional immediate consolidation in the US airline industry. "Imaginations are likely to run," says Barclays. "But we discount the idea that the new company will be a category killer that others will need to mount an immediate response to," says Barclays, who explain the success of Delta's merger with Northwest didn't hamper United "from a major relative profitability transformation on a stand-alone basis".

Source: Airline Business