Airline Forecasts’ Vaughn Cordle argues a merger between Continental and United Airlines, rather than US Airways and United, would bring twice the additional market value to the ultimate company and would make for the better merger, especially when coupled with the developing Atlantic and Pacific joint ventures the two are working on. Many observers indeed suggest the US Airways talks are actually designed to provoke Continental's interest. A three-way deal might be better still, he suggests. Some unions may beg to differ - and the role of global alliances in the airlines' strategic thinking should not be underestimated.
Whatever the case, the airlines need to move quickly. Says Cordle, “The window to create the most value is open, but it will start closing as labour pressures for higher wages (USD3.3–6 billion) and higher airport PFC fees (USD2 billion higher) and security costs (USD2.7 billion by 2014) kick in...Also, higher fuel costs have become a catalyst, encouraging CEOs and CFOs to move towards protecting and enhancing shareholder value. Fuel costs in 2010 will be around USD6.4 billion higher than in 2009 – USD80 per barrel is the base case this year and USD84 in 2011. Given the very poor balance sheets and inadequate profits, and the fact that higher costs are on the way, it's best for UAL, US Airways, and Continental to start the merger dance.”
Noting that between 1999 and 2009 the US airline industry lost over USD70 billion in 2009 dollars, Cordle believes consolidation is a must. “The domestic-only market has too many airlines and needs to consolidate,” he said, “Consolidation is the only way the industry can earn capital costs. United, Continental and US Airways are the weakest players and are in need of a merger partner. Hence, the need for greater concentration and pricing power, which does not exist in the domestic market. Bottom line: A merger will be good for the industry, labour and shareholders. Moreover, it can benefit the consumer as the industry moves towards a more viable structure that can afford to properly invest and provide the required level of service.”
Cordle estimated a Continental-United merger would create an additional USD5.8 billion in market value - a 95% increase above the market value sum of the two airlines today with cost and revenue synergies around USD2.2 billion. “A US Airways-United merger would create an additional USD2.5-USD3 billion in market value - a 65% increase above the market value sum of the two airlines today,” he said. “Cost and revenue synergies would be in the USD1.8 billion range within two to three years. I suspect that Continental will regret not merging if US Airways works out a deal with United. However, if US Airways, Continental, and United could work out some type of three-way deal that could create value for all stake holders.”
Cordle noted the Atlantic and Pacific joint ventures being developed by United and Continental would add several USD100 million to each airline. “But, if Continental doesn't want to do a full merger with United, US Airways makes for the next best deal,” he concluded. “A 65% return is better than no incremental increase in value.”
A Continental-United deal would result in an estimated USD34.2 billion in combined revenues in 2011, surpassing Delta at USD33 billion. A US-UA deal would result in lower combined revenue in 2011 of USD31.2 billion, he estimates.
In addition, combined 2011 earnings – not including cost and revenue savings – would be USD650 million for a 1.9% margin for Continental-United and USD420 million and a 1.4% margin for US Airways-United. As a benchmark, he noted Delta would have a USD1.1 billion in 2011 estimated earnings and a 3.3% margin including the cost and revenue synergies from its merger with Northwest.
“I would expect any US Airways or Continental combination with United to be smaller than the two airlines as stand-alone airlines because fares are too low to be sustained given higher costs in the pipeline,” said Cordle. “In other words, the industry still has too much capacity, which results in destructive fare competition. Weak airlines merge because the only other alternative is to destroy economic value. A 5-10% smaller combined airline is expected if the merger goes through.”
Airline Forecasts ran a Herfindahl (HHI) concentration analysis of the industry and found that, in the domestic-only segment, its value is around .14 and would increase to .18 if United merges with US Airways or Continental. “Anything under .2 is considered ‘perfect competition’ and results in destructive price competition where consumers capture the bulk of the value produced by the industry,” he said. “In other words, even after another merger, the industry will still be unable to earn the cost of capital over a full business cycle, and consumers will continue to benefit as airlines price the product below true costs. Shareholders can ride the value upward – if the deal goes through – but should exit the investment when fairly valued. The share price will capture part of the ‘fair value’ of the merged company as soon as the deal is announced, or strong rumors of a deal emerge.
“Not all of the cost and revenue synergies will fall to the bottom line,” Cordle continued. “Stated differently, shareholders will only capture perhaps one third to one half of the USD1.8–2.2 billion I'm estimating as the base-case cost/revenue synergies for a United-US Airways or a United-Continental merger. Even at one third, the leverage to the bottom line is significant, which is why market values will increase 65% (US/UA) or 95% (CAL/UA).
He predicted that labour will demand a 25% wage increase at all three airlines, but the combined airline would be able to afford it. But, he added, they could accept, say 10%, “with an equity kicker of 5–10% of the merged company.”
“Cost and revenue synergies in the USD1.8 billion to USD2.2 billion range will allow the profits required to satisfy labour and to properly reinvest in the airlines,” he said. “My best guess is that labour will get 5%-10% of the new airline, which should provide a nice incentive for labour to sign off on the deal,” he continued. “My next best guess is that labour will get 5–10% of the new airline, and perhaps a 10% raise, again a nice incentive. There would be much less value for labour if the airlines do not merge. If United merges with US Airways, labour costs could increase by 10%, about $650 million which is most likely. A 20% hike is about USD1.3 billion and a 25% would be about USD1.6 billion. But, seniority issues should be settled before any deal is completed. It’s best to get labour onboard first and then dangle the carrot of an equity stake to encourage participation. The opportunity-cost of not merging is very high for shareholders and labour.”
But US Airways has yet to solve the seniority issues resulting from its merger with America West, years ago. Cordle suggested that labour could eventually capture all of the new value created by the combined entity, but indicated the surviving company could continue to create additional value for shareholders if a labour deal can be cut. He predicted a new contract would create a five-year window to create that value. “I think they can because the management will is there, and so is the incentive, which is partially based on the fear of another bankruptcy or failure, which I think likely over the longer term if a merger does not occur,” he concluded.
Cordle went on to indicate that the USD1.8 billion in cost and revenue synergies will be reduced by 35–75% with a new labour agreement that includes a 10% to 20% pay raise. “A 5% stake in the company could be worth USD350 million to labour, and 10% would be worth USD700 million,” he said. “This is my base-case estimate. The bottom line: US Airways and United labour could end up with a package worth USD1–2 billion. This is a lot of incentive to sign off on a merger deal.”
In analysing labour, Cordle pointed to the new and moderate union leadership at United which would likely embrace a merger. However, a big if, he said, is whether or not leadership can “communicate the value of the merger in terms that line pilots understand. The group has historically been militant and not too bright when it comes to making the big decisions that impact the corporation and its own pilots' best interest over the longer term. New pilot leadership is taking less aggressive approach with management and should sign off on a merger deal.”
He also suggests junior pilots at Continental may fight a merge because they would take a hit in the merger of seniority lists since United has more senior pilots. “The junior pilots have greater say with the pilot leadership at Continental,” he said. “Pilots at US Airways are divided but should embrace a merger – for survival and financial reasons – if presented right.”
The US Airline Pilots Association represents US Airways pilots. In its Iron Compass newsletter, the union contested CEO Doug Parker’s contention that the pilots' contract has been a deal breaker in mergers. The Street picked up on this and reported there is a clause calling for pilot wages and benefits to snap back to pre-2002 bankruptcy rates in the event of a merger.
"Nothing in the pilot contract blocks a transaction." Scott Theuer, spokesman for the US Airline Pilots Association told The Street, adding the clause was intended as compensation if concessions led to a successful outcome, according to the publication. "The company agreed to a provision which brings our pay back to where it should be. Now the company says it is either not going to merge or it is going to merge and make sure we do not get what we negotiated."
Whatever the rights and wrongs, the effect is inevitably to create a disincentive to merger.
Lurking in the foreground of any new relationship is the impact it would have on the increasingly important global alliances - and vice versa. International markets are rapidly growing in strategic importance for US carriers and, whereas in the past domestic considerations would have dominated thinking, there are now new motivations to influence decisions.
United heads the Star Alliance on the American side of the Atlantic, with Continental a recent convert. US Airways' east coast network directly confronts Continental's at many points, so this is going to ruffle some feathers one way or another.
Alliance alignments are reaching a stage where they become essential components of long term strategic planning. But, as JetBlue's recent slot swap and codeshare with US Airways illustrates, there is still room for movement - and surprises. Nonetheless, the window for alliance flexibility is narrowing. Meanwhile, standing on the sidelines, American is the only major not to be linked to merger talks.
All of these factors will challenge merger minded managements. Even if, as Mr Cordle suggests, a Continental combination could generate better returns for United, achieving a workable arrangement must be the overriding priority. Meanwhile however, Continental - management and unions alike - will be exploring their options.
JP Morgan last week described the US Airways-United deal as “the most logical and feasible among potential legacy combinations,” according to the Wall Street Journal. “Pilot wages at each are closely aligned and among the lowest in the business, meaning labour might not require the same approvals required of Delta to integrate Northwest. In addition, save for a handful of A330s and 777s, US Airways doesn’t fly a single type United doesn’t. A combo wouldn’t likely change alliances either, limiting objections by Continental.”
Given the high stakes involved, it does seem however that there may be more twists to this story as it unravels.
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