“It looks as if [United Chair Glenn] Tilton’s plan is coming together,” said AirlineForecasts Partner Vaughn Cordle, reacting to the news that United and Continental have renewed merger talks, according to The New York Times Deal Book which first broke the story of United’s merger talks with US Airways last week.
Most observers concluded that the US Airways talks were a feint to get Continental to the table. United Air Line Pilots Association Master Executive Council (MEC) Chair Captain Wendy Morse furthered this assumption. "Presently, there are no meaningful merger discussions with US Airways," she said in a message to pilots last week. "The United master executive council has confirmed that the report is speculation.” Earlier this week Stifel Nickolaus Analyst Hunter Keay predicted Continental would join the fray if, for no other reason, as a defensive move against being the odd man out.
Deal Book reported Continental revealed it was in the early states of renewed merger talks with United at 1 pm yesterday, only saying that it received confirmation from people briefed on the matter, who naturally cautioned that the deal could fall apart at any time.
The news quickly ricocheted around the industry.
The two had a run at merging in 2008, only to back off with the fuel crisis and the compounding recession. Sources also indicated that Continental walked away owing to United’s weakness. Many have mentioned that the anti-trust immunity gained by United and Continental is already gaining synergy benefits that would unlikely increase with an outright merger.
“This would be Continental's second go-round with UAL in as many years, and the situation is the same,” said Airsavings CEO Raphael Bejar. “Even though analysts might cite a slightly higher value of a merger between these two airlines, the fact is that they already engage in a codeshare alliance. This means that though they may each have routes that could complement the other’s routes, they are already reaping some of the benefits of these complements. Since that deal didn't go through in 2008, it's hard to envision it happening now. That said, the consensus seems to be that a Continental merger would be more valuable than a US Airways one, so anything is possible.”
Question remain regardless of whose dancing
Questions were already swirling around the proposed US Airways-United merger and most still remain regardless of who the players are. The questions include who is buying whom, who will run the resulting company, where it will be located, how regulators will react and, of course, how will changes wrought by the merger be financed even if the merger itself is done by stock swaps.
Of course, the wild card is labour and whether it will go along. US Airways has yet to resolve pilot seniority issues from its 2005 merger with America West. United pilots and flight attendants have issued statements universally opposing a merger saying it would distract from current contract negotiations.
One thing is clear, any deal between United and US Airways will have to crafted to address the overlapping markets as well as their control of Washington DC at both Washington Dulles and National airports where a US Airways-United deal would control 63% of departures, according to JP Morgan. US Airways is set to solidify its strength at National in its slot trade with Delta.
This might end up being Southwest’s shot at gaining a foothold at its third Washington airport. Already serving Baltimore and Dulles, it has long sought access to National and was frozen out of the recently proposed slot swaps at the airport between Delta and US Airways and between American and JetBlue. However, if United and US Airways do tie-up with an ensuing relinquishment of slots at National, they could do what Delta, US Airways, American and JetBlue have done – pick and chose who gets the slots. If Southwest is frozen out again, its howling may get so loud that the Department of Transportation will have to listen.
“An interesting aspect of this is the recent report that the Justice Department is considering mandating that the new airline surrender some routes,” said Bejar. “If the merger goes through and these routes are opened to new competition, this could provide an opportunity for LCCs to enter into previously choked markets. If the administration accepts this interpretation, then a deal seems possible. And this is a real possibility; whereas the conventional wisdom is that this administration is less amenable to large mergers than the last, it has extracted similar concessions from the BA-AA codeshare alliance, indicating that appropriate route distribution could be perceived as a remedy to anti-competitiveness.”
Washington dominance aside, the Department of Justice should have few concerns despite assertions that United hubs at Los Angeles, San Francisco and Denver overlap with US Airways at Phoenix. That is largely a matter of hub rationalization, something we’ve seen before when US Airways abandoned Pittsburgh as a hub.
No one argues that the US airline market is terribly overcrowded. While consolidation is a good thing as is the resulting capacity and redundancy cuts as well as the cost streamlining, there is little doubt others will move to fill in any voids created by either proposed merger. Since 2003, nearly all capacity cuts by the legacies have been taken up by the low-cost carriers and this pattern will likely continue.
“A US Airways-United merger could win DOJ/DOT approval, if structured properly,” said Cordle. “Structuring the deal properly includes addressing at least 15 city pairs, in addition to Washington DC, that have too much overlapping concentration.” He added the entire industry will benefit as the industry naturally consolidates after USD70 billion in losses (-5.7% of revenue) over the last decade.
“The increase in market concentration post-merger will still be too low for anti- competitive pricing and should not be a concern for politicians like [House Transportation and Infrastructure Chair James] Oberstar and the DOJ,” he continued. “I would expect a Congressional show-trial hearings on any merger that could be perceived as anti-consumer. It's not anti-consumer when the industry must consolidate to earn its cost of capital and more importantly, to satisfy all stakeholders, not just consumers. In my estimation, market concentration after another merger will not increase pricing power to a level that is considered anti-consumer.”
One of the bigger questions is whether the Department of Transportation will be forced to take another look at the United-Continental anti-trust immunity should a United-US Airways merger ultimately happen. DOT is already requiring continued oversight of the ATI, requiring United and Continental to submit annual progress reports. They have yet to execute and submit their metal-neutral contract to DOT and if it is not submitted by 10-Jan-2011, the ATI automatically expires. A deal between US Airways and United would likely change that contract.
US-UA still a good deal
Cordle, in a recent piece, defied conventional wisdom saying that if Continental did not join the party a LCC-UAL link would be a pretty good deal. However, from the outset he has advocated not only that a CAL-UAL merger would be stronger but a three-way between the companies would be better still. See related report: Continental-United a better combination than US Airways-United? Airline Forecasts on mergers
Even so, it is highly unlikely that that would result in too much market concentration simply based on the opportunities it would create for low-cost carriers – JetBlue, Southwest, AirTran and Frontier. Then again, it could present opportunities for Alaska to go further afield, although some have advocated for a three-way deal between Alaska, JetBlue and American.
The worst of the impact would be at the regional airline level. For regional airlines, an already risky environment would be made that much more threatening as the ultimate carrier rationalised its feeder operations.
The Continental news
Late yesterday, Cordle said “US Airways could be in real trouble if UAL merges with Continental, the best outcome for both companies. It will likely come down to who runs the show and how much does the exiting team get.”
The prospect that Continental would not join the party, said Cordle, had a large opportunity-cost in not participating in a merger with UAL. “UAL wins with a US Airways merger, and it wins even more if Continental decides to work with UAL or even makes a bid for UAL to preempt a linkup between US and UAL,” he said. He added that the biggest winners would be United shareholders once a bidding war gets underway.
“A United/Continental merger creates almost twice the post-merger value (up-and-above the current sum of the independent airline values) than a United/US Airways merger,” he continued, “In my estimation, UAL could raise the capital required to make a bid for US, even when a control premium is involved and after higher labour costs are considered. I believe that Wall Street will support a US Airways bid, or a merger between UAL and US.
Cordle, in an analysis entitled The Logic behind a UAL Bid for US Airways – Why conventional wisdom may be wrong, attacks the assumptions already being made on a United merger, including:
- US or CAL management would displace UAL management in a merger;
- US Airways is a basket case and would not work with UA;
- A merger with UAL will fail because most airline mergers are unsuccessful;
- Tilton leaves after merger or perhaps stays as Chair of the board.
“All of these airlines are basket cases and unfit for long term investment,” he said flatly, noting that none of the US carriers have the truly national reach that is needed without merging. “They continue to shrink vis-à-vis low-cost carriers, and their only salvation will come from their ability to fully participate in a branded global alliance, such as Star Alliance, Skyteam or oneworld. The successful US legacy airline must have a national market – access to and provide access - to all the regional markets in the US and link those markets to a global network.”
Cordle, who authored the analysis with AirlineForecast Partner Carlos Bonilla and retired KLM VP of Government and Legal Affairs, Paul Mifsud, indicated that because US legacy carriers have historically developed geographically regional strengths, mergers make much more sense.
“From a network perspective US Airways is a much better fit than most people seem to realise,” he said, noting that a Philadelphia or Boston hub to London and Europe could be very attractive as an alternative to the ever-congested New York airports. However, US Airways is downsizing Boston, with little remaining save its shuttle operations. “Then, Charlotte flanks Delta at Atlanta and would empower a Star move on oneworld’s stronghold in Miami. With UAL and US, Star would end up with a balanced and strong US carrier with national reach. It is strong in the southwest and West Coast as well as on the East Coast. The merged airline would be able to expand further in the southern US as well as South America.”
He also pointed out that US Airways has morphed into a strong domestic, low-cost network model that might thrive when linked to United’s international networks. “Airlines that do not have the ability to participate fully in a more integrated and connected national and global network will not succeed and it should be obvious to Doug Parker and team that the airline cannot survive without a merger partner like UAL,” Cordle concluded.
Still, Bejar suggests that airlines cannot consolidate their way to profitability. “This indicates that the legacy carriers in the US still believe that consolidation is the solution to entrenched operating challenges,” he said. “Whereas many, if not most, legacies managed to embrace some aspects of the low cost or LCC business model – ancillary revenue generation in particular – it is clear that these larger airlines have yet to grasp the fundamentals of LCC operations. Until carriers like United and US Airways realize that effective cost management and group purchasing strategies and other LCC operating tactics are the way forward, these mergers will continue to occur at regular intervals.
“I believe that the solutions to the industry's long-term challenges lie not with larger and larger airlines, but with a more diverse market with a strong LCC presence,” he continued. “The sound practices that have enabled LCCs to become a fixture in healthier air travel markets – Latin America, Southeast Asia and the European Union – need to be adopted by US legacy carriers. These include point-to-point routes, robust commission based ancillary revenue programs, efficient booking platforms and vigilant cost management.”
Indeed, many are looking at the legacy hub model as something in need of change because hubs are so expensive to operate. This at least suggests that more hubs will be downsized. As for point-to-point operations at legacies, it would take an operational sea change for that to happen. Indeed, if it were not for legacies concentrating on hubs, LCCs would not have the position they do today. Should legacies return to point to point, that will likely have a negative impact on LCCs, if they can gain competitive costs. But, then again, that is a lot of “ifs.”
Who is going to end up on first?
Conventional wisdom has it that the perceived stronger management teams at Continental or US Airways would manage the resulting company but Cordle questions this. “Tilton may not buy the argument that Continental and US Airways management is superior,” said Cordle. “In other words, Tilton and team may want to manage the newly merged company and will not want US or CAL to benefit from the new value (cost and revenue synergies) that could be divvied up among UAL's stakeholders. It's likely that Tilton and team have calculated the opportunity-costs of not being the deal maker and managers of a much larger airline with much improved economics.”
Listening to United’s unions, however, suggests that part of the price for agreeing to a merger will see him gone. But, more on that later.
A merged airline only needs one set of executives meaning that the other set will have to be bought off with an attractive compensation package, Cordle suggested. However, the post-merger value of the airline should make that more affordable. “The post-merger value of the airline will determine whether or not the surviving management team can benefit financially from a merger,” he said. “Management should receive a large enough stake in the enterprise to align their interests with shareholders. A 5% stake is an appropriate stake for management and should do the trick, with perhaps 1% for the CEO.”
Cordle’s base-case estimate suggests that a US Airways-United deal could be worth at least USD9 billion post-merger, once cost and revenue synergies are fully realised.
Pointing out that is USD2.8 billion over and above the sum of the two airlines' market value today, he said that 5% management stake would be worth USD450 million in addition to other forms of compensation and incentives.
“This ‘pay-off’ would not be available if the companies do not merge,” he pointed out. “Moreover, given large cost increases that are already in the pipeline, I would argue that current airline values are more than fully valued. In other words, equity compensation in the form of stock options will not provide the incentive boost that management requires to stay properly focused and engaged in terms of creating value.”
Labour needs to get on board
Labour will only lose if they do not embrace mergers, but Bejar indicated labour is not feeling optimistic. “While the financing conditions may have finally improved to a point to allow consolidations like this, the overall economic picture clearly hasn't improved enough to encourage buy-in among key labour groups,” he said. “Not that the unions would suffer such a merger, if the unemployment rate were in the mid- to low-single digits. After all, the cost savings from these consolidations draw as much from labour force reduction as from the creation of economies of scale. But the timing of this seems particularly insensitive. The truth is, both airlines are in dire enough straits that the case can be made to unions and other groups for consolidation. But then, after the 'Great Recession', nearly every airline is in dire straits.”
The big fear is that any merger will mean more labour contraction with little resulting in the way of growth. United MEC Captain Wendy Morse immediately went on record after the US Airways-United negotiations were revealed as opposing the merger.
“We are vehemently opposed to any merger that would not lead to a stronger and more viable United Airlines,” she said. “We are not opposed to any merger that would benefit the careers and the long-term future of United pilots. A merger with US Airways does not appear to come close to meeting that standard.”
Flight attendants at US Airways, America West and United put out two press releases opposing a merger. "The notion of joining together two airlines in turmoil is absurd,” said Greg Davidowitch, AFA-CWA President at United, Lisa LeCarre, AFA-CWA President at America West, and Mike Flores, AFA-CWA President at US Airways, in a statement. “The track record of management at each of our airlines is abysmal. For nearly five years CEO Doug Parker has failed to negotiate a joint flight attendant contract, continuing to operate the airlines separately with disparate treatment of flight attendants at each former airline. Parker has left merger issues unresolved all this time, which hardly qualifies him to consider the possibility of another merger.”
Then, turning to United the three said: “CEO Glenn Tilton has been clamoring for a merger at any price since he first arrived at United Airlines eight years ago. Flight Attendants have expressed no confidence in Tilton to run the airline and they have actively sought his removal as CEO for two years. This, all against the backdrop of record low labour relations due to unresolved contract negotiations, outsourcing of flight attendant jobs, cuts to staffing and flight attendants continuing to struggle from cuts forced during United's 38-month bankruptcy while executives are awarded millions of dollars in bonuses each year.”
The union said that management at both airlines should lose the merger idea and resolve current labour issues before considering such a move. “Our current management needs to address the problems they have created at each airline before contemplating any other joint venture,” they said. “Unless meaningful and immediate action is taken to resolve the outstanding road blocks to success at each of our airlines, flight attendants' issues will become real and significant obstacles in the path of any merger."
United Flight Attendants echoed that sentiments saying they will adamantly oppose anything that would distract from contract negotiations for the pay, healthcare, working conditions and retirement security.
"United Airlines needs to get its own house in order before attempting to foist the problems management has created onto another business deal,” said Davidowitch. “We will oppose any transaction that serves to delay, disrupt or impede our efforts to improve compensation and working conditions."
Unions could block deals in Washington
Cordle indicate the airlines need to get labour in early if they are to avoid unions exerting political pressure to block deals. The Obama Administration has already proven its loyalty to unions and will likely continue in that vain. He also said that mergers would provide much more opportunity to gain better compensation.
“Labour unions would be wise to support a UAL merger because, otherwise, they risk even more high-paying union job losses than what has already occurred over the last decade as the big network airlines have ceded market share in a long war of attrition and slow liquidation,” he said. “It will be extremely difficult for labour to extract higher compensation from airlines that are simply not viable as stand-alone businesses, especially in an industry that has too little market concentration and no pricing power. In fact, US Airways and United labour have the most to lose if political forces gather enough force to kill any potential combination that will benefit the industry and labour. Moreover, consumers benefit from an industry that can afford to properly invest in itself and provide the level of service that consumers require. Demoralized and stressed out employees, working for impoverished, penny-pinching and nickel-and-diming airlines do not make for enjoyable consumer traveling experiences.”
Bloomberg, citing Airline Pilot Central, reported yesterday that United pilots earn on average USD137 an hour, while US Airways pilots average USD125 an hour. It noted that the highest average hourly rate was at Southwest at USD206 an hour.
Labour is already hot about executive compensation. Earlier this week American Airlines’ Transport Workers Unions took out full-page ads in the Dallas Morning News and Tulsa World criticising management stock awards set for distribution next week.
"How much is too much,” asked TWU’s Air Transport Division Director John Conley, according to DMN Aviation Editor Terry Maxon. “In the past five years, the top executives at AMR have enriched themselves with more than USD300 million in bonuses, and their proxy statement shows that they'll be back at the trough again this year. And they've stiffed our members at the bargaining table for the past four years - even though we were the ones who stepped up to take a 30% pay cut in 2003 to save the airline from bankruptcy."
Maxon noted that TWU, the Association of Professional Flight Attendants and the Allied Pilots Association are in negotiation and growing very frustrated by the National Mediation Board process.
“Labour can moan and groan all they want about ‘greedy’ management, but this type of equity compensation is standard and required by shareholders who must be the dominate stakeholder if the enterprise is to survive and thrive in a capitalist market economy,” said Cordle of the payout to executives that would result from a Continental or US Airways merger with United. “Labour unions and Team Obama may have a different idea about the type of system we should have, but this doesn't change the economics of business and the returns required to attract and maintain capital. Without adequate earnings, the enterprise is simply not viable.”
However, he also noted that the value of any post-merger company would leave room for union payouts too. “The newly created equity post-merger is a form of currency that can also be used to buy labours' support for the deal, which will be required to preempt political pressure that will build in an attempt to kill the perceived anti-consumer deal,” he said. “Labour could get, say, 10% of the newly merged UA/US airline and this could be worth USD900 million if the estimates are correct. Throw in a 5%-10% pay raise, worth USD325 to USD650, and labour’s take could be in the USD1.2 billion and USD1.6 billion range. Not a bad pay-off for a deal that is clearly better than the compensation package that can be derived from a standalone airline that can't benefit from USD1.5 billion in cost and revenue synergies. Labour would miss out on this higher total compensation if a merger deal is killed because it is perceived to reward managers at the expense of consumer benefits, which is a false assumption.
“Labour groups will take a short-term view of a merger, driven by their position on the seniority lists, regardless of what makes sense for the airline and the other stakeholders,” he predicted. “Shareholder returns are not part of a labour equation when it relates to negotiating a new contract, but it is the value created by the merger that will allow higher compensation for rank and file.”
As for airlines continuing as stand-along entities, Cordle noted the USD70 billion in inflation-adjusted losses over the decade ending 2009, USD63 billion of which was in the domestic market alone. “Balance sheets have been sucked dry of tangible equity and labour is biting at the bit to recoup 33% inflation- and size-adjusted cuts in total compensation,” he said. “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.”
He also noted that fuel costs have been a catalyst for management to move towards protecting and enhancing shareholder value. Using an USD80 base, he predicted fuel costs this year will be around USD6.4 billion higher than 2009 and will rise still more given a USD84 base case in 2011.
“It is merger time in the airline industry and the United, US Airways and Continental teams are likely to make a move that will benefit these airlines, labour, the industry, and even the consumer,’ Cordle concluded. “If the merger rumors are true, and conventional wisdom is wrong (as I think it is), then if UAL makes a bid for US (or vice-versa), this will force CAL to enter into merger discussions. UAL wins if it mergers with either US or CAL, even if the CAL deal is a better fit and creates more value. And, UAL labour prefers a CAL deal.”
Finally, he suggested the best case merger would be a stock swap in order to avoid a control premium. “Whether or not the deal is a takeover, or a stock swap merger, the benefits to shareholders and labour is an opportunity too large to ignore,” he said. “For this reason I believe the potential US Airways deal is real and should be consummated if Continental doesn't step up to the plate which it now seems to be doing. Moreover, UAL should move fast before any political momentum gathers enough steam to kill the deal, and labour will need to be involved as soon as practical and offered a deal that secures their support.”
Please send your feedback to Vaughn at Airline Forecasts.