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The airlines merger that will not fly
The airlines merger that will not fly
By John Gapper
Published: April 16 2008
When a business venture is declared to be good for everyone – even those with widely differing interests – it often turns out not to be particularly good for anyone. This, I fear, will be the case with this week’s proposed merger of Delta and Northwest Airlines to form the largest airline in the US, and one of the biggest in the world. The new Delta, its combined name, sounds impressive but few me… Continue
When a business venture is declared to be good for everyone – even those with widely differing interests – it often turns out not to be particularly good for anyone. This, I fear, will be the case with this week’s proposed merger of Delta and Northwest Airlines to form the largest airline in the US, and one of the biggest in the world. The new Delta, its combined name, sounds impressive but few me… Continue
Posted on May 14th, 2008 at 11:23pm —
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By Justin Baer
Published: June 5 2008 19:02 | Last updated: June 5 2008 19:02
Thirty years ago this October, President Jimmy Carter brought the regulated era of commercial US aviation to a close, opening the domestic market to competition, freeing carriers to set their own fares and paving the way for decades of rapid expansion.
EDITOR’S CHOICE
In depth: Airlines - Jun-03
Continental Airlines cuts jobs and aircraft - Jun-05
United Airlines to cut fleet, flights and jobs - Jun-04
United seeks marketing ties with Continental - May-30
Airlines keep up the chase for coy Continental - May-02
Continental-United in advanced talks - Apr-26
Forgive executives if they neglect to uncork the anniversary champagne.
US carriers have descended into a crisis that will leave few, if any, unscathed. Fuel costs have surged in the past year, wiping out earnings and threatening to send even some of the largest airlines back to bankruptcy court. The economy’s slowdown has damped demand for business and leisure travel alike, leaving more empty seats on flights already struggling to make money.
Irritating fees and frequent delays have tarnished the industry’s reputation with passengers, while recent restructurings and bankruptcies have strained relations with workers. As for airline stocks, their performance this year would make even Wall Street executives blush.
Further evidence of the harsh conditions faced by the industry came on Thursday when Continental Airlines said it was cutting 3,000 jobs and taking 73 aircraft out of service. The news came a day after United Airlines announced that it planned to ground a fifth of its fleet.
“A durable competitive advantage has proven elusive ever since the days of the Wright Brothers,” Warren Buffett, the world’s richest man and a one-time airline investor, wrote recently. “If a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favour by shooting Orville down.”
Mr Wright’s safe landing in North Carolina more than a century ago made it impossible for future generations of capitalists to imagine a world without flight, and it seems equally unlikely to many airline executives that the industry will ever return to a regulated era whose rationale, in part, was to help ensure their stability. The carriers that survive the current downturn will offset mounting fuel prices by finding the right balance between trimming unprofitable routes and raising fares, or merging with a peer that makes those choices easier.
“We won’t see re-regulation,” says Richard Anderson, chief executive of Delta Air Lines. “The marketplace is going to react to supply and demand the way an unregulated market should.”
Air travel is more popular than ever. The 1978 measure has largely lived up to its mandate to “encourage, develop, and attain an air transportation system which relies on competitive market forces”. Affordable fares have helped free businesses to reach the rest of the world from practically any sizeable US city, spurring global trade and transforming the professional and personal lives of countless Americans. For those reasons, there is little groundswell in Washington to bring back regulations that would shelter airlines from competition.
“No, it was a good idea,” said Representative James Oberstar, the Minnesota Democrat who, as chairman of the US House Transportation and Infrastructure Committee, is one of Capitol Hill’s most vocal members on most aviation issues. “Air travellers are still saving compared to pre-deregulation ticket prices.”
While cheap fares and intense competition have remained constant since deregulation, financial stability at the airlines themselves has not. “There’s just so many risks to mitigate – it’s energy-intensive, subject to weather, it’s tough to execute a schedule and labour-intensive,” says Gary Kelly, chief executive of Southwest Airlines, the world’s largest low-cost carrier. “It’s a marginal profit at best for most airlines. Any change in the variables can have a pretty dramatic impact.”
No single variable looms larger this year than fuel, which for most carriers has surpassed labour as the single-biggest expense. The run-up has forced carriers to take increasingly desperate measures. American Airlines will soon charge some passengers $15 to check a single bag, while US Airways recently banished all free snacks.
Most airline executives acknowledge the industry must take more drastic steps to return commercial aviation to the stability it enjoyed, however briefly, before the latest surge in fuel prices. “The simple fact is that the US airline industry, as it is constituted today, was not built for $125 per barrel oil,” Gerard Arpey, chief executive of American Airlines, said last month during the world’s biggest carrier’s annual shareholder meeting. “The industry will not and cannot continue in its current state.”
Some industry insiders continue to argue that sweeping consolidation would help carriers shed unprofitable routes and wield enough market power to raise ticket prices without losing a significant amount of traffic to low-cost airlines. When Delta agreed to merge with Northwest Airlines earlier this year, those executives and their advisers predicted other deals would follow.
But the window for reaching a deal in time for a regulatory review by Bush administration officials – viewed as being more open to mergers than any of their potential successors – has all but closed. Many other legacy carriers, including United and Continental, have bowed out of the M&A game, at least for now.
In conceding that talks with US Airways had ended, Glenn Tilton, United’s chief executive and a vocal advocate for consolidation, said during a message to his employees that the costs of integrating two complex operations would threaten to overwhelm a carrier already burning through its cash reserves to pay for fuel.
Should oil prices continue to climb, some battered carriers may have no choice but to return to the table. Indeed, many of the industry’s biggest deals took place when one of the merger partners was under duress, says Andrew Watterson, a partner with Oliver Wyman in Dallas. “You could see some shotgun weddings.”
“Mergers are not easy,” says Ilker Baybars, a professor of operations management at Carnegie Mellon. “It is painful. But when an industry is so competitive and margins are so small, consolidation is inevitable.”
In the meantime, carriers will take deeper cuts to their flight schedules, trim administrative staff and ground older, less fuel-efficient aircraft. But this may not be enough to counter fuel costs should oil prices remain where they are or climb higher. CreditSights, a debt-research firm, predicted that the 2008 fuel bills of Delta and United would surpass each airline’s current cash position should crude oil remain at $125 a barrel. Of the 11 biggest US carriers, only Southwest, US Airways, Alaska and Northwest would end the year with cash on hand with oil at $150.
In past downturns, including the one triggered by recession and the 9-11 terrorist attacks, troubled airlines filed for bankruptcy. Under the court’s protection, US Airways, United, Delta and Northwest reduced their debts, won wage concessions from employees and discarded older aircraft. While they emerged healthier, their revivals did little to confront what some executives see as the industry’s real problem: too many legacy airlines flying too many planes.
“If a tree is dead, it should die because it has had its use and can make for new shoots,” says Sir Richard Branson, founder of Virgin Atlantic. “In America most of these airlines have gone through Chapter 11 at least once. The quality is dreadful and the old planes stay in the air.” Sir Richard blames the ease with which US companies can emerge from bankruptcy largely intact. “You’re going to get a major carrier going into Chapter 11 again in the next few months, with fuel prices being at these levels,” he says. “Let those who should be dead die. That would be the best shot in the arm for the American industry.”
If only it were that easy. The liquidation of a major airline would cost the economy thousands of jobs and dramatically reduce air service to some communities. Politicians would fight it, as may organised labour. “It is the worst scenario for the employees working for that carrier,” says Captain John Prater, president of the Air Line Pilots Association.
Large suppliers, which often land influential seats on the creditors’ committees of bankrupt airlines, may seek to ensure that they do not lose customers. “Saving them is almost always the cheaper and easier option, even if it’s a government bailout,” says Peter Walsh, a managing partner at consultant Oliver Wyman who runs the firm’s manufacturing, transportation and energy business.
Some executives believe the government can play a role in fixing the industry. They have lobbied federal, state and local officials to modernise US airports and air-traffic control systems, and aim to convince Washington to ease airlines’ tax burdens. Air-traffic delays cost carriers $19bn last year in excess labour, fuel and maintenance expenses as planes circled crowded airports or sat on gridlocked runways, according to a recent study by Congress’s Joint Economic Committee.
Airline executives also argue they should no longer be subject to excise taxes generally levied on luxury items, cigarettes or alcohol. Carriers must pay those fees on the fares they sell, no matter how cheap the ticket or how unprofitable the airline, Mr Walsh says. “Flying airplanes is neither a sin nor is it an addictive substance,” he says. “It’s a commodity business.”
Also awaiting a resolution from Washington are potential changes to the rules limiting foreign ownership of US airlines. Liberalising the cap of 25 per cent tops the agenda in the US and European Union “Open Skies” negotiations that opened last month in Slovenia.
Removing or raising this cap could give carriers another source of potential capital. Germany’s Lufthansa bought a 19 per cent stake in JetBlue Airways, a low-cost US carrier, earlier this year, and Air France-KLM weighed making an investment in Delta while its transcontinental ally negotiated its merger with Northwest.
Congress resisted past efforts to change the restrictions, with some members – including Mr Oberstar – concerned that foreign ownership could threaten carriers’ commitment to ferrying military personnel and supplies around the world in times of war. “Why should we let foreign airlines buy up extremely valuable US assets?” Mr Oberstar says. “We’d have to dramatically change the legal structure. And I’m not going to let that occur on my watch.”
Mr Kelly, who succeeded Herb Kelleher as Southwest’s chairman last month, is optimistic his industry will rebound. The current challenges of record oil and a softened economy have punctuated what has been a “difficult decade” that began with terrorist attacks and recession and continued with adjustments to heightened security and record congestion at US airports.
Most carriers, he says, have shown they can be profitable in more stable times, in the latter half of the 1990s and again in 2006-2007, when the industry enjoyed a fleeting renaissance. As they have in past downturns, the best airlines, large or small, legacy or low-cost, will adjust. “But it takes real resolve here,” he says. “There is not going to be instant gratification. There is very high demand for air travel, and if we can make improvements, demand will be even greater.”
Prof Baybars agrees. “Service is not going to go away. Consumers are going to be fine and you’ll have plenty of seats.”
But as services are cut, airline executives hope Americans accept they need to forgo a few of those seats, at least until fuel prices stabilise.
Copyright The Financial Times Limited 2008