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The U.S airline industry has been on a tumultuous ride the past decade. Flying high into the 21st century with improved technology, an expanding international presence, and dramatic increases in revenue, the airlines were slammed by the tragedy of 9/11 and the subsequent recession, posting cumulative losses of $40bn dollars between 2001 and 2005, according to the MIT Airline Data Project. The industry then went through incredible highs and lows, from years of record profits to dramatic bankruptcies by all six major airlines. Today the market has regained its interest in airline stocks as the industry consolidates and stabilizes. Investors’ zeal for airline stocks stems from predictions of drastically higher revenues despite a weak recovery and fierce competition between legacy carriers, such as American and United, and low cost carriers, such as Southwest and Jet Blue. Investors believe the recent wave of mergers has calmed the turbulent market, and will allow for current profits to persist. But not everyone shares this enthusiasm. Warren Buffett spoke the conventional wisdom of many when he called the airline industry “a death trap for investors” last year. Fundamentally, the key question comes down to the following: do airline mergers really work? With the completion of the American-US Airways merger in December, this question becomes more pressing than ever before.

Background

To answer this question, we must examine the deep-seated issues the airline industry faced at the turn of the century. Several major problems turned investments into risky gambles. First, airlines had and have among the highest fixed costs across all industries. Overheard costs can consume anywhere from eighty to over a hundred percent of revenue, depending on the year, according to the MIT Airline Data Project. These fixed costs stem from the huge range of services airlines are required to provide, from airplane maintenance to IT services to sales management.

Second, airlines’ margins depend heavily on the cost of fuel, which, like all commodities, can vary significantly depending on an extraordinary number of circumstances. Older airlines, with less efficient planes, are especially hard hit by high fuel prices. Third, airline labor costs are among the highest across industries, a controversial issue due to either high unionization rates or low productivity rates.

Finally, airlines must make expensive long-term gambles. Airlines must purchase planes years in advance and thus have to predict what the most profitable plane will be five or ten years down the road. An exceptionally fickle market makes this a near-impossible task. Yet, airlines must do this regularly in order to keep up with the competition offering newer, more fuel-efficient planes that provide better services.

Together, these challenges made the airline industry highly unstable. At the time, six airline carriers, now known as the legacy or network carriers, dominated the market: US Airways, United, Delta, Northwest, American, and Continental. Cyclical profits and soaring costs eventually forced bankruptcy for four out of six within five years of 9/11 and all six by the end of the decade. Adding to their woes, new airlines focused on

maintaining low overhead costs entered the market. These airlines, dubbed low cost carriers, or LCCs, began to post steady profits and growth. Many of these, such as Southwest and Jet Blue, began to dominate regional markets. Clearly, something had to change.

The Rise of the Merger

Facing the seeming insurmountable task of achieving profitability, airlines began focusing on bringing stability to the market. One by one, the legacy carriers began to merge and acquire the others: Delta merged with Northwest Airlines in 2005, United merged with Continental Airlines in 2010, and finally, American Airlines merged with US Airways. Furthermore, although attention focused on the mergers of the six legacy carriers into four, numerous smaller carriers also began merging to wield more clout. Republic Airways and Shuttle America merged in 2005, Republic Airways merged with Midwest Airlines and Frontier Airlines in 2009, and Southwest bought AirTran Airways in 2011.

Does the Merger Pay Off?

Airline executives argued that such mergers benefited the market and their companies. They insisted that fewer options lead to more choices for passengers as the four major network airlines are now able to operate at every airport across the country. This means healthier, more stable competition. Mergers can also cut costs by allowing for routes to be combined: instead of two half empty planes on two different airlines flying between destinations, one full plane can carry the entire load. This consolidation can be extended to the entire network of flights, as well as to IT services, where the incompatibility of competing airlines’ optimization systems has long been a major cost. The merger also would decrease the use of domestic hubs and would lead to a more decentralized structure that could respond more flexibly to market pressures. This would allow for airlines to capitalize on sudden demand and reshuffle in the case of sudden cutbacks.

While many analysts agree on these benefits, many also caution on blind exuberance. The mergers are fraught with perils. The following two cases depict both the benefits and pitfalls.

The United-Continental Merger

The United-Continental merger, completed in October 2010, was hailed for establishing the world’s dominant airline. The combined airline has the largest commercial fleet of any airline in the world and flies to more destinations than any other competitor, according to a recent article in the Economist. Almost immediately, however, the airline ran into difficulties. While attempting to convince investors to support the merger, the airline claimed that the deal would save $1.2bn by 2013. The airline fell well short of this goal, admitting in 2013 that, although the payoff was hard to quantify, it was nowhere near that figure. Furthermore, on-time performance suffered in the two years following the merger, plummeting to 64% by July of 2012, and frequent reservation system disruptions plagued the carrier.

Just as the airline started to post signs of improvement in 2013, including the fact that on- time performance had soared, that profits had increased, and that the reservation system had improved, the US Department of Transportation fined the airline $350,000 for taking too long to process refund requests. The airline squarely blamed the issue on the merger, revealing that the United electronic system had not been fully integrated with Continental’s.

Further issues persist, most notably in labor contracts. Because airlines are so heavily unionized, every independent United union, from airplane maintenance workers to flight attendants, has had to hash out contracts with the Continental unions and the company executives before the merger could be completed. Three years after the end of the merger, these talks are still ongoing. The only union to have completed talks is the pilots union.

While finalizing permanent contracts, the airlines have been forced to operate on a temporary, new contract called the “metal contract.” This forces Continental flight attendants to fly on Continental planes and United flight attendants to fly on United planes. This impedes the optimization benefits that are supposed to accompany a merger; the combined carrier can’t move planes to certain markets where they would be more in demand without shifting the entire crew as well, creating a huge expense.

Other touted benefits haven’t materialized either; the decentralization of the network, the disappearance of regional hubs, and the increase in options are all still future prospects, not current realities. In its anti-trust suit against the American-US Airways merger, the Department of Justice argued that the United-Continental merger has raised fares up to 57% on some routes. This translates to larger profits, but some analysts argue that such profits are temporary as low cost carriers begin to compete on more routes with the legacy carriers.

A Complex Recipe for Success

Despite poor financial indicators, the United-Continental merger will likely not go down as a failure. The previous merger of two legacy carriers, Delta and Northwest in 2005, started off similarly in troubled waters. Like the merged United carrier, Delta had the worst on-time record in 2010 and generated profits well below expectations. But by 2012, Delta was outperforming all of its peer rivals, notably on a key measure of airline success: the passenger revenue per available seat mile. This measure indicates how much an airline is profiting off the current routes it runs as well as how efficient its routes are. United, suffering through the merger, posted an incremental 1.7% gain, while Delta posted a tremendous 7% increase. Analysts expect that, with the completion of labor negotiations, United too will begin to post increases in profitability and efficiency.

History suggests that mergers increase profits and efficiency long-term after a tumultuous transition period. But questions remain. No evidence exists that the airline industry has broken away from its infamous cyclical profit trend. Low cost carriers continue to pose significant threats to the legacy carriers. The fact legacy carriers began to turn a profit despite a recession and a surge of low cost competitors is encouraging, but should be treated with caution. Companies coming out of bankruptcy filings are able to be more

flexible, an advantage that translates to significant benefits in the airline industry. All four legacy carriers operating today underwent bankruptcy in the past decade. A key indicator will be whether the airlines can maintain this flexibility. Much of this flexibility will depend upon how the airlines conduct their merger: whether they can successfully integrate their underlying computer systems, whether legacy carriers can use the merger to boost productivity per employee to the levels of low cost carriers, whether the labor contracts allow for enough flexibility with shuffling planes and routes around, and whether airlines can successfully invest profits into more modern, more efficient fleets with lower costs and greater amenities. Profitability of the entire airline industry also depends on responses to future challenges, most significantly due to decaying infrastructure among US airports. Numerous studies, from an analysis by MIT’s Aviation Project to the National Society of Civil Engineers, and experts, from former Secretary of Transportations to private industry analysts at Oliver Wyman, warn that the current infrastructure will not be able to support future demand, causing tremendous delays and incurring huge costs for both carriers and passengers.

Thus investors should move with caution with respect to the American-US Airways merger and in regards to airline industry as a whole. While the industry does appear to be on track towards achieving stability and profitability, much work remains to be done. If past mergers serve as a lesson, the American-US Airways merger faces several tough years before fully integrating. Already, though, mergers have fundamentally altered the face of the airline industry, revitalizing the old legacy carriers and throwing into question the paradigm of the unprofitability of airlines. Whether these mergers bring a calm to a turbulent market remains to be seen; in the end, only time will tell.

Written by thefinancier

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