Merger of Equals

The proposed merger of Continental and United will create a potent global
competitor, but only if Continental’s winning ways can be integrated into the successor

The mergerbetween United Airlines and Continental Airlines, if consummated, will continue the consolidation of the US airline industry, a process that took what effectively was a federally imposed 14-year hiatus between the final collapse of Eastern Airlines and Pan American in the early 1990s and the 2005 merger between US Airways and America West except for the disappearance of a failing TWA into American Airlines in 2001. Under terms of the agreement announced May 3, United and Continental will combine in an all-stock transaction valued at $3 billion under which CO shareholders will receive 1.05 shares of UA common stock for each share of CO common stock they own.

Assuming it is approved by shareholders and clears Dept. of Justice scrutiny, the deal will create an airline with more than 87,000 employees and a fleet of almost 700 mainline aircraft and a further 550 regional aircraft under capacity purchase agreements serving 370 destinations with 6,100 mainline and regional departures. The airlines carried a combined 143 million revenue passengers on mainline and regional services last year, generating some 204 billion RPMs and 250 billion ASMs (see table, p. 48).

The new carrier, which will operate under the United name but with the Continental livery, logo and colors, arguably will be the most balanced US major airline in terms of regions served, mix of domestic and international flying and hub geography. Approximately 40% of United and 50% of Continental capacity is deployed on international routes. The carriers share very few direct routes and are not significant competitors at any congested hub airports.

“Put simply, Continental is strong where United is weak and United is strong where Continental is weak,” is how CO Chairman and CEO Jeff Smisek described the situation during a webcast announcing the merger. “We have no international route overlaps.” Smisek will serve as CEO of the combined company while UAL Corp. Chairman, President and CEO Glenn Tilton holds the post of nonexecutive chairman through Dec. 31, 2012, or the second anniversary of the deal’s closing. In addition to Smisek and Tilton, the 16-member board of directors will include six independent directors from each company and two union directors, required under United’s charter.

The airlines expect synergies of $1 billion-$1.2 billion annually by 2013 including $800 million-$900 million of incremental annual revenues and $200 million-$300 million in net cost synergies (arguably an insignificant number for a company that will have a budget of more than $28 billion). One-time merger costs are expected to total $1.2 billion spread over a three-year period.

“I’m really excited about this merger. I think this is really a good one,” says William Swelbar, research engineer at MIT’s International Center for Air Transportation. He gives high marks to United for making itself more attractive after it was left at the altar in 2008, reportedly over concerns about its financial position and operational integrity. “I really take heart that United after getting snubbed in 2008 went back to Chicago and did a lot of work in making that operation really respectable and improving their financials,” Swelbar tells ATW.

Others were less bullish. Frost & Sullivan Analyst Max Sukkhasantikul called it “a marriage of convenience,” noting that “both carriers are loss-making.” Another observer, who preferred to remain anonymous, described it as “the old guard circling the wagons and trying to protect their position” in the face of growing low-cost competition. To be sure, neither airline is growing domestically. United’s domestic ASKs fell 10.4% last year, according to DOT data, after declining 7.8% in 2008 and 3.3% in 2007. Mainline revenues attributed to its domestic operation totaled $7.7 billion in 2009, down from $9.7 billion in 2008 and $10.9 billion in 2007, although much of that can be attributed to the recession. Continental’s domestic ASKs rose 4.5% in 2007 but then fell by an equal amount the following year and a further 6.5% in 2009 as the downturn hit home.

In any case, UA’s greatest promise lies in its transpacific network, including its hub at Tokyo Narita, which gives it the capability to operate beyond routes into Asia. This will be complemented nicely by Continental Micronesia, CO’s Guam-based subsidiary that provides extensive service in the western Pacific including to nine Japanese cities, more than any other US carrier.

Perceptions notwithstanding, UA’s European network is not large; over the years it has been content to let most of the transatlantic heavy lifting be handled by its antitrust-immunized Star Alliance partners. UA serves 13 transatlantic destinations compared to 33 for CO, 29 of which are served out of CO’s Newark hub.

Likewise, UA is a small player in Latin America, serving a handful of destinations in South America plus routes to Mexico and the Caribbean. CO, on the other hand, is a major presence, with some 30 Latin American and Caribbean destinations from EWR—a network that actually pales in comparison to its Latin presence at Houston Intercontinental, from which it served 29 cities in Mexico at the end of 2009 plus 10 in Central America, six in the Caribbean and seven in South America.

Merger of Equals

The companies have called the transaction a “merger of equals,” meaning that both contribute equally to the combined entity. But from a comparative standpoint, Smisek’s summation—that one is strong where the other is weak and vice versa—is a better description. United, which is around 30% larger by revenue, brings industry-leading RASM growth and claims to trail only Delta Air Lines in having the lowest nonfuel stage-length-adjusted CASM among the network carriers. But it lags in some key areas, foremost among them its reputation for customer service.

To be fair, it has made major strides, including achieving the best ontime performance among network airlines in 2009 and for the first quarter of 2010 after being in the bottom half of the pack for many years. But it was well behind CO in terms of baggage handling last year and drew a third more complaints to DOT. Although severe weather can distort performance on a monthly basis, CO also has a significantly higher completion factor. Furthermore, UA placed 13th among US airlines in the 2010 Airline Quality Rating, a ranking system based on the four DOT metrics produced annually by Purdue University and Wichita State University. Continental ranked sixth, second among network airlines. “Continental is still best in class among the legacy carriers,” notes Swelbar.

UA also has the older fleet, with an average age of around 13 years versus nine years for CO. The latter is installing DIRECTV live television on its entire fleet of 737NGs and 757-300s, a commitment not matched by UA. Both have or are in the process of installing Aircell’s Gogo inflight broadband on some of their 757s.

United is rolling out new international premium cabins across its fleet, but this will be a lengthy process and the existing product is badly dated. Earlier this year it finalized orders for 787s and A350s,  its first new orders since 1998, with first delivery in 2016. It has not addressed its future narrowbody needs, although in a declining domestic environment this perhaps is less urgent.

Employee-management relationships are another area in which United trails its merger partner. UA is the more heavily organized—82% of its workforce is in unions—and work groups remain bitter over wage and benefit reductions and the termination of their defined-benefit pension plans during the carrier’s four-year bankruptcy reorganization and the downsizing and layoffs that have continued sporadically since 9/11. Tilton, who emerged from the bankruptcy as one of the carrier’s largest individual shareholders, has been a lightning rod for their anger.

Although CO has gone through difficult times as well, with layoffs and wage and benefit concessions, relations are largely positive, helped by a succession of leaders who imbibed deeply of former Chairman and CEO Gordon Bethune’s “Working Together” plan of the mid-1990s with its emphasis on creating and maintaining a winning company culture and rewarding superior performance with generous profit-sharing. Smisek, who assumed the top spot at the beginning of this year, joined the airline in the era of good feelings engendered by Bethune and maintained by former Chairman and CEO Larry Kellner during his 2004-09 tenure. Approximately 45% of the CO workforce is unionized. Significantly, this does not include its nearly 11,000 airport agents; UA’s public contact employees are represented by the International Assn. of Machinists.

Pilot workforce integration is always a challenge, but both groups are represented by the Air Line Pilots Assn., which could ease the task (although this did not help in the US-AWA merger). The larger UA group (5,600 pilots versus 4,300 at CO) is expected to see a bump in pay to the higher CO level, which should help soothe feelings. A key issue, however, will be scope clauses. Currently, CO has the strictest scope clause in the industry and as a result CO Express partners cannot operate jets larger than 50 seats.

“I think it is going to be the issue that is most difficult in negotiating a joint collective bargaining agreement,” Swelbar says. But he believes the CO contract “just does not conform to the realities of today’s marketplace . . . So much of the UA system is built around the Embraer 170.” Another touchy subject is the UA-Aer Lingus joint venture that has angered United pilots and is certain to make CO pilots uncomfortable.

Culture and workforce integration will be major challenges; another task will be to persuade antitrust regulators to approve the merger without imposing such severe conditions that the carriers decide they cannot move forward. DOJ is already on record opposing DOT’s grant of antitrust immunity to the two as part of the Star Alliance’s so-called Atlantic Plus Plus partnership. It is true that DOJ approved the 2008 Delta-Northwest merger, but that was under the second Bush administration.

“This is an administration that doesn’t like consolidation in any industry, let alone the airline industry,” Swelbar observes. On the other hand, the merged company will be based in Chicago, where sits a shrewd and politically powerful Democratic mayor with close connections to the US President who has made the city his adopted home.