The Domino Effect: Will Airlines Follow One Another in the Consolidation Game?

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Delta Airlines is reportedly about to merge with Northwest Airlines in a deal that’s likely to set off a major round of consolidation in the airline industry. Wharton experts say that other major airlines are likely to fall in line with their own consolidation plans. Or so the speculation goes. But this scenario has been talked about before. Is the latest consolidation dance for real this time?


For Delta and Northwest, the advantages of consolidation are relatively clear: Delta dominates the southeast, and Northwest has complementary routes in the northern part of the United States. More importantly, Northwest has international routes to Asia. According to Elizabeth Bailey, Wharton professor of business and public policy, the need to build lucrative international routes is one of the reasons airlines are consolidating. In addition, she states, a merged Delta-Northwest would have minimal overlap.


“If Delta and Northwest merge, the question will become what happens to the others at the dance,” says W. Bruce Allen, a business and public policy professor at Wharton. “Scale matters, and there will be a domino effect. Once one (airline) goes, others will consolidate.”


Indeed, United Airlines and Continental are also in serious discussions, according to the Associated Press. On February 16, The Wall Street Journal reported that Continental had been in merger discussions with American Airlines as well. The rush to potentially consolidate the airline industry raises a few questions. Would consumers be hurt if major carriers dwindled from six or seven to three? Could these mergers realistically deliver cost savings? Would low-cost carriers like JetBlue be forced into mergers? Can consolidation improve the economics of the airline industry?


For now, these questions are still in search of answers, although few doubt that consolidation will happen — eventually. But first, two major carriers need to merge for the other airlines to follow suit. Airline executives have said that a merger of two major carriers would give one player too much market share, which would trigger rivals to react. However, if a combination of two major carriers doesn’t happen, executives have said they will be content with the status quo. That attitude is one reason why airline consolidation hasn’t happened yet, say experts at Wharton. “Because of the risks involved, it doesn’t make sense for individual carriers to merge until someone else does,” says Wharton management professor Peter Cappelli.


Bailey expects there will be three to five major airlines once consolidation actually begins. If the industry does consolidate, she says, airlines will enjoy potentially better economics and pricing power. According to the U.S. Department of Transportation’s Bureau of Transportation Statistics, there are seven airlines with more than 5% market share. American is the leader with 14.9% and Southwest second with 12.2%. “There’s no reason those seven carriers couldn’t become five,” says Bailey. “Consolidation would only become worrisome to regulators if the number of major carriers fell to three or two.”


W. Douglas Parker, CEO of US Airways, which merged with America West in 2005, has been outspoken about the need for airline consolidation. US Airways, which today has about 5% of the U.S. domestic market, tried to acquire Delta in late 2006 when the latter airline was in bankruptcy proceedings. Speaking to analysts on a January 24, 2008,conference call following the company’s fourth quarter earnings, Parker reiterated that consolidation is inevitable. “We believe that first and foremost, consolidation is going to happen. While there clearly is value in getting international route networks broader, the real value of consolidation is rationalization of the domestic industry, which is overly fragmented.”


Continental CEO Larry Kellner said that his airline continues to watch consolidation developments closely. “We have a strong plan, should the industry remain as it is. Should the landscape change, we will always act in the best long-term interest of our shareholders, our co-workers, our customers and the communities we serve,” he said on January 17 during Continental’s fourth quarter earnings conference call.


According to Wharton professor of operations and information management Serguei Netessine, the airline industry has developed a consensus about the need for mergers. “There’s a clear understanding that even though 2007 was a decent year, the industry has to do something. It’s very likely that those mergers will happen. Airlines have huge fixed costs and can lower them by merging.”


Flight Delays


The benefits of airline consolidation for the industry have been clear for decades, says Cappelli. Lower capacity, more pricing power and economies of scale are a few potential payoffs. However, mergers among large airlines are rare. “People have been talking about three mega carriers for 20 years,” he says. “These big mergers have lots of complications and they are really hard to pull off.”


One of those big complications is labor contracts, says Bailey. “Delta and Northwest will only merge if they get approval from the pilots union. That has been the big problem with mergers in the past. It has been hell combining the workforce.” Indeed, US Airways still operates under two separate pilot contracts — one from US Airways and the other from America West — due to conflicts over seniority rules.


On February 14, Lee Moak, chairman of Delta’s pilot union, sent a letter to the airline’s pilots about the possibility of industry consolidation. He outlined the process behind merging labor contracts and noted that US Airways still hasn’t integrated its pilots.Moak also pledged that the union would look out for the interests of Delta pilots in the event of a merger with another airline, such as Northwest. In December, Moak said in a statement that the pilots union “will participate from the beginning in any successful Delta merger or it will not happen.”


However, labor issues aren’t the only hurdle for airline mergers. Talk of synergies between two companies rarely becomes reality, says Allen. “There are always these talks about synergies as a result of mergers. But a lot of times you ask: ‘Where are they?’ And although these synergies can be accomplished, it is never as easy as it’s portrayed.” 


Merged airlines have to combine technology systems, rationalize aircraft and optimize routes. During this time, rivals can gain market share, says Netessine. It’s also initially expensive for an airline to lay off employees and rationalize a fleet depending on lease terms, adds Cappelli. “How strong is evidence that these airlines ought to merge? The people who are driving the merger talks are the ones looking at it from a 30,000 foot level. The people closer to the ground realize mergers are painful. But those [people] never win these arguments.”


Cappelli adds that the integration pain is one reason that airlines have been reticent to merge — unless they have to in order to remain competitive.


Capitalizing on ‘Carve Outs’


Airline industry consolidation could have numerous implications for a number of groups: consumers, suppliers like Boeing and Airbus which would have fewer customers, and smaller rivals known for beinglow-cost carriers, like JetBlue, which could be inclined to merge with other airlines in order to improve their competitive position.


The biggest impact of airline consolidation, however, could be on consumers. Experts at Wharton were mixed on whether a rash of airline mergers would raise fares dramatically. Bailey says as long as there are three major airlines, there will be “still enough players for price competition.” Cappelli disagrees. “It’s hard to imagine that this (likely consolidation) will be good for consumers,” he says. “Consolidation reduces competition.”


It’s likely, suggests Allen, that airlines would cut the frequency of flights, which could hamper business travelers. And if capacity were cut, some markets would suffer because not all airports would have six carriers. “Consolidation could mean higher fares with less service frequency,” he says.


In Netessine’s opinion, it’s too early to determine whether mergers would dramatically increase prices. Airlines would cut capacity, but there are enough smaller airlines to fill the void and keep prices low. “The consensus is that mergers will drive fare prices higher, but I don’t think it will happen.” Netessine also predicts that the government would force merged airlines to give up gates at major airports so that no one carrier would dominate. These divested gates would likely be scooped up by low-cost carriers like JetBlue and AirTran. These additional airlines would therefore keep fares low because they would be competing against incumbents for passengers.


Indeed, Kevin Healy, senior vice president of planning and marketing at AirTran, gave some credence to Netessine’s theory during a January 29 fourth quarter conference call, during which he stated that if large airlines merged, there may be what he called “small carve outs,” or airport gates, that would be divested. “We would like to actually participate in some of the small carve outs that we anticipate. We think circumstances are … right for change in this industry. Carriers like AirTran can really capitalize on the opportunities that the situation can provide.”


Upside-Down Economics


Cappelli remains skeptical that airline consolidation will be a panacea for the industry, because the economics in the airline industry are a problem — no matter how many carriers merge. “The basic economics of the industry don’t make sense.” 


One of the biggest challenges for airlines is balancing customer demand with high fixed costs — including aircraft, fuel, labor and maintenance. Meanwhile, Cappelli notes, pricing pressure will always be an issue for one basic reason: The marginal costs — essentially beverage service and snacks provided on the plane — of adding a customer are below the fuel, labor and maintenance costs of carrying one. In other words, airlines have no reason to be disciplined about lowering fares to compete with a rival. That behavior translates into an industry with high fixed costs, no pricing power and thin profit margins. Although it seems logical to add more passengers at any price just to fill seats on a plane, doing so at a loss just produces more red ink for the industry, says Cappelli. The rational alternative — reducing capacity to assure higher prices and full planes in the industry — hasn’t played out due to competition. As a result, airline profit margins remain low, he says.


In his 2008 outlook released on January 3, John Heimlich, chief economist at the Air Transport Association, said that the deregulated airline industry has never posted a net profit margin higher than the average U.S. corporation. As a result, only one (Southwest) out of the 10 U.S. carriers rated by Standard & Poor’s has an investment grade debt rating. That means airlines can’t borrow money at low rates to invest in initiatives — such as fuel efficient planes and upgraded facilities — that would save money and potentially increase sales in the future.


“You have to wonder why anyone puts money into airlines,” says Cappelli, who also notes that there is a consumer benefit to this irrational industry. “Passengers have done well and fares are still relatively cheap.”


According to Netessine, even though fares have risen of late, airlines are merely passing along additional costs and not profiting from the increases. However, he adds, carriers have been smarter about ticket pricing and are better operated today than in prior years. Given that backdrop, consolidation should improve the economics of the industry for carriers even if it’s unlikely that airlines will ever enjoy healthy profit margins.


The market ramifications of airline consolidation are largely unknown because big carriers haven’t merged yet. Until there are more test cases, it’s unclear what the impact of these mergers will be. Right now, says Netessine, “It’s hard to draw conclusions.”

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The Domino Effect: Will Airlines Follow One Another in the Consolidation Game?. Knowledge@Wharton (2008, February 20). Retrieved from http://knowledge.wharton.upenn.edu/article/the-domino-effect-will-airlines-follow-one-another-in-the-consolidation-game/

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