United Airlines-U.S. Airways Merger: Turbulence Ahead?

Which of the following will be factors in the proposed merger of UAL’s United Airlines and U.S. Airways Group?

    1. Powerful UAL pilots
    2. Travel-weary consumers
    3. Concerned politicians
    4. Worried regulators
    5. The presidential election
    6. All of the above

If F was your final answer, please take a seat in first-class and enjoy a complimentary cocktail. But don’t forget to fasten your seatbelt because it could be a long, bumpy ride before this deal lands safely, if ever, according to Wharton faculty members who follow the airline industry.

The proposed merger of United, the nation’s biggest carrier, with No. 6 U.S. Airways would create a jumbo-jet of a company. It would handle 27% of U.S. airline passengers with a fleet of some 1,000 planes, serve 170 cities worldwide and fly in and out of eight major U.S. hubs. UAL has offered to buy U.S. Airways for $4.3 billion, or $60 per share, and assume $7.3 billion worth of the smaller carrier’s debt and leases.

The merger makes sense for the two companies, says Elizabeth Bailey, professor of public policy and management. "I think U.S. Airways is really concerned about its long-term profitability" because it has high operating costs and charges high prices, she says. "It is in many ways a large regional carrier with its business concentrated east of the Mississippi. To be focused in one region makes it very hard for an airline to achieve long-run sustainability in a world where frequent-flyer plans and one-stop shopping are important to consumers. Consumers with frequent-flyer miles want to be able to travel to a lot of different places, not just cities in one region."

For its part, United, whose business is largely focused in the Midwest and West, would attain a long-sought East Coast presence, as well as get access to U.S. Airways’ European routes, she says.

The proposed combination, announced May 24, immediately prompted other airlines to consider partners. American Airlines, a unit of AMR Corp. and America’s No. 2 carrier, has held discussions with Northwest Airlines and, most recently, with Delta Air Lines. In Europe, officials of British Airways and KLM Royal Dutch Airlines have also explored the idea of combining.

"United is already the largest airline and a merger would make it the mega-largest," Bailey says. "That would make everybody else say, ‘We don’t want to get weaker.’ When any company in any industry becomes much larger, it destabilizes the rest of the industry." As W. Bruce Allen, professor of public policy and management, puts it: "Merger talk begets merger talk."

No Rush to Decide

The United/U.S. Airways deal is so sensitive, however, that both Bailey and management professor Peter Cappelli say the Justice Department will be in no rush to make a decision. "The public is not especially happy with airlines and air travel," Cappelli says. "I think to some extent it’s a political hot potato, so it won’t be solved until after the presidential election." Bailey says a Bush administration would be more likely to approve the deal.

Consumer groups and legislators in Washington have raised concerns that the merger would lead to higher ticket prices and lackluster service. But Bailey and Allen say travelers probably would not be adversely affected. Indeed, says Bailey, "they may be better off, since anyone who earns frequent-flyer miles on U.S. Airways would have more attractive vacation destinations to choose from. The route structure of the merged carrier would be better. Prices would probably be no worse. You already have high prices for flights to Charlotte [N.C.] because one company, U.S. Airways, controls that airport. Ditto for Pittsburgh."

In general, travelers have legitimate complaints about airline service, Allen says, but they may not always be justified. "I’m not sure that service is worse than before or whether we’re just more conditioned to gripe. Certainly planes are fuller than before, but traffic growth has been gigantic and we have not added many new airports or taken other steps to handle the increased load and the delays that come with it. Airlines get blamed for a lot of things that aren’t their fault."

On its face, the Wharton professors say they see no reason for antitrust lawyers to reject the merger. For one thing, United and U.S. Airways share very few overlapping routes. Indeed, anticipating a potential objection on the part of regulators, United has proposed spinning off U.S. Airways’ routes at Reagan National Airport in Washington, D.C., where most of the two companies’ overlap occurs, to a new carrier called DC Air. Robert Johnson, founder of the media company BET Holdings Inc. and a director of U.S. Airways, would operate DC Air.

In addition, United has said it would freeze domestic fares for two years when the merger takes effect, raising prices only to keep up with higher fuel costs and general inflation.

One Wall Street analyst, Brian D. Harris of SalomonSmithBarney, sees only economic positives resulting from consolidation in the airline industry. "We believe the airline industry is overhubbed and would be more efficient with fewer (though larger) hubs – a development which would be accelerated via airline mergers," Harris wrote in a research report following the merger announcement. Harris adds that having fewer competitors "should also result in more rational pricing and capacity growth." Salomon Smith Barney, it should be noted, served as adviser to U.S. Airways in the deal.

Two Big Hurdles

Either the Justice Department or the United employees who belong to the Air Line Pilots Association could seal the ultimate fate of the merger – and other possible combinations in the future.

Aside from the particular issues in the United-U.S. Airways case, the Justice Department also has to take the future into account: if United and U.S. Airways get a green light, what about other companies that want to consolidate? It is one thing to reduce the number of major domestic carriers from eight to seven, but further mergers could cut the number as low as two or three. "The Justice Department worries about too small a number of total competitors," says Bailey. Cappelli says regulators are acutely aware of the reverberations that would occur if they sign off on the deal. "If they approve it, it will open the door for the wave of mergers behind it."

Adding to the complexity of the regulatory picture is the fact that antitrust law is difficult to apply to the airline industry. "Antitrust law doesn’t make a lot of sense in the context of airlines because it is one of the industries where policy makers realized early on that the economics of it was so different and that’s why it needed to be deregulated," Cappelli explains. "Antitrust law doesn’t fit because the cost per unit of product, the marginal cost of putting additional people in seats, is essentially nothing. So it is possible, and quite likely, that you set your prices below the average cost per seat. In another industry, if you set your prices below the average cost, that would be seen as predatory."

But with airlines, Cappelli says, such pricing is common practice. "The government knows the industry is different, so they know it makes sense to do that. But then the question is, what does count as predatory pricing? There’s no real standard. If a big carrier wants to drive a little carrier out of business, it just lowers its fares. That’s not illegal because there isn’t a real standard."

It may turn out that the deal gets scuttled before regulators even get a chance to weigh in on the matter. The reason: The 10,000 unionized pilots at United, who have already expressed displeasure with the deal, may see no reason to change their minds. The terms and conditions of their employment are based on seniority, which establishes an internal ranking that determines who receives the best pay and will fly the best routes. Seniority is determined in different ways at the two carriers, so there is no easy solution, such as giving pilots from both companies seniority based simply on the length of employment.

"You may find yourself being a relatively senior pilot at United, which has grown considerably in recent years, and as a result of the merger you find yourself being a much less senior pilot because people at U.S. Airways have been there longer," Cappelli points out. "The stakes are so high that seniority drives everything. The difference between 11 years and seven years of seniority can mean a ton of money and much better terms and conditions."

Pilots in the Driver’s Seat

Such disputes have doomed airline mergers in the past, and Cappelli says it could happen again. United’s pilots are "in the driver’s seat of that company. They own it through an ESOP [employee stock ownership plan] and effectively have veto power over management decisions." The UAL pilots hold 25% of the employee-owned company and have a seat on the board.

A spokesman for U.S. Airways’ 5,000 pilots has been quoted by the Wall Street Journal as saying that while pilots there were not "elated" by the proposed merger, they were in no position to block the deal. How might the seniority issue be resolved? "It’s a distributive bargaining game," Cappelli says. "Airlines only have so much money to spread around. It’s just horse-trading and politics."

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