Consolidation Is the Logical Next Step in the Industry’s Evolution

Over at the National Journal's Transportation blog site, the question of the week is:  “Should Continental and United Be Allowed to Merge?  Lisa Caruso, the blog’s editor asks:  “What do you think of the proposed merger? Will it benefit the two airlines? What about customers and the airline industry as a whole? Should the Justice Department approve it? 

To date there have been responses to the question from Robert L. Crandall, former Chairman and CEO of American Airlines; Carol J. Carmody, formerly the Acting Chairman and Vice Chairman of the National Transportation Safety Board; Kevin Mitchell, Chairman of the Business Travel Coalition; and yours truly, William S. Swelbar, the author of www.swelblog.com. 

I urge you to read the comments as they are diverse and even “agnostic” toward the proposed merger of United and Continental.  Swelblog readers can comment directly to the National Journal Transportation blog.

Below are my comments to the question posed by the National Journal’s Ms. Caruso.

After decades of destructive competition, consolidation is the logical next phase of evolution in the U.S. airline industry.  This, after all, is an industry that lost $60 billion over the past decade – making folly of the goal of the 1944 Chicago Convention in charging the International Civil Aviation Organization to “prevent economic waste caused by unreasonable competition.” 

Instead, the U.S. domestic passenger market produced plenty of economic waste over the past 32 years, affecting shareholders, lenders, employees and most other stakeholders.  The only clear winner from the industry’s singular strategy of adding uneconomic capacity was the consumer.

Today, the legacy network carriers are focusing away from the bloodletting in the domestic market with an eye toward international flying. Too often, regulators and legislators and even some analysts see the global airline industry as somehow U.S.-centric.  It is not.  In aviation, the U.S. is one piece of a big puzzle that is influenced by global economic interdependencies, just as the U.S. economic recovery could be affected by events in Greece and possibly Portugal and Spain.

For the legacy carriers, this round of consolidation is more about preparing to compete with the world’s other big carriers as much as it is about competing with Southwest or AirTran or jetBlue.  That’s why so many are shaping their networks and alliances to attract domestic and international bound passengers.   The footprint established by the low fare carriers is now national in scope, while the fares they charge should be considered as much of a  contributor to that fact that many smaller communities are losing air service as is the economy and the price of oil.

The 1978 Airline Deregulation Act clearly accomplished the goal of delivering safe and affordable air service to the masses.  Today, airplanes are packed with flyers paying, on average, 55 percent less for a ticket when adjusted for inflation than they paid in 1978.  Why?  Because most U.S. airlines responded to deregulation in the 1980s and 1990s with a capacity-led business model that made cost control imperative.  Some of today’s cost controls can be found in the outsourcing of maintenance or downguaging the size of airplanes to adapt to the realities of the marketplace.  

For decades, the only way the industry knew how to grow revenue was to grow capacity.  Airlines used the tools and methods that had their roots in regulation and were focused on estimating market share.  Fundamental to that analysis was the belief that growing revenue meant the need to grow capacity – and most airlines did, even before demand warranted it.

Everybody focused on “screen display.”  Statistics showed that if an airline’s flight did not appear on the first few CRS screens of available flights in a market, that airline didn’t get as many bookings. The more sophisticated the global distribution system (GDS), the more important electronic “shelf space” became.

Only recently has the industry worked to rid itself of too much capacity brought about by this market share mentality – one result of the role of CRS/GDS bookings that made an airline seat a commodity.

Today’s consolidation is working to undo the capacity-added wrongs of the past. Consider labor.  For too long, airlines carried uneconomic capacity, employed too many people and signed on to labor contracts that created unreasonable expectations for airline employees.  That steady growth also created expectations that airlines were somehow required to serve smaller communities, even when demand did not warrant service and those routes could not be flown at a profit.

Much of this is still true. U.S. airlines have used bankruptcies and other restructuring efforts to cut capacity and increase productivity, but many did not go far enough.  The real catalyst to capacity discipline was $147 oil.  And that capacity discipline needs to continue if the industry is ever to get to a period where it earns at least its weighted average cost of capital. 

Unlike other rounds of consolidation that focused primarily on network scope, scale, revenue and cost synergies, this round is different.  Now the industry is looking at the balance sheet. The market rewarded Delta following its acquisition of Northwest with a market capitalization that exceeds that of United, Continental, American and US Airways combined.  Consolidated carriers promise more stability to employees, shareholders and communities that benefit from the combined strength of the respective balance sheets.

Capital has smartened up.  We do not see as much creative financing or unsecured lending as was common in the past.  Assuming successful mergers, combined airlines will be able to raise capital more easily, carry their labor costs and offer passengers more choice of routes and destinations. 

The U.S. market should not fear the “end to end” network consolidation like Delta – Northwest and the proposed United – Continental merger.  The market has demonstrated time and again that where competition is vulnerable, a new entrant will exploit that vulnerability.  Where there are market opportunities, there will be a carrier to leverage that opportunity.  And where there is insufficient capacity, capacity will find the insufficiency.

Simply put, the legacy carrier model of the 1980’s and 1990’s does not work in today’s environment. Consolidation is a logical step to position airlines in a highly fragmented industry to better weather the financial challenges that have caused years of economic pain and a rising tide of red ink.

More to come.