A normal industry?
Feb 14th 2008
From The Economist print edition
Much is riding on the possible merger of America's third- and fifth-biggest airlines
ONE by one, the obstacles along the runway to what could be one of the most transforming deals in the world's air-transport industry are being cleared. If, within the next few days or weeks, executives at Delta and Northwest succeed in hammering out a common labour contract with their 11,000 pilots, the airlines will declare their intention to merge, subject to regulatory approval.
Were the deal to go ahead, it would almost certainly trigger similar mergers between the rest of the “big six” American network carriers, with United and Continental likely to pair off on one side, and American and US Airways on the other. If, and it is still a big if, what emerged was a stronger, more stable American airline industry, that in turn would be an important step towards completing the stalled liberalisation of the global aviation industry.
It is not the first time that America's big airlines have attempted to join forces. Delta saw off an $8.7 billion hostile bid by US Airways in 2006, and proposed mergers between Northwest and Continental in 1998 and United and US Airways in 2001 were blocked by the competition authorities. But a lot has changed since then. Four of the big six have been restructured under Chapter 11 bankruptcy protection, the industry has reduced its workforce by 39%, wages have been cut by 30% and there has been a $20 billion default on pensions. Even so, and despite booming business and leisure demand and a return to respectable profits in the past few years, the big airlines are still in a fragile state.
Gains in operating efficiency have been partially offset by the huge rise in the price of jet fuel. According to the International Air Transport Association (IATA), airlines' global spending on fuel has risen from $40 billion in 2002 to $135 billion last year. Expensive fuel hits the American airlines harder because their fleets are much older than those in Europe and Asia. The average age of planes in Northwest's gas-guzzling fleet, which includes DC-9s that first flew 30 years ago, is 18 years, for example. In the collective trauma that followed September 11th 2001, the airlines' net debt rose to 20 times operating cashflow. Buying new planes, which are up to 30% more fuel-efficient than old ones, was not an option. And balance sheets are still too stretched to permit large-scale fleet renewal.
What is also concentrating minds at America's airlines is the certainty that 2007 marked the peak of the business cycle for the industry worldwide, and that North America will be the region hardest hit by the recessionary headwinds. Yields (the average revenue per passenger mile), load factors (the share of seats filled) and profits are already starting to fall.
Airline managers also reckon that time is not on their side for political reasons. If there is a Democrat in the White House next year, it may become even more difficult to secure regulatory approval for mergers that will lead to further job cuts in one of the country's most unionised industries. And although there are good grounds for discounting fears that reduced competition will drive prices upwards, a less pro-business administration may be more inclined to heed the inevitable protests of passenger lobbies fearing the closure of routes or a city hub.
Some industry critics are sceptical of the airlines' claims about the efficiency gains that mergers will make possible. They counter that the airlines are already big enough to enjoy economies of scale and that the difficulties of knitting together complex organisations with different cultures will distract managers and divert scarce cash. They also argue that proponents of consolidation exaggerate the boost to load factors that a reduction in capacity will bring. Low-cost carriers, they say, will quickly move to occupy abandoned hubs and routes, replenishing capacity almost as soon as it is reduced.
The success of big airline mergers is certainly not guaranteed. More than two years after their merger, US Airways and America West are still struggling with integration. That said, Air France's experience after taking over KLM, and Lufthansa's after buying Swiss, have been largely positive. Even without trying to integrate their businesses fully, the airlines have cut costs and benefited from economies of scale more quickly than investors expected, so they are now confident of being able to pull off more ambitious deals. Air France even believes it will quickly be able to make money by buying Alitalia, one of the weakest airlines in Europe.
And there are good reasons to think that the Delta-Northwest and United-Continental deals would make sense. For one thing, airline managers have become more professional during the past few years. The visionaries have left the field, and their successors have ruthlessly focused on cutting costs. One measure of their success is that the market share of low-cost carriers appears to have stabilised at around 30%, at least for the moment.
Furthermore, the big network carriers know that their future depends on developing their long-haul business, where there is greater scope for savings, and where the growth of premium traffic continues to buck other industry trends. Delta has been particularly keen to take advantage of the “open skies” agreement with the European Union which comes into force next month. With Northwest's strength on the Pacific, a merged airline would be able to offer a more comprehensive set of destinations.
That both airlines regard securing a single agreement covering all their pilots as a pre-condition for a merger is an indication that they plan to go further than Air France-KLM and Lufthansa-Swiss have in integrating operations. Success would mean a much bigger pay-off. The prize for passengers, investors and regulators would be a globally competitive American airline industry that no longer needed to shelter behind bankruptcy laws and outdated bilateral agreements that keep foreign investment and ownership at bay.
“All of us in the airline business need a strong American industry, because it would be less protectionist,” says Willie Walsh, the chief executive of British Airways. Giovanni Bisignani, the chief executive of IATA, also sees strong American airlines as one of the keys to unlocking change in the industry and opening the way to further international consolidation, of the kind that happens in other, “normal” businesses. “If we cannot change the rules of the game,” he says, “we will never be a normal business.”
