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By Basili Alukos

There has been much talk recently in the news about a potential merger involving United Airlines (UAUA) and Continental (NYSE:CAL). Although the talks have intensified recently, we believe both companies have already made numerous announcements that, taken collectively, appear to foreshadow a merger. In this piece, we will analyze and discuss the timeline of these events, describe why the carriers are compatible partners, and explain how a merger could positively affect the entire airline industry.

Timeline of Events
May 2008--Shortly after Northwest and Delta (NYSE:DAL) announced their merger, Continental and United briefly held negotiations involving a possible merger. Although a golden share (which served as a deterrent to a change of control) held by rival Northwest was partially responsible for the deal's collapse, we also suspect that Continental was terrified of United's fragile financial position and quickly ended all discussions.

June 2008--Continental announced that it will switch to United's Star Alliance from its current membership in Delta's SkyTeam. We suspect that the new Delta entity was so large that it was stifling Continental's benefits from the SkyTeam and that Continental wanted a better share of the alliance's benefits.

April 2009--The Department of Transportation (DOT) gave Continental its initial blessing to join the Star Alliance. However, the antitrust department of the Department of Justice (DOJ) questioned the anticompetitive nature of the switch, prolonging the approval.

July 2009--After both firms altered the proposal to include some of the DOJ's recommendations, the DOT allowed Continental to join the Star Alliance. Additionally, Continental and United were given antitrust immunity on international flights, more easily enabling the firms to reduce redundant marketing expenses and share revenue from common passengers. In our opinion, this was an essential stepping stone for a merger, since United and Continental have a significant portion of overlapping flights, specifically at London's Heathrow Airport, that could have been problematic.

July 2009--Just days after the DOT's decision, Continental CEO Larry Kellner announced he will step down at the end of 2009, citing his success in brokering the airline's acceptance into the Star Alliance. Given that Kellner was CEO during the failed negotiating talks in 2008, we think his absence will be another positive for re-igniting merger talks.

July 2009--Nearly a week after the DOJ's blessing, Continental and United announced plans to share a joint technology platform in the Star Alliance; both firms claimed this would solve numerous customer issues. This is extremely telling, in our opinion, since IT integration is paramount for a successful merger. For example, the US Airways (LCC) and America West merger took nearly three years to integrate both systems successfully, and the delay cost the entity millions.

July 2009--Approximately two days after the IT news, United announced it will change its independent auditor beginning in fiscal year 2010 to Ernest & Young--Continental's public auditor. While we admit that an auditor cannot veto a merger, an auditor must assess the client's risks and gain comfort with its accounting procedures. Gaining a better understanding of the firm will make future audits more efficient, possibly saving millions over the coming years.

April 5, 2010--United announced its willingness to bring its flight attendants up to the pay scale of their counterparts at Continental Airlines in exchange for changes in work rules. We thought this was a key step in getting labor on United's side, since labor unions have been recalcitrant obstacles in previous merger talks. For instance, labor disputes played a role in the United-US Airways merger talks falling apart in 2001.

April 7, 2010--The New York Times reported that United Airlines and US Airways were in merger talks. Individuals with knowledge of the situation confirmed these reports on the condition of anonymity, although both airlines did not comment on any rumors.

April 15, 2010--Numerous sources reported that Continental re-entered into merger talks with United. Sources close to the situation believed that the potential talks with US Airways were merely a ploy to have Continental return to the negotiating table--a ploy that appeared to work.

April 22, 2010--US Airways acknowledged, via a press release during Continental's first-quarter earnings call, that it had officially ceased merger talks with United Airlines. At this point, rumors were beginning to speculate that the UAUA-CAL company would call Chicago home and that Continental CEO Jeff Smisek would assume the CEO role. In addition, reports surfaced that the companies were exchanging financial information.

Compatible Partners
We think Continental and United are compatible for several reasons, namely, complementary hubs, similar fleets and disparate geographic networks.

First, we posit that since neither firm operates a hub in the same city, we think the DOJ would allow a merger since the combined entity would not create a monopoly in any market, which is a significant feat. Second, both firms operate similar fleets. Continental flies an all Boeing (NYSE:BA) fleet, and United flies mostly Boeing aircraft. By the end of 2009, United had removed all (roughly 100) of its older Boeing 737 planes, while Continental has firm commitments to purchase 54 new 737s through 2016. Therefore, the combined entity would have to purchase only one block of 737s, which would dramatically reduce capital spending in the years to come since the carriers would not duplicate the same order. Lastly, we think the two firms create a natural link between their disparate networks, with each carrier strengthening the geography where the other is weak. For example, United would give Continental its much-needed exposure in the western United States (via Denver and San Francisco) and Continental's Newark, N.J., hub gives United an important East Coast exposure. On the international front, United's strong Chinese presence and Continental's large Latin America exposure would complement the global network nicely between the firms, making the firm a formidable global player.

End Result
In all, we believe that consolidation is necessary in the mature airline industry. The previous cycle experienced rapid growth from low-cost carriers--Southwest (NYSE:LUV) flourished and newcomers JetBlue (NASDAQ:JBLU) and AirTran (AAI) went public. Today, we believe the domestic market is mostly mature, so there are few, if any, meaningful domestic markets that don't already have airline service. The reduction in additional capacity should help boost prices while removing redundant costs from the system. Eventually, we suspect the airline industry is on its way toward at least earning its cost of capital, but it is too early to tell how disciplined the industry will be during the next upturn. Moreover, there is nothing substantial restraining another new startup--unless of course, the startup realizes how unlikely the chances are of making money.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

Source: How Long Has a Continental-United Merger Been in the Works?