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By Vaughn Cordle, Paul Mifsud and Carlos Bonilla

Without consolidation, five separate weakened network carriers will be unlikely to accommodate the higher industry costs we project by 2014:

· $6.5 billion more in fuel costs in 2010 over 2009, and an additional $2 billion in 2011

· $2 billion in higher airport passenger facility charges

· $2.7 billion in additional annual security costs by 2014

· $4-6 billion in higher labor costs.

The network airlines cannot absorb these costs by borrowing, since none of them are creditworthy; they all carry below-investment-grade credit ratings. What’s more, they are not capable of either generating the level of earnings they need or readily accessing the credit market to fund the shortfalls in earnings that will inevitably occur with the next downturn or the next spike in fuel prices. In short, several of the network airlines are likely not to survive another downturn given their inability to raise capital. AA would benefit from the car wash of a bankruptcy, but management cannot take this action until it is painfully obvious that it’s the only option left.

A merger of AA and US provides one path that can create real value for the stakeholders of these two airlines and the industry. In our judgment, it is the best option. Why? The size of these increasing cost estimations leads to the conclusion that even consolidation from five to four network carriers is insufficient to stem the tide of failures or achieve stabilized network carrier competition.

With the merger of UA and CO, the odds of liquidation and/or bankruptcy for US and AA increase because it will be too difficult, if not impossible, for them to remain viable as stand-alone businesses. In the end, the loss of US through liquidation provides the same result—three network carriers. But without the national scope provided by merging with another network carrier, where would AA stand among global competitors such as the UA (+CO) and DL (+NW) alliances?

In combination, AA and US would both gain from economies of scope, both benefit in terms of cost and earnings from eliminating redundant and overlapping functions, and both will be able to provide their customers with a more rational domestic operation. In addition, an AA/US merger should remove even more uneconomic capacity than the UA-CO combination.

Airline liquidations and bankruptcies are chaotic events, and they do not always result in desirable outcomes like capacity reduction or more favorable market conditions. Mergers, on the other hand, allow effective managers to control the restructuring of their networks and fleets in a way that works best against the market, industry, and economic forces that negatively impact company earnings and growth.

It's the network, stupid.

Removing costs and increasing an airline’s scope with the least amount of capital is the path to financial success. Given the downward spiral in market share for network airlines that has occurred over the last decade, a powerful business and valuation case can be made that the three network combinations that would result in an optimal market structure could reduce costs in the $3 billion range annually.

On the revenue side, the economies of scope (i.e., the network effect) would also increase revenue and cash flows by approximately $3 billion. The net effect of the mergers is approximately $6 billion in additional value created, or roughly $2 billion per combination. Revenue and cost synergies result in lower costs for the consumer than what would be the case otherwise, when all else is held constant.

Network efficiencies and the resulting lower costs are a function of the degree to which the various markets are integrated into the network. Optimizing efficiency through integration will result in a business worthy of longer-term investment, and one that can satisfy both consumers and labor.

Domestically, the regional carriers provide access to markets too small to support full service by network airlines, and internationally, foreign networks provide global access. Domestic integration with regional networks is a function of, among other things, the kind of effective labor-management relations that lead to unit costs that make service by small jets viable. Internationally, while cooperation among larger domestic carriers is somewhat circumscribed by US antitrust laws, the US. DOT (over the objections of the DOJ) has encouraged US and certain foreign airlines to increase their network efficiencies through antitrust immunity, which led to the development of three global branded alliances. Although these alliances are still in the process of developing, one strategic element is clear: Each participating network carrier is valued in terms of its access to its national home markets. Broad market access is also highly valued by the network airlines' most important commercial customers.

For AA, this means that the UA/CO and DL /NW combinations can provide their global branded alliance partners and customers richer, more integrated access to the US market than AA can, but an AA/US merger would enable AA to remain competitive within the US market. Since neither CO nor US, on their own, can provide a comparable scope of market access, it should be evident that, if US policy, as enforced by the DOJ, prevents CO or US from merging, these smaller network carriers will be consigned to second-class status within the branded global alliances in an environment of increasing costs and shrinking revenue.

Internationally, US negotiators and DOT policy have positioned the major US carriers at the center of the developing global networks. European, Chinese and other Pacific governments and their carriers seem content for the moment to let the US and its carriers take the lead. Therefore, the big US policy question is whether the DOJ will focus its competition concerns on a few narrow domestic markets (as it has in the past) or consider the national interest by encouraging a strong, dynamic global aviation network.

If it does the latter, then our analysis shows that the UA/CO merger will result in a more extensive national network that utilizes about 10% less capacity than the pre-merger airlines combined. Similarly, an AA/US merger will result in a national network with more scope utilizing, say, 10-15% less capacity than the pre-merger airlines combined. It is efficiencies such as these that start the industry back on track to sustainable profitability. (To make the optimal structural case, we assume that UA/CO and a hypothetical AA/US combination are each 10% smaller than the sum of the paired airlines before the mergers.)

However, even a UA/CO combination that is 10% smaller removes only 2% of the industry’s domestic capacity, while the industry currently has 10-12% excess capacity and maintained approximately 7% too much capacity over the decade ending in 2009. This excess capacity resulted in over $70 billion in losses system-wide for the US airline industry, which represented 5.7% of revenue. Domestic losses represented 90% of those losses, and the network airlines reported the bulk of those losses.

Currently, there is no off-the-shelf replacement for the benefits that the network carriers bring to the local communities and the global economy. Five network carriers operate unprofitably, even with 80% + load factors, from a variety of hubs, and each of these hubs represents an American community that receives considerable benefits from the access to global markets. Allowing the network carriers to make their networks more rational is far preferable to continuing the hemorrhaging until one or two of the players wither on the vine.

Business, labor and government leadership is required.

Mergers are not a panacea. They involve risk, and without the right leadership from management, labor and government, they can perform poorly and fail miserably. The success or failure of any merger depends on the details of the deal, the ability to execute profitability, and the quality of labor and management cooperation. The DL/NW merger appears to have been implemented with unprecedented levels of labor cooperation from the pivotal pilots’ groups, and reports are circulating that UA and CO pilots also exhibited insightful levels of cooperation.

The same cannot be said for either AA or US at this juncture. However, the structural dynamics we highlight are well recognized throughout the industry, so the announcement of a UA/CO deal may well provide a fresh perspective to the labor-management positions of US and AA.

Airlines cannot satisfy labor with the current industry structure.

Labor at the network carriers have lost, on average, 33% of their legacy pay and benefits while undertaking a heavier workload, and the resulting employee discontent in the service-oriented airline industry has contributed to public hostility. Unless a path to renewed growth can be found, employee disenchantment—and public hostility—will continue to grow.

We estimate the network carriers' domestic capacity will shrink to 53% of the total domestic capacity by the end of 2010, after the UA/CO combination versus 80% 10 years ago [Figure 2]. If network consolidation proceeds as we believe it should, the three rationalized networks will lower network capacity and costs considerably—approximately $1 billion for each combination—and facilitate the profitability required to restore labor compensation to an acceptable level. Moreover, if the secular trend of faster relative growth in LCC capacity continues, and the three network airlines combine as we suggest, the remaining three networks would eventually provide only 35-40% of the total domestic ASMs. The result is a level of market concentration that protects the consumer from anti-consumer pricing and encourages an increase in lower-cost competition.

Figure 2:

The resulting domestic market will be divided among the low-cost and regional carriers, on one hand, and the network carriers on the other. Southwest continues to be a dominant provider of ASMs but, viewed in global terms, this domestic configuration does not risk giving any player unreasonable market power. Airlines will be able to share more with labor and make much-needed capital investments if industry consolidation results in system-wide network rationalization.

Where do we go from here?

In the meantime, the network carriers remain vulnerable to higher costs that may be forced on them by poorly conceived government policies or labor actions. With higher costs, the network airlines’ slow liquidation spiral will accelerate as more aggressive LCCs attack the network airlines’ international and domestic markets.

The network carriers provide an essential service to the national economy as their networks link small, medium, large and international markets around the globe. Given the current condition of the industry, the network airlines can survive over the long run only if the government allows consolidation in the form of mergers.

The market structure work we recently completed provides data and analyses that demonstrate how network consolidation and rationalization can allow the industry to break even in economic cost term over a full business cycle. This is a valid measure of minimum profitability that we believe is the best way to assess the industry’s health and viability. It is our contention that the market and its global network structure is the proper context for a healthy debate about the benefits and risks of network airline mergers and consolidation. Whether viewed in national or global terms there will remain a wide variety of competitive airlines providing consumers with many air travel choices.

It takes rational government policies and sound management and labor leadership to arrive at a public policy that can advance, rather than hinder, the restructuring this industry needs. Absent a change in industry structure, the network airlines will continue to shrink. As a result, communities around the nation will be increasingly isolated from global markets, and capital markets and labor will continue to withdraw their support in ways that ultimately harm the consumers of air travel and the broader economy. It is for this reason we believe that further consolidation is needed and that a merger between AA and US likely represents the best option for the stakeholders of these airlines.

UA, CO, DL, and NW management have made the right decision to combine operations in a way that benefits their employees, shareholders, and the communities and air travelers that can now be better served by a business that has a chance to earn the required level of profitability. In the final analysis, we believe that mergers represent the best outcome for an industry in desperate need of consolidation.

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Vaughn Cordle, CFA is Managing Partner and Chief Analyst at AirlineForecasts, LLC and serves as an airline analyst to various institutional investors and money management firms. Cordle has over 25 years of experience in the airline industry and is a former B777 Captain for United Airlines. He has attended numerous executive education programs at Kellogg, Wharton, and other business schools and is a Principal of The Aviation Group, a Gerson Lehrman Group Leader, and a member of the New York Society of Security Analysts. mailto:vaughn@airlineforecasts.com

Paul Mifsud, an airline political strategist and government affairs expert in private practice, focuses on aviation alliances and metal neutral joint ventures. Formerly Vice President, Government & Legal Affairs, USA, for KLM Royal Dutch Airlines, he was named 2008 Transportation Lawyer of the Year by the Federal Bar Association and received the Order of Oranj-Nassau (Officer) on behalf of the Queen of the Netherlands. mailto:pmifsud@earthlink.net

Carlos E. Bonilla is Managing Partner and Chief Economist at AirlineForecasts, LLC. A former Sr. Vice President with Washington Group, Bonilla has represented clients before the U.S. Congress and other parts of the Federal government. From 2001 to 2003 he served on the White House's National Economic Council as Special Assistant to the President for Economic Policy, where he held the aviation and labor portfolios and was part of the tax policy team. Prior to that he served as Senior Economist for the U.S. Congress House Budget Committee and as tax policy adviser for the chairman. Bonilla is on the Board of Directors of Mesa Air Group serves on its Audit Committee. mailto:carlos@airlineforecasts.com

Disclosure: No positions

Source: United and Continental: Set for Take-Off, Part 2