Why the Big Three Airlines Keep Getting Bigger

by: Matthew Green

Last Sunday, United Airlines (UAUA) and Continental Airlines (NYSE:CAL) announced that they would merge their operations. This follows in the footsteps of another combination of major carriers, Delta Air Lines’ (NYSE:DAL) acquisition of Northwest Airlines in October 2008.

Over the past decade, we have seen four major US airlines (TWA, America West, Northwest, and Continental) swallowed up by, or merged with, one of their peers. The remaining “legacy” airlines are the “Big Three” of Delta (DAL), United (UAUA), and American (AMR), along with a few smaller legacy carriers such as US Airways (LCC) and Alaska Airlines (NYSE:ALK).

The trend of consolidation within the US airline industry stems from the governmental deregulation of the airline industry in 1978. In the post-deregulation era, three trends have defined the evolution of the airline industry.

First, a largely unionized workforce and high cost structure prior to deregulation meant that downward pressure was inevitably placed on employee wages and benefits in the post-deregulation era.

Second, new low-fare airlines with business models built around lower cost structures emerged and to this day continue to take away significant market share from the legacy airlines.

Finally, competition and the subsequent need to expand led the better-positioned airlines to acquire or merge with the weaker ones, thus leaving only a fraction of the original legacy airlines in business today.

With the latest round of consolidation, we have reached a point where future mergers will likely be multinational due to antitrust concerns. Equally likely is the prospect that legacy airlines will attempt to take over low-fare carriers in order to retain them as low-cost subsidiaries, but reorganize the competition in their own favor.

As the railroad industry suffered from rapidly declining traffic in the 1960s, air travel was on the rise, even though it was still a relative luxury for most Americans. Additionally, air transport was a highly regulated industry. The structure was rigid, highly inefficient, and fares were high. The government’s Civil Aeronautics Board (CAB) regulated routes, pricing, and maintained high barriers to entry for newcomers. Even the existing airlines often had to wait years to get new routes approved.

One of the most famous stories involved Western Airlines waiting over a decade for approval to fly to Hawaii. It got it in 1969, after years of red tape and attorneys’ fees. Nevertheless, the industry was profitable and airline employees enjoyed relatively high salaries and benefits, made possible in part by the unionization of the workforce. With the CAB virtually ensuring profits, the companies could afford the high salaries, and the system was allowed to work in favor of the carriers and their employees.

It is a harsh reality that all forms of mass transportation are only marginally profitable at best. This is true across the industry, whether it is trucking, shipping, or rail. The airline industry was reminded of this when the 1973 oil crisis forced the airlines to raise fares, which the CAB readily approved.

Despite this, the subsequent recession and declining passenger traffic caused the airlines to experience losses. With the massive 1970 Penn Central Railroad bankruptcy a recent memory, (Penn Central was the product of the 1968 merger of the Pennsylvania and New York Central Railroads, a necessity due to the desperate railroad situation), voices in Congress began to express concern that the same thing could happen to the airlines.

Subsequently, hearings on airline deregulation began in 1975, spearheaded by Ted Kennedy. In 1977, President Carter appointed Cornell University economist Alfred Kahn as Chairman of the CAB. This was a notable because, as a marginal-cost economist, Kahn was known as an academic who favored deregulation regardless of the industry in question.

As congressional hearings continued, the airlines, who favored the rigid system despite its flaws, began to lobby against the proposed legislation. Kahn envisioned an industry with lots of midsize carriers in competition with each other, where reduced profits brought about by competition would largely be balanced out by an increase in passenger numbers resulting from lower fares.

Many industry veterans knew better. American Airlines Robert Crandall, who would later be known as one of the fiercest post-deregulation CEOs, stood up in one congressional hearing and chastised the committee that “you’re going to ruin this industry!” Nonetheless, the bill found little resistance in Congress, and President Carter signed the bill into law on October 24, 1978.

While deregulation was necessary to open up air travel to the masses, there were several factors that Kahn and the other deregulators did not address. The most important factor was one for which the airlines found themselves completely unprepared prior to deregulation: highly unionized workforces made it difficult to adjust cost structures without tense labor relations and costly strikes.

Not surprisingly, the 1980s brought about harsh realities for many airline employees. The post-deregulation environment immediately exerted downward pressure on the generous wages and benefits of airline employees, a process that continues to this day. Frank Lorenzo, a Queens, NY native, established himself as arguably the most prominent airline executive during the 1980s by building Texas Air into a holding company that would later purchase Continental, PeopleExpress, New York Air, and the once-mighty Eastern, all the while establishing himself as a vicious cost-cutter.

In 1983, Continental declared bankruptcy, and Lorenzo used the courts to force necessary cuts on the unions, emerging shortly thereafter as a lower-overhead, profitable carrier. After former astronaut-turned executive Frank Borman sold Eastern Airlines to Lorenzo in 1986, constant labor struggles ensued. Eventually, a six-month machinists strike in 1989 led Eastern to declare bankruptcy.

During this time, Lorenzo was quoted as saying “I'm not paid to be a candy ass; I'm paid to go and get the job done.” By 1990, Lorenzo was a poster boy for the airline industry’s lousy labor relations. That year, he left Texas Air/Continental upon its second bankruptcy filing. His aggressive actions throughout the decade indicate that Lorenzo arguably knew better than any other airline executive what was necessary for the industry’s long-term financial health.

Despite this, his tactics poisoned labor relations and made it harder for future airline executives to make necessary cuts due to the lingering atmosphere of distrust. An airline tycoon had become a pariah in just a few short years. His tarnished legacy was apparent in 1994, when Federico Pena’s Department of Transportation rejected an application to launch a new airline from an investor group that included Lorenzo, partially on the grounds that he was involved.

Throughout the rest of the 1990s, a good economy resulted in prosperity for the legacy carriers. However, well-publicized labor struggles remained. With low fuel prices aiding to produce several years of billion dollar-plus profits, the unions, particularly the Air Line Pilots Association (ALPA), began to demand more lucrative contracts. American’s CEO Bob Crandall needed President Clinton’s help to avert a 1997 pilot strike, which Clinton did by invoking the Railway Labor Act (amended to include airlines in the 1930s).

The next year, Northwest was forced to impose a lockout on its pilots for two weeks. As the airlines’ profits remained steady into 1999 and 2000, ALPA members significantly lifted their demands. United’s pilots in particular demanded that their pay levels return to pre-deregulation levels, adjusted for inflation.

At the turn of the century, United was indeed flying high, confirming its slogan at the time - “United: Rising.” On the strength of its West Coast network, United rode the tech bubble to profitability. SFO briefly became the sixth-busiest airport in the world, providing United with a great amount of premium and business fares.

Frustrated, United’s pilots took action by refusing to fly overtime. United was forced to cancel major portions of its summer schedule and largely acquiesced to its pilot’s demands later that year. Delta’s pilots used this as leverage to do the same in 2001, just months prior to 9/11.

In a clear illustration of the union’s unwillingness to accept lower wages, despite the industry bleeding red ink after 9/11, Delta’s pilots refused to accept concessions until 2004, when oil prices began to strain the carrier’s finances.

After three decades of wage and benefit cuts, the legacy airlines remain union-heavy. However, the airlines have experienced the toughest decade in their history in the aftermath of 9/11 and with higher fuel prices. This has forced the unions to accept more flexible cost structures.

The list of bankruptcies is extensive. US Airways went through bankruptcy twice, in 2002 and 2004. American narrowly averted bankruptcy in 2003 by winning large wage concessions. United was in bankruptcy from 2002 to 2006, and Delta and Northwest filed Chapter 11 on the same day in 2005. With the bankruptcies of this decade more drawn out than in the past, the airlines have been able to adjust their cost structures downward like never before.

This offers hope that the airlines will be able to cope with the possibility of higher oil prices and industry difficulties in the future. Unfortunately, it took 30 years and a revolving door history of bankruptcy for unions and airlines alike to accept the new realities.

The lower barriers to entry post-deregulation led to the other two secular industry trends: the rise of low-fare airlines, and the commencement of a Darwinian race to survive among the legacy carriers. First, a look at the history of deregulation start-ups and a new breed: low fare carriers.

Immediately after deregulation, new upstart passenger airlines began to take to the skies. Midway Airlines of Chicago was planned pending the legislation, and thus began operating in 1979 from its namesake airport. The new, competitive environment meant that passengers suddenly had a choice of which airline to fly, because multiple airlines were competing on the same routes.

More importantly, the lack of CAB fare regulation meant that passengers usually flew with the carrier who offered the lowest fare. This was not lost on several entrepreneurs, in particular a man named Donald Calvin Burr. In the late 1970s, the Harvard-educated Don Burr was working for Texas Air under future union foe Frank Lorenzo.

Seeing the potential for low-fare airlines, he resigned in 1980 and moved back to the Northeast, setting his sights on Newark Airport. A sleepy airport during much of the 1970s, Burr found that the Port Authority was willing to lease Newark’s deteriorating North Terminal at fire lease rates. He also found that there were many Boeing 737’s on the market that were old, but well-maintained and in good flying shape.

In 1981, Don Burr’s PeopleExpress took to the skies out of Newark, forever changing the industry by redefining the concept of low-fare and no-frills service. The only thing included in the fare was the transportation. To check a bag or to get a snack or beverage on board involved an extra charge – “added value” - as Burr put it. To better utilize flight attendants, the company collected fares on board, and never had a toll-free phone reservation line, preferring local toll numbers for each of its destinations.

The no-frills experience and low cost structure enabled Burr to profitably offer lower fares than his competitors. Passengers did not mind the no frills experience, and PeopleExpress grew exponentially as the public embraced low fares.

While PeopleExpress was synonymous with, and can be credited with catalyzing the growth of low-fare carriers in the 1980s, the art of running a low fare carrier was perfected by Dallas-based Southwest Airlines (NYSE:LUV), which quietly rose to prominence throughout the 1980s and 1990s. After struggling as an upstart carrier in the early 1970s, Southwest introduced a new business plan emphasizing low costs. It employed a largely nonunion work force and initiated aggressive fuel hedging strategies, which both continue to be the foundation of its low cost structure today.

Southwest was also on the cutting edge of utilizing its aircraft to the maximum by targeting short turnaround times, maintaining simplicity by only flying Boeing 737s, and focusing on point-to-point service rather than the hub-and-spoke system embraced by the legacy carriers in the 1980s. Southwest’s growing clout was apparent by 1993, when it opened shop on the East Coast. It began by initiating service to Baltimore, quickly followed by a large expansion to Florida, thus tapping the lucrative leisure market to and from the Sunshine State.

New, upstart airlines continued to emulate the PeopleExpress/Southwest model, whether they started as small operations such as Valujet and AirTran, or large, well-capitalized startups such as JetBlue (NASDAQ:JBLU). By the 2000s these airlines were a prominent thorn in the side of the legacy carriers, further putting fare pressures on the large airlines and subsequently on the wages of the old-line employees.

Finally, the third secular trend of the past three decades has been the survival of the fittest. The original Big Three that emerged in the early 1990’s remain the dominant triumvirate to this day.

First, a brief history on the mergers that led to this. After deregulation, many legacy carriers immediately began to struggle. Pan American World Airways, for decades America’s flag carrier to so many nations, found itself grossly unprepared for deregulation because of its lack of a domestic network to feed its flagship international operations.

To remedy this, Pan Am purchased National Airlines in 1980. This was a harbinger of what would become the trend throughout the 1980s. After the industry was shocked by the sudden collapse of Braniff during the 1982 recession, the better-positioned airlines went on a buying spree. In order to acquire the “critical mass” to weather the new environment of cutthroat competition from deregulation upstarts and old foes alike, airlines began to purchase stakes in smaller airlines to establish feeder or “express” networks. Then, later in the decade, they began to acquire their competitors.

The industry experienced rapid consolidation in 1985 and 1986. Carl Icahn (then a famous corporate raider, different from his current practice of shareholder activism) purchased TWA in 1985, and immediately purchased St. Louis-based Ozark Airlines in 1986. That same year, Northwest Airlines purchased Minneapolis-based Republic Airlines. Pan Am’s marriage with National was not a happy one, and the struggling carrier sold its valuable transpacific routes and San Francisco hub to United in early 1986. Don Burr’s PeopleExpress, seeking to grow and gain a presence in the western US, purchased Denver-based Frontier Airlines in 1985. Unfortunately (and ironically with this week’s merger), Continental and United responded by initiating a bloodthirsty fare war in Denver.

After a proposed sale to United fell through, the Frontier division of PeopleExpress was placed into bankruptcy in 1986. Burr was able to avert the bankruptcy of the entire company by selling to his old boss, Frank Lorenzo, in October of that year. Finally, 1986 ended with Delta doubling its size by purchasing Western Airlines, while American purchased AirCal.

By 1990, the “Big Three” of American, United, and Delta were more well-positioned than ever before to feed on the remains of other legacy carriers who continued to struggle. The Gulf War and subsequent oil spike proved to be the final nail in the coffin for several carriers. Eastern, having sold off major portions of its network and fleet, attempted to come back but ceased operations in February 1991. Midway, the original deregulation upstart carrier, attempted an ill-fated expansion at the same time fuel prices rose, and ceased operations in late 1991. Pan Am’s struggles continued to mount, accelerating after the Pan Am 103 terrorist attack in December 1988.

After declaring bankruptcy in January 1991, Pan Am sold its crown jewel - its JFK hub and transatlantic routes, to Delta along with its Northeast Shuttle operation in exchange for cash and financial support. With that move, Delta became the world’s largest carrier overnight. Over the course of the year, Pan Am attempted to reorganize around its original Latin American routes and negotiated with Carl Icahn to merge with TWA.

Sadly, before a merger could materialize, Delta cut off its support, and our nation’s most historic airline was forced to shut down in early December. American subsequently cemented its Latin American dominance by purchasing the Miami hub and Latin American routes. As mentioned earlier, the prosperous 1990’s led to a period of relative stability for the major carriers, but that all changed with 9/11.

Even before 9/11, United had entered into merger talks with US Airways, but due to antitrust concerns from John Ashcroft’s Justice Department, the plan was quashed mere weeks before 9/11. (Considering that both airlines declared bankruptcy in 2002, in United’s case lasting more than three years, the antitrust concerns were somewhat unwarranted given the subsequent events and the fact that much larger mergers have now taken place.)

TWA, unable to regain its former glory, especially after the 1996 Flight 800 disaster, was purchased by American in 2001. The last remaining deregulation upstart survivor, America West, was bought by US Airways in 2005. The accelerating rise of oil prices after 2005 led to Delta purchasing Northwest in 2008, gaining a valuable transpacific network in the process. This in part necessitated the merger of United and Continental.

Concerning the future of the industry, it is necessary to look at the global picture. In Europe, the past decade has seen countries lose their historic flag carriers. Belgium’s Sabena went bankrupt in 2001. Some airlines have been bought and are now subsidiaries of others, but are kept as separate brands partially because of national identity and pride (the Netherland’s KLM is now owned by Air France). Others have gone bankrupt only to have their assets transferred by their creditors and re-launched under a new name for the sake of keeping a national flag carrier (Swissair, bankrupt in 2002, was reorganized by Credit Suisse and UBS as Swiss International Air Lines).

In the future, consolidation will likely become a global phenomenon. It is possible that we may see the airlines within alliances spearheaded by American, United, and Delta (Oneworld, Star Alliance and SkyTeam, respectively) begin to merge with each other. The fact that some countries can no longer support even one flag carrier in today’s economic environment supports the notion that the US was an anomaly with six to eight major carriers ten years ago. Without European-style government subsidizing of the airlines, it is likely that airline consolidation will continue in the US.

The question is which strategy will the Big Three adopt? In the US, we have reached a point where future airline mergers may need to be multinational in order to avoid antitrust actions. If any of the Big Three announced merger plans with one another, antitrust concerns would immediately complicate the prospects of a deal. It will be interesting to see at what point, if any, the Justice Department steps in.

Another possible step could be low-fare carriers being bought or merged with the legacy carriers. This would likely cause fares to rise, as less low-fare competition would make it easier for the Big Three to keep fares at more profitable levels.

Taking a final look at the big picture, airline deregulation in the US has more than fulfilled its main objective of making flying cheaper, and therefore more accessible to the general public. The winner has been the American consumer; the nominal price of an airline ticket is up just 45% since 1978. (By comparison, the price of many food staples is up over 100%, while a college education is up over 500%.) The losers have been those who invest in the airlines, and most of all the employees. Deregulation exposed the rigid union cost structure as inadequate for such competition and unpredictable cost fluctuations, particularly the price of oil.

Bob Crandall summed up the post-deregulation industry when he said,

I've never invested in any airline. I'm an airline manager. And I always said to the employees of American, 'This is not an appropriate investment. It's a great place to work and it's a great company that does important work. But airlines are not an investment.’

Indeed, since deregulation, over 150 airlines have gone bankrupt, the vast majority small startups that could never effectively compete with the large airlines, most folding within a few years.

Those that still exist have to cope with cutthroat competition and the fact that the transportation industry, even in the good times, is only marginally profitable. Yet, we are able to get from city to city much cheaper than we were 30 years ago. In the end, it depends on one’s perspective, particularly the degree to which a traveler or employee may harbor nostalgia for the way the industry used to be.

Disclosure: No positions