Continental: A Basket Case Rescued By A Weakling

When Continental Airlines Inc. revealed on Nov. 9 that it had agreed to accept a bid by Air Canada and investor group Air Partners, Continental Chief Executive Robert R. Ferguson III pronounced the deal a "major milestone." Air Canada's CEO Hollis L. Harris was "thrilled." With $450 million from its new partners, Continental now should finally escape from bankruptcy. And Air Canada, long gnawed by fears of extinction, would increase its access to the vital U.S. market and secure its place in a fast-consolidating business. The two boast they will be able to exploit great synergies in route structure, purchasing, and maintenance.

But this marriage of two weak players raises as many questions as it does hopes. Although the cash infusion may propel Continental out of bankruptcy court, it's nowhere near enough to make it a strong competitor. Continental is saddled with an aging fleet. The 23 months that the carrier has spent in bankruptcy reorganization have done nothing to help it reinvest in the new equipment needed to keep up with stronger rivals. Moreover, Continental's image problems persist, and with them a failure to attract its share of business travelers. The upshot: low revenues that offset its lower-than-average labor costs.

FAILED DEAL. Solving all of these problems calls for vast capital investment. Trouble is, Air Canada itself is highly leveraged and in no position to supply the dough needed for new jets and more. So, Continental will emerge as a "viable but fairly weak player," says Standard & Poor's Corp. analyst Phillip Baggaley. With deep pockets an ever more crucial determinant of success, "they are swimming against the tide," he says.

In the near term, Air Canada gains far less than Continental. Its $235 million investment in Continental--$85 million in equity--does nothing to stem its own losses, which were running about $1 million a day in the first three quarters. All that red ink is only furthering the strain on a balance sheet with just $370 million in equity against more than $3 billion in debt and other obligations.

Recent developments in its domestic market threaten the carrier, too. A deal it had struck to merge with its weaker rival, Canadian Airlines International, collapsed. Canadian now is talking with American Airlines Inc. Should powerhouse American buy a chunk of Canadian, the dying carrier could perpetuate the fare wars that have harmed both Canadian airlines. Indeed, unless Air Canada sees a major upturn in traffic next year, Ross Healy, CEO of Solvency Analysis Corp. in Toronto, predicts: "You have all the ingredients of a real financial nightmare"--insolvency, in a word. Air Canada dismisses such concerns, arguing that it has plenty of cash on hand from asset sales. It also expects sharp cost-cutting to end the losses.

The critics also contend that both carriers lack management depth. Numerous managers have abandoned Continental during its long spell in bankruptcy. Harris has fans among Continental's rank and file. But since it was Ferguson who succeeded him as Continental's CEO less than two years ago, his future role there is uncertain. Ferguson, for his part, enjoys less respect for his skill as an airline manager than for his cost-cutting talents and is mistrusted by some airline employees who view him as what one veteran pilot calls a "Frank Lorenzo crony." He and David Bonderman, a principal in Air Canada's co-investor Air Partners, are friends from their association with Braniff. Ferguson is expected to remain CEO.

Another worry is that the operating synergies the airlines are counting on may be tough to realize. Continental says it may use Air Canada's maintenance shops instead of contracting the work out, but the high cost of labor in Canada may cancel any benefits from that. It also will take work to meld the two carriers' route systems. Although Air Canada could quickly add routes if an open-skies agreement between the U.S. and Canada is completed, the airline doesn't fly to either Denver or Houston, two of Continental's biggest hubs.

Ultimately, the carriers' best hope may be to become part of something greater than themselves. The airline industry is headed toward a future dominated by megacarriers, whose routes would span all continents and command huge market share. In recent months, Air Canada has struck marketing alliances with Air France and United Airlines Inc., and it hopes financial investment might come later on. Economist Fred Lazar of York University even predicts that in a few years' time, United may "step in, make an investment, and run the whole operation."

Antitrust guidelines make that sound farfetched. But in the airline business, the incredible can happen. Continental and Air Canada can only hope they're still around when it does.