The Ever Shrinking Skies

Fewer airlines--not better service, lower prices, or higher profits

As the top two gorillas in the airline industry, American Airlines Inc. and United Airlines Inc. have a long-running rivalry. When American sought government approval a year ago to fly from Chicago to Shanghai, United demanded and won the route instead. When United expanded legroom in the first few rows of coach seats for high-paying passengers, American struck back last year by offering more room throughout the cabin. That's pretty much the way it goes with these two: jab and counter-jab.

But American's stunning reaction to United's proposed merger with US Airways Group Inc. is something else altogether. In a deal announced on Jan. 10, the two airlines are essentially cooperating to carve up US Airways as well as critical East Coast markets. They'll even jointly operate the New York-Boston-Washington shuttle, splitting the flights 50-50. To worried consumers and lawmakers, it has all the look and feel of collusion. "You have to worry about the degree of cooperation between American and United. Just think what they had to talk about to do this transaction," says Harvard University law professor Andrew Gavil.

And that's not all. American is planning to snatch what's left of No. 8 Trans World Airlines after its bankruptcy filing, which occurred on the same day the American-United deal was announced. When all is said and done, the deals will eliminate two of the 10 majors now flying the U.S. skies and give both American and United rough parity--about 25% of the market each. That dominance is likely to set off another round of dealmaking by rivals, including No. 3 Delta, which lags behind with about 18% of the market. "Not reacting is not an option," says one rival executive. Ultimately, three big carriers could control nearly 85% of U.S. air traffic.

SHREWD MOVE. There's little doubt that the megadeal is good for American and United. And ailing TWA and its 20,000 jobs might otherwise disappear. Indeed, American's multi-pronged deal looks like a clever move in its race to keep up with United. The $5 billion it expects to pay, including assumed leases, looks like a bargain in comparison to United's $11.6 billion marriage with US Airways and the $14 billion that Northwest Airlines was demanding in its merger talks with American. Moreover, American can easily handle the $1.8 billion in cash required for both TWA and the United deals. "It's a well-thought-out plan," says one rival.

But can any of this be good for the flying public, including the huge corporate travel accounts for which the two will be vying? Already, worried consumer advocates and their allies in Congress are decrying the loss of competition that's likely to result. But American Airlines CEO Donald J. Carty touts the benefits for customers of an expanded network with more destinations for frequent fliers and big corporate customers seeking to do deals with a single carrier. Economist Steven A. Morrison of Northeastern University says American and TWA overlap on only 4% of their passenger miles, while United and US Airways overlap on just 5.4% of their passenger miles. "What's driving this consolidation is expanding networks, not eliminating competitors," insists Carty.

Many see consolidation as the natural outgrowth of an industry still struggling to reach a steady altitude after deregulating in 1978. For all the outcry from travelers about high fares and poor service, this capital-intensive, labor-sensitive industry is still trying to prove to skeptical investors that it can sustain profits and not lose billions in an economic downturn, as it did in the early 1990s. The revenue that airlines collect per passenger-mile is down 18% since 1990, says economist Morrison.

Still, it's far from clear that consolidation will create a more profitable industry. Nor is it likely to improve service much or lower prices. Removing a player like TWA, which often sells tickets below cost just to get desperately needed cash, will certainly help stabilize the industry. And positioning for the day of global consolidation among airlines may prove to be smart for American and United, says Thomas I. Barkin, co-head of McKinsey & Co.'s airline practice.

LITTLE CHEERING. But in the near term, Barkin expects labor, aircraft makers, and others to siphon off whatever economic value might be created. "You have an industry that consumers and the government are convinced is out there pillaging the consumer, but that shareholders are convinced will never return any value," he says. It's no surprise, then, that American's stock is down about 12% since details of its deals first leaked out, while United's stock is off 7% in the same period.

If shareholders see no reason to cheer, neither do most consumers. While airline execs and analysts argue that route-by-route competition will be little diminished by the deals, there's widespread fear of the ways that the industry's two giants might use their newfound clout. Fewer players might better control capacity, and thus the availability of discounted fares. And eliminating two competitors means fare increases could stick more readily. "It only takes one large airline to shoot down an increase," says analyst Philip Baggaley of Standard & Poor's.

In a survey last June of its business members, the National Business Travel Assn. found that 96% believed consolidation could make it more difficult to negotiate deals with the big airlines, while 82% said it would mean fewer choices and higher fares. "The business market is divided into two sets: those that are large enough to have substantial corporate deals and those that aren't," says Rustin I. Carpenter, a vice-president at American Express Consulting. And even for the largest, he adds, "I haven't seen the size of the networks improve service yet."

On the contrary: If these deals pass muster with antitrust regulators, many expect service to get worse, at least in the short term, as both United and American grapple with integrating new employees and fleets. Consider Carty's own efforts to integrate tiny Reno Air in 1998, which sparked a 10-day sickout by pilots and $200 million in losses. "I'm very concerned about what would happen during a labor stoppage on an airline that big," says Ed Perkins, consumer advocate for the American Society of Travel Agents.

Consolidation also threatens to keep smaller rivals from competing effectively. David G. Neeleman, CEO of low-fare JetBlue Airways Corp. in New York, which offers such amenities as free TV and leather seats on new planes, worries that ever-bigger carriers will be able to use profits from the routes where competition is limited to subsidize the cost of rubbing out upstarts like his. And Samuel D. Addoms, CEO of Frontier Airlines Inc. in Denver, predicts the bigger carriers will have more clout with corporate discounts and travel-agent bonuses for steering traffic their way: "When you aggregate that much more power, you are vulnerable to them using it."

There are still plenty of hurdles to overcome before that threat becomes reality. American's play for TWA must wend its way through bankruptcy court, where other players--including former TWA owner Carl C. Icahn--could make trouble (story, below). And the Justice Dept., facing growing political opposition to airline consolidation, must sign off on United's and American's acquisitions.

But even if it takes months of analysis to satisfy Congress, many experts expect the deals to pass muster with antitrust watchdogs. One area likely to receive close scrutiny: United's latest deal gives American a marketing alliance and 49% of a new entity to be created at Ronald Reagan National Airport, where US Airways is now the leading carrier, with 33% of the traffic. That should create a stronger competitor for United, which has a hub at Washington's Dulles International Airport. Previously, DC Air, owned by entrepreneur Robert L. Johnson, was dependent on United for planes and crews, ensuring United's domination of the region's airports. Now DC Air's planes and crews will come from American. But how aggressively the two giants duke it out over the market remains to be seen.

In the end, successfully integrating and operating an entity with nearly 40% more aircraft could prove daunting for an airline that has suffered plenty of glitches in recent years. American service in recent times has been mediocre at best. United has had its own slew of service and labor problems. Hardly the best foundation for building two new supercarriers.

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