Why United Is Ready to Unite

The airline is struggling. But finding another carrier willing to cement a merger may be problematic

When news broke in mid-November that New York hedge fund Pardus Capital Management was pushing United Airlines (UAUA) and Delta Air Lines (DAL)—two carriers in which it's a big investor— to consider a merger, Delta Chief Executive Richard Anderson quickly dampened expectations of any deal. That United CEO Glenn F. Tilton didn't step up to discourage such talk wasn't surprising, because no other airline executive probably has more of an urge to merge right now. "He's been perfuming United for sale" ever since it emerged from bankruptcy, says industry consultant Michael Boyd.

United and its parent, UAL, are in a real jam. And a sale may be the best option for the iconic airline, which, under the ownership of aviation pioneer William Boeing, flew the first commercial flights, in 1930. United, like many other carriers, filed for bankruptcy after the 2001 terrorist attacks. But it missed a major opportunity in Chapter 11 to remake itself into an airline that could compete with both low-cost carriers at home and foreign airlines abroad, industry experts say.

United emerged from bankruptcy in early 2006, yet it is saddled with relatively high debt, and its profit margin, 2% over the last 12 months, remains one of the thinnest in the industry, not even half US Airways Group's (LCC) 4.4% or Southwest Airlines' (LUV) 6.1%. "They didn't push as hard in bankruptcy to transform the business model, and they've been playing catch-up ever since," says Stuart A. Klaskin, an airline industry consultant in Coral Gables, Fla. "And it's clear that Tilton now believes a merger is the road home."

One sign of that is United's extended pause on fleet expansion. While other carriers have begun placing orders for new planes, the Chicago company says it plans to rely on its existing fleet of 460 jets until 2015 or 2016. By then the planes will be 20 years old, on average. While United executives say they're simply waiting until the next generation of fuel-efficient, narrow-body jets hits the market. Industry insiders believe Tilton (who wasn't available for comment) knows that loading up on pricey plane orders could lessen United's appeal to other carriers.

At the same time, Tilton is exploring asset sales that would lower United's debt and make it a more attractive partner. The $20 billion carrier is exploring the spin-off of its frequent-flier program, Mileage Plus, which Bear Stearns (BSC) analyst Frank Boroch calls "perhaps the most underappreciated asset at UAL," with a stand-alone value of $7.5 billion. That's 50% more than UAL's current market value.

It's also looking into the sale of a partial stake in its maintenance operations and perhaps its cargo business to private-equity investors. That would raise billions of dollars in cash, strip down United to its core assets—planes and routes—and make it more enticing to a suitor. Even if no buyer emerges, Tilton could still deliver investors a return comparable to a buyout. Some Street analysts believe that UAL shares, now trading at around 38, would be worth 80 after all the spin-offs, and 90 in a buyout. "I think Tilton is determined to make sure United isn't left standing on the street corner," notes Robert W. Mann, an airline consultant in Port Washington, N.Y. "If he can't sell off the airline whole, he can do it in pieces."

But it isn't clear who will dance with United. Despite the rationale from Pardus that a marriage between Delta and United could generate the biggest cost savings of any partnership, Delta doesn't seem interested in its Chicago rival. Industry insiders believe the natural fit for Delta is with Northwest Airlines (NWA). The two carriers already finish some connecting routes for each other, belong to the same international alliance, and have complementary route structures. Northwest is strong in the Midwest and Asia, while Delta is a power in the East, Europe, and Latin America.

Delta CEO Richard Anderson previously served in the same post at Northwest and is remembered fondly by unions there. "My betting is on a Delta-Northwest deal," says Ray Neidl, a veteran airline analyst at New York's Calyon Securities USA.

With a Delta deal uncertain at best, Tilton has looked elsewhere. Industry sources say United last year approached Continental Airlines (CAL), but the Houston carrier took a pass. Northwest isn't an option, given the overlap on both carriers' Midwestern routes. A tie-up between American and United, the No. 1 and No. 2 carriers, respectively, would never pass muster with regulators. That leaves US Airways, whose ambitious young CEO, Douglas Parker, is struggling to prove he can integrate his 2005 merger with America West Airways.

To make a United merger doable, Tilton may have to first broker peace with his employees, who are still seething over the sharp pay cuts forced on them in bankruptcy. Flight attendants, now getting 1985 pay levels, want more money. "You can't run a service business when you're at war with your employees," warns Greg Davidowitch, president of the Association of Flight Attendants at United. Nor is such workplace strife a big selling point for potential United merger partners.

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