Continental and United - A Merger of Equals?

The proposed merger of Continental and United announced on May 3rd came as a surprise to nobody in the airline industry. Since Continental indicated its intention to join Star Alliance, it was all but inevitable that these two carriers would merge. In fact, Gordon Bethune published an article stating that these two carriers should merge - as long as Continental's management was allowed to run the airline.

This last point is the key, because if you look at the merger from the logo (Continental's) to the makeup of it's management team (Continental's CEO), one would think that the only thing that is United is the name. While that is certainly far from true, what is true is that this merger is one of necessity for both carriers. The reality that is now the mega-Delta, with a strong transatlantic alliance with Air France/KLM, Star Alliance found themselves in a weakened position absent some kind of US alliance of their own. Continental and United makes the most amount of sense for a number of reasons, but the concept of a "Merger of Equals" from a number of different perspectives simply isn't accurate.

What is accurate is the following:

1. It will arguably be the most balanced of the US airline mergers in terms of regions served, mix of domestic and international flying and hub geography. Approximately 40% of United and 50% of Continental's capacity is deployed on international routes. The carriers share very few direct routes and are not significant competitors at any congested airport hubs.
2. While United has 56% of the operating revenues of the two airlines, it lost $15M more than Continental in operating loss, but worse, its' net loss was nearly 2.3 times that of Continental (-$651M vs. -$282M).
3. In looking at RASM/CASM for the two carriers, UA had 114.2M RASM on a CASM of 140.7M (-18.9% Unit Margin), CO had 89.1M RASM on 109.6 CASM (-18.7% Unit Margin); CO is slightly better than UA on unit margin.
4. Neither airline is growing domestically. UA's ASM's dropped 10.4% last year, after declining 7.8% in 2008 and 3.3% in 2007. Mainline revenue attributed to its domestic operation totaled $7.7B in 2009, down from $9.7B in 2008 and $10.9B in 2007, although much of that can be attributed to the recession. Continental's domestic ASM rose 4.5% in 2007, but fell by an equal amount the following year and a further 6.5% in 2009 as the economy continued to fall.
5. United's strength lies in its Pacific network with its hub operation at Narita and its rights to operate point to point beyond Narita into Asia. CO's Pacific operation is not large, but its Micronesia operation based in Guam provides extensive service to nine Japanese cities and extensive service in the western Pacific, more than any other US carrier.
6. In the Atlantic, UA's operation is not as large as one might believe, as LH and other Star carriers have carried the UA code on its own aircraft. UA serves 13 destinations on its own where as CO operates 33 transatlantic routes; 29 of them from Newark.
7. In South America, UA has a small presence, whereas CO has a much larger network, serving 30 Latin American and Caribbean destinations from Newark; a network that pales in comparison to its Latin American operations at Houston, in which CO serves 29 cities in Mexico plus 10 Central America cities, six in the Caribbean and seven in South America.
8. The big difference is in the mixture of the fleets. CO operates 737-500s and variants of the 737NG, 757-200/300, 767-200/400, 777-200ERs, with a large number of 787's coming starting next year. UA has a large number of A319/320s, 757-200s, 747-400s, 767-300s, 777-200/200ERs, with orders for 787s and A350s for arrival in 2016. While CO has the smaller fleet, it also has a more efficient fleet, all Boeing and very little crossover between aircraft and great commonality in the 737/757/767 and 777 fleets. UA's fleet costs are higher as a result of the larger number of variants, an older fleet (16.9 years vs. 9+ for CO) and significant costs in upgrades to their product, which must be updated for competitiveness, adding to UA's overall fleet costs.
9. Another significant difference is the regional fleets and the SCOPE clauses for each airline, which are a greater problem at CO than at UA. The fact that both carriers are represented by ALPA may be a help, but the consolidation of the fleet will cause some issues in pilot contract integration as will the issue of the SCOPE clause at CO, which is far more restrictive than UA's contract.

Each carrier has it's strengths and weaknesses; however, one significant strength that will come from this merger is the CO philosophy of "Working Together" which has been inbread into the management philosophy ever since Gordon Bethune sat in the CEO chair. A significant aspect of this is sizeable profit sharing for employees which is a very large carrot for improving efficiencies and customer service.

While Glen Tilton will be Chairman, he will be an "Executive Chairman" a figurehead position which he will hold for a short time, then Jeff Smisek will take his place as Chairman and CEO. While integration of the UA/CO management teams will be an interesting exercise, I expect COs management to take a much larger role in the day to day management of the airline. I also expect some really talented people at UA to join their team, which will make them a much stronger competitor in the end than some may anticipate.

For the average passenger, it's a net positive. If CO is successful, it will take the best parts of United's product and integrate it into its own very successful and popular onboard product. What will change? If we take a crystal ball and peer into the future, this is what we might see:

1. United has already announced the retirement of the 747-400 fleet. This will very likely be speeded up as the CO fleet and UA fleets are rationalized. If CO does get their 787-8s on schedule next year, then as they get them, expect those aircraft to replace the 777-200s on the ultra long haul routes and the 777-200s to be redeployed on the higher density routes. United's 767-300s will be combined with CO's 767-200s and will make up the bulk of the aircraft flying the longer Atlantic routes with CO's 757s operating the shorter routes across the Atlantic and possibly from Chicago (using UA's ps aircraft which could make ORD-LHR with lower density higher yielding traffic a real possibility).
2. The Airbus A350 order will most likely be cancelled in favor of additional Boeing 787/Boeing 777-200LR/300ER aircraft. UA will be able to get these aircraft into their fleet earlier than the A350 and allow them to speed up the retirement of the 747-400 which will provide them additional CASM savings on the Australia/South America high density routes.
3. CO's 737-500s will be retired and eventually, the UA A319/320s, as the cost of operating these aircraft in a mixed manufacturer fleet are going to be higher than COs single manufacturer deal with Boeing for which it receives considerable savings.
4. In terms of product, Economy Plus will be expanded to the CO aircraft and the CO Business First product will likely become the product expanded to the entire fleet over time. Whether a First Class product will remain will be an open question; one based on the number of passengers actually paying for the product vs. those upgrading from Business Class. It is most definitely not required across the Atlantic; but across the Pacific their might be a need for an F cabin based on the long stage lengths; although carriers such as Air New Zealand, Air Canada and others are doing just fine without an F cabin, so it may remain to be seen if BusinessFirst becomes the ultimate premium product for United. In many ways, it makes good sense; a solid premium product in the front and an Economy Plus product at a reasonable upgrade cost for the Economy passenger may just be the ticket; with other carriers installing a Premium Economy cabin (and charging considerably more for it than Economy), this might be just the carrot to pull the passenger away from those carriers that have it.

In any case, the upcoming merger of CO and UA (which will get approved by the DOT/DOJ without too many concessions) will be a strong competitor to Delta and SkyTeam. The question now is what will American do without a US carrier with whom to merge. It is approaching British Airways and with the expanded US/UK/EU treaty allowing greater foreign ownership of a US carrier, the chances that an AA/BA deal could occur. Should that occur, then watch out for other foreign carriers (Lufthansa in particular) get into the US market in a much greater way than just their deal with jetBlue). Of course, the jetBlue deal will have an impact on CO/UA (they may get UA's Airbuses for example), but expect LH to have a say in how the CO/UA deal comes together, as, after all, they are the Star Alliance powerhouse in Europe, with Swiss, LH Italia and potentially SAS under their wing before long.

One thing is certain: The US airline landscape is certainly changing in favor of consolidation, but greater than that, we are seeing two levels of airline product developing in this country: The LCC point to point model and the network/alliance carrier model providing a higher level of product and service (with a commensurately higher price). How these carriers will complement and compete with each other will be an interesting experiment to watch unfold.

Data and analysis: Courtesy ATW June 2010.