Merger Odds Rising for Delta Air Lines

Feb. 6, 2006
Some experts say there has never been a better time to fix the ailing industry through a few careful matchups.

Feb. 5--Norman Mineta was just thinking out loud when the U.S. Transportation Secretary mused last month about a merger between Delta Air Lines and Northwest Airlines, his spokesmen say.

And Delta Chief Executive Gerald Grinstein says the ailing Atlanta carrier is not laying the groundwork for a merger with anybody.

Yet the idea that a merger may figure into Delta's deliverance from years of financial turmoil isn't likely to go away that easily.

Some experts say there has never been a better time to fix the ailing industry through a few careful matchups. Others argue the industry is too weak, or question where Delta fits into the picture. What most agree on, however, is that the airline industry is overdue for consolidation.

"The stars are lined up," said Richard Aboulafia, a longtime aviation consultant with the Teal Group in Fairfax, Va.

"I will be very surprised if there is not a proposal" this year for a large-scale merger, Air Transport Association economist John Heimlich said.

Merger odds are rising, they and others say, for a number of reasons. For one thing, last year's marriage of US Airways and America West offered a template that could be followed by airlines now in bankruptcy court. Beyond that, experts and executives have long felt the industry cannot support consistent profits at six or seven mega-carriers, all trying to add seats in hot markets and competing fiercely on price.

Simultaneous Chapter 11 filings by Delta and Northwest last September fostered rumors they might pair up -- an idea Mineta said he wondered about when asked about it at an industry conference.

Despite denials by his spokesmen, some think Mineta was signaling that the federal government's attitude toward airline mega-mergers -- the DOT killed a US Airways-United merger in 2000 -- might be easing.

"If the secretary of transportation is looking at [merger possibilities], I would certainly hope Delta management is looking at it," said Lee Moak, chairman of Delta's pilots union. He added that Mineta's comment "sent a message to me to be prepared."

The Delta union recently activated a merger preparation committee and hired legal advisers to prepare for various scenarios. Pilots also approved paycheck deductions aimed at raising $1 million to cover the union's financial and legal work should a merger occur.

"The bottom line is the analysts have been stating that consolidation is inevitable," said Moak.

Not everyone agrees, however, and over the years talk has been cheap when it comes to mergers.

Combinations aren't likely to heat up for at least a few years, until more airlines have become profitable, said Mike Miller, a partner with Velocity Group, an aviation consulting firm in Washington.

"As long as airlines are as weak as they are, I don't see any mergers in the next two years," he said.

At the same time, he said, Delta could become a takeover target before then if its court-supervised reorganization starts to fall apart, as US Airways' nearly did. America West bought US Airways last year when many were predicting that the foundering airline wouldn't survive its second trip through bankruptcy.

The combined carrier will fly under the US Airways banner, although it still has the different brands for now. America West won $565 million in backing from private investors who were drawn to the idea of a combined carrier that married the buyer's western U.S. network with US Airways' brand recognition, its East Coast strength and its post-Chapter 11 cost structure.

America West's shareholders, US Airways' creditors and a federal agency that previously guaranteed loans to both carriers also have large stakes.

American or Continental could likewise finance acquisitions of financially weakened rivals with backing from hedge funds or other investors, say some industry people.

Eventually, Miller said, "someone is going to like you as a takeover target if you don't right the ship." It's still too early to tell what the outcome of Delta's restructuring efforts will be, he said.

Delta CEO Grinstein is among those who've long predicted the industry will shrink to two or three major network carriers, but he said Delta plans to remain independent.

In a recent interview, he sought to knock down the idea that Delta sees a merger as a bankruptcy exit strategy.

"If you were going to merge, this would be the time to lay the groundwork for it, because you'd shape your fleet to add somebody else's," Grinstein said. "We aren't doing that. We want to create as independent a company as we possibly can, and then have the strength to decide what we're going to do if there's going to be consolidation."

He predicted big mergers will be "beyond '07."

Airline mergers have long made "tremendous intellectual sense," according to CreditSights analyst Roger King. The number of traditional hub-and-spoke airlines needs to shrink, he said, because "too many airlines and too many hubs generate too much overhead for the current fare levels."

But big airline deals have often faltered in the past either because of political opposition, as happened with the proposed United-US Airways proposal, or because huge operational issues tripped them up, such as combining aircraft fleets and work forces with differing wages, work rules and unions.

Delta and Continental tiptoed to the brink of a merger in 1998, but Continental opted for a marketing alliance with Northwest, in part because of labor issues.

Government opposition to big airline mergers seems to be softening, said King. But the "real door buster," he added, is the bankruptcy process.

He and other experts say the industry's biggest players now can use Chapter 11 cases to slash costs, attract capital, prune fleets and simplify issues such as combining union work forces.

In bankruptcy court, Delta and Northwest have sought concessions from union employees, aircraft lessors, bondholders and suppliers. They are widely expected to seek to terminate their underfunded pension plans, as United and US Airways did, although both say no decision on that has been made.

The merger of America West and US Airways has provided a precedent for how to combine bankruptcy and merger strategies, said Aboulafia. The melding of US Airways' Chapter 11 and America West's merger deal allowed the would-be partners to retool lease, supplier, union and finance contracts and reap nearly $2 billion in cash infusions from investors, suppliers and asset sales.

"With bankruptcy, the good news is you can cut costs and merge. That is to say, you don't have to explain yourself to unions and equipment lessors," said Aboulafia. "Thanks to bankruptcy, you can make things happen while merging."

But while the current spate of bankruptcies may help usher in a wave of mergers, airline analysts disagree on the specifics of who might be involved in those deals.

King said his favorite potential merger is between Delta and United, which just emerged from three years in Chapter 11. That would combine their massive Chicago and Atlanta hubs and United's Asian routes with Delta's European destinations. But he thinks the marriage would be so huge that federal regulators still would probably block it on antitrust concerns.

United could also look at Continental, which has a strong European and Latin American network, in a deal that might pass antitrust regulators, said King. Northwest's Asian route network, meanwhile, would make it an attractive target for American or Continental, he speculated.

A merger between Delta and Northwest, both in bankruptcy, is "fraught with too many legal uncertainties" to be likely, he said.

Miller agreed that Delta and Northwest "are so weak that they might become weaker" in a merger.

He said both Continental and Northwest have route networks that would fit well with Delta's, but neither is a likely merger partner anytime soon.

"They are the only two domestic carriers that would even look through Delta," he said. Delta's Atlanta hub and its reach in the Southeast are the "big prize," he said.

Continental is in better shape and is expected to report a profit next year. But "nobody wants to acquire a money-losing operation. Delta has to work on its internal issues first," said Miller.

He said Delta's revenue lags competitors' on the same routes, and it still needs to lower its labor costs, shrink its domestic operations and increase its international network.

Aboulafia has a different view.

"Delta and Northwest are the biggest potential," he said, calling a merger between the two carriers a "fantastic" strategy to exit from bankruptcy. "They would be a lot stronger together as they emerged from bankruptcy."

He doubts that Continental, on the other hand, would be interested in buying Delta. "Frankly, I'm not really sure that Continental would want the challenge. They're not all that bad off on their own."