Another round of airline industry consolidation may be in the works now that the nation's carriers, prompted by losses of $40 billion during the last five years, are completing a cycle of major changes in their operating models.

Three and a half years ago, US Airways, now part of the new US Airways Group ( LCC), became the first major airline to seek bankruptcy protection after the Sept. 11, 2001, terrorist attacks.

Since then, airlines have sliced billions in costs as three of the six legacy carriers and a half-dozen smaller ones have followed US Airways into Chapter 11. US Airways itself even made a second visit.

Salaries have fallen dramatically, systems have been modernized, inefficient airplanes have been stripped from fleets, and lease rates have been reduced. Now, experts agree, many of the cost excesses of a once-regulated industry have been pared, and a round of industry consolidation is looming.

In particular, the two legacy carriers still in bankruptcy, Delta Air Lines ( DALRQ) and Northwest Airlines ( NWACQ), one day could be involved in mergers.

As for establishing new operating models, the industry is closer to where it needs to be, said David Banmiller, the CEO of Aloha Airlines, which emerged from bankruptcy in February.

"Look at the Federal Aviation Administration's projected growth rate, the high load factors, the pullback in capacity and the orders for new airplanes, and I'd say we are maybe reaching equilibrium," he said. "The last few years have flushed out a lot of costs."

Long Legacies

The number of airline passengers is expected to reach 1 billion in 2015, based on annual growth of about 3.2% in domestic passengers and about 5% for international passengers, the FAA predicts.

Jon Ornstein, CEO of Mesa Air Group ( MESA), said the industry is near the end of a cycle in which high fuel costs and intense competition forced a series of bankruptcies.

Carriers have "managed to fix themselves through the bankruptcy process," he said. "The market has a remarkable way of correcting inefficiencies, because start-up carriers like AirTran ( AAI) and JetBlue ( JBLU) have clearly forced everyone to adapt to market-rate cost structures."

The number of legacy carriers will likely continue to decline. Standard & Poor's airline analyst Philip Baggaley said he expects a round of mergers involving Delta, Northwest and Continental Airlines ( CAL), the third-, fourth- and fifth-largest carriers.

"There's a particular window of opportunity because in some ways it's easier to acquire a bankrupt airline," Baggaley said. "You can make changes in the cost structure of the aircraft fleet and in the size of the network, things that would be harder to do outside of bankruptcy. So we may see some movement in the next year or two."

As the legacy carriers shift more and more of their emphasis to international flying, consultant Robert Mann said their number could be reduced to three, matching the number of global aviation alliances.

The majors "want to believe that being one of six network majors represents a continuing opportunity to grow, but I'm not sure it does," Mann said. "With three global alliances, there is room for three or maybe four majors, but not six."

Imagining the two biggest airline companies, American Airlines' parent AMR ( AMR) and United Air Lines' owner UAL ( UAUA), as acquirers in any merger scenario isn't difficult. Both are already affiliated with strong global alliances. And in 2000, after United bid unsuccessfully to acquire US Airways, American responded by buying TWA.

At the JP Morgan aviation conference in February, Beverly Goulet, American's treasurer and vice president of corporate development, said: "Northwest has a very extensive Pacific network, and that's obviously something people presume that AMR might have an interest in." She said that American knows the "challenges inherent in undertaking something like that."

During the same conference, UAL Chief Executive Glenn Tilton, who oversees the second-largest carrier in United, was a strong advocate for shrinking the industry.

"Consolidation is going to take place in the sector, and consolidation should take place in the sector," Tilton said, adding that United would expect to participate. "One thing this company won't do is sit by idly and watch the consolidation take place."

While the number of major airlines has declined since deregulation, with Braniff, Eastern, Pan Am and TWA having disappeared, the U.S. is still awash in carriers. The country has 130 of them, ranging in size from American Airlines, the biggest carrier, to small air taxis, according to the Transportation Department.

Still, comparable regions generally have more. China has about 200 airlines, Banmiller said. Aviation consultant Dan Kasper of the firm LECG in Cambridge, Mass., said the European Union, roughly the same in population and geographic scope to the U.S., has more because most of the 25 member countries are home to a number of national carriers.

More With Less

Reducing the number of U.S. airlines might help the industry's financial health, Baggaley noted, but "the flip side is that a more concentrated industry might lead to higher fares, which from a passenger perspective might not be good." Additionally, significant job losses would result from the shutdown of a major airline.

Joe Leonard, CEO of AirTran, told the JP Morgan conference that he expects mergers to take place, though more likely in 2007 or 2008 than this year. Leonard spoke of a new model, one in which legacy carriers cede much of their domestic flying to lower-cost domestic partners such as AirTran.

"I think that's a good (role) for us to play," Leonard said. "I'm not sure that will happen this cycle (but) these legacy carriers will not be everything to everybody."

The most recent merger in the airline industry was a hybrid creation in which low-fare, low-cost carrier America West Airlines took over management of legacy carrier US Airways. In the past, legacy carriers have taken over lower-cost carriers, including the California carriers AirCal, Western and PSA, but haven't retained their lower-cost advantages.

"Maybe US Airways CEO Doug Parker seized upon a new consolidation model, one that creates value," consultant Mann said. "If people believe in that, they may look to recreate it using other pieces such as Delta or Northwest."

While merger talk permeates the airline industry, the capacity reduction created by a merger would most likely be short-lived.

"People in the industry believe that if you get rid of a couple of airlines, you would get rid of capacity and give those who remain more pricing power," Kasper said. "But the evidence doesn't support the theory. In the short term you would have a situation where prices would go up if a carrier went away, but that capacity isn't going to disappear. Just look at the order books. Southwest ( LUV) has 300 planes on order, JetBlue has over 100 and AirTran has 60."

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