The Deal: The Trouble With Being United

NEW YORK ( The Deal) -- This time was supposed to be different.

Airlines have a long history of dealmaking, and through most of that history things have not gone well. The past is riddled with companies that were unable to hit cruising altitude because of the excess baggage taken on via mergers.

But those rough trips have done little to temper the urge to merge. And despite the past a chorus of survivors promising they have learned from their mistakes has provided investors with enough confidence to whole-heartedly endorse an ongoing round of consolidation.

Alas, the 2010 merger of UAL Corp.'s United Airlines Inc. and Continental Airlines Inc. could call into question how much has really been learned. The deal provided the combined United Continental Holdings Inc. ( UAL) a substantial portfolio of assets, combining United's strengths across the Atlantic and Pacific oceans and its Midwest and western strongholds with Continental's substantial South American reach and lucrative Newark, N,J., hub.

The resulting company is far from a failure. But United Continental to date has struggled with post-deal turbulence that has resulted in a share price that lags gains made by rivals. Its issues double as a warning for would-be merger partners AMR Corp. ( AAMRQ) and US Airways Group Inc. ( LCC), who are seeking regulatory clearance to complete a deal that would see them dethrone United Continental as the world's largest carrier.

This has been a boom time for so-called legacy U.S. airlines, sparked by a 10-year period of, first, reorganizations and, more recently, M&A that has improved balance sheets, cut costs and eased competitive pressures. The industry, according to LLC, generated a cumulative profit of $2.5 billion on sales of $37 billion during the second quarter of 2013, producing a cumulative profit margin of 6.6%.

AirlineFinancials says you have to go back to 2000 to find a higher second-quarter profit margin.

But the news was not universally positive. While Delta Air Lines Inc. ( DAL) and US Airways were having record second-quarter profits and others were setting new highs in sales, United's numbers lagged. United reported a 5.2% margin in the quarter compared to margins of 8.7% at Delta and 8.4% from US Airways.

United, according to AirlineFinancials, was also the only airline to see year-over-year decreases in passenger revenue, and has the highest net debt to operating revenue among its peers. Shares of United Continental reflect muted optimism. The stock is up 24% since the Oct. 1, 2010, deal closing date, compared to a 64% rise for Delta and a 72% jump for US Airways.

Though United has largely been able to keep pace with analyst expectations, it has done so in part by gradually talking down guidance as the year goes on. JPMorgan analyst Jamie Baker noted after United's second-quarter results that the period was the airline's ninth consecutive quarter of year-over-year declines.

"Our concern remains that United has inadvertently stepped into the industry role once occupied by old AMR, that of perennial disappointment and relative underperformance," Baker wrote.

United's issues, analysts say, boil down to operations. Though United was the surviving entity, Continental's management, which was highly regarded prior to the transaction, took the captain's seat post-deal. They brought along Continental's information technology and systems and have experienced hiccups trying to bring the larger United onto their platform, with at least two high-profile reservation system failures since the deal closed causing widespread delays.

The team also inherited a generation of poor labor relations on the United side, and has tried to use higher wage rates to make peace. Raymond James & Associates managing director James D. Parker in a recent note focused on nonfuel costs, which were up 7% year-over-year in the second quarter, driven by higher wages, greater depreciation and high maintenance expenses.

New labor contracts that went into effect at the airline in 2013 include a 40% to 61% cumulative wage rate increase, Parker said, including a step up of at least 18% in the first year. And there is still significant work to be done: United finally made peace with its pilots late last year, but major groups are still without post-deal joint labor agreements covering both legacy United and Continental employees.

As recently as April United fleet service, passenger service and storekeeper employees rejected a tentative agreement reached between the International Association of Machinists and Aerospace Workers and airline management. The discord is making it difficult for the company to reap the benefits of combining the two route networks.

"Until United resolves their ongoing labor issues from the 2010 merger with Continental, they will continue to struggle both operationally and financially," AirlineFinancials founder Robert Herbst said.

United chairman and CEO Jeff A. Smisek on a July call with investors admitted the company is not satisfied with its results, but said he believes his airline has turned a corner and he is "excited about the direction where we're going." He also issued a warning to American and US Airways as they prepare to join forces.

"Look, going through these mergers is tough," Smisek said. "It happened to our friends earlier when they first merged, and I'm confident it'll happen to our friends in the next merger."

US Airways and American have more pressing issues to worry about, with the Department of Justice on Aug. 13 filing suit to block their $11 billion merger. But the companies and their advisers are insistent that they will either prevail in court or the case will be settled, and still hope to complete the deal by year's end.

Assuming they do get the merger past regulators, American and US Airways have a lot of work to do. Smisek is correct that there are many similarities between the United Continental deal and the pending merger. Management of US Airways, like their counterparts at Continental, will take the helm of the combined company despite coming from the smaller airline. And both management teams face the onerous challenge of placating disgruntled workers.

Tempe, Ariz.-based US Airways is no stranger to such challenges. The company, then called America West Holdings Corp., in 2005 bought the larger US Air out of bankruptcy and attempted to run the combination on America West's undersized platform, causing mishaps. America West, like United Continental, pushed labor integration off until after the deal was complete. And US Airways today -- some eight years after that deal closed -- is still operating under two separate pilot labor agreements dating back to before the merger.

US Airways CEO Doug Parker has been emphatic in saying that he has learned from the past, both his company's and United's. Parker and US Airways began courting American's dissatisfied labor groups nearly a year before the Valentine's Day 2013 deal announcement and have won the support of union leaders. The combination will also fold US Airways operations into American's more robust systems in hopes of avoiding overwhelming the technology and causing flight delays.

In total the airlines expect to spend $1.2 billion over three years to complete the integration.

Analysts say the pressure is higher on Parker than it was on Delta or United Continental because the new American is behind its two rivals. American can't afford system disruptions or to alienate customers with both Delta and United pressing hard to win corporate contracts.

"The success of this deal boils down to American's ability to hold on to existing customers, and that means having happy workers and functioning reservation systems and the like," one industry consultant who has worked with the deal partners said. "As we have seen in the past, including with United Continental, these are not simple tasks."

US Airways, echoing the industry's refrain, believes this time will be different. But as United Continental's Smisek can attest, merging two airlines is tough. Investors had better hope the companies are up to the challenge.

Written by Lou Whiteman.

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