Air Industry Faces Uncertain Future After Surprise DOJ Move On AA-US Airways - Business Travel News

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Air Industry Faces Uncertain Future After Surprise DOJ Move On AA-US Airways

August 14, 2013 - 12:25 PM ET

By David Jonas

"We did not expect this." That was the initial reaction by Jamie Baker and crew at J.P. Morgan's North America Corporate research team yesterday following news of the U.S. government's decision to file suit against the planned American Airlines-US Airways merger. It is a sentiment shared by many. The prevailing wisdom had been that the last piece of the U.S. air industry consolidation puzzle nearly was in place, and if there were any additional hurdles to overcome, they would come in the form of specific concessions demanded by regulators. Instead, the U.S. Department of Justice's Antitrust Division said it is bent on achieving a "full-stop injunction."

This development is bad news for American, which seemingly had a clear path to emerge from bankruptcy, for US Airways, which had built its future on the merger, and possibly for the U.S. airline industry at large.

"The industry's longer-term earnings prospects are jeopardized by a standalone AMR business plan that must grow its way (rather than merge its way) to competitive network parity with post-merger Delta and United," according to the J.P. Morgan analysts.

According to Fitch Ratings, improvement in airline credit rating profiles during the past several years had been "driven by a more sustainable industry structure, with a smaller number of stronger carriers benefiting from disciplined capacity management practices, higher passenger yields and better revenue fundamentals. The DOJ complaint, which specifically identifies potential injury to consumers resulting from reduced competition and higher fares, may indicate that further consolidation-related improvements in airline operating profiles may not be achieved, at least in the near term."

Morgan Stanley analysts in a Wednesday research note wrote that DOJ's move "is unequivocally an incremental negative vis-à-vis our attractive industry view." They also noted that Delta and United "would have a duopoly on corporate travel, superior networks and more valuable frequent-flyer programs."

Without doubt, AA as a standalone entity would be challenged to maintain effective competition against its adversaries, but the impact on its larger rivals, or any others, could be mixed.

"Capacity is likely to move higher, in our view, diminishing margins along the way, while service levels are less likely to improve should carriers fail to generate adequate returns and reinvest in the business," according to J.P. Morgan analysts. "A network duopoly (Delta and United) where US Airways and American increasingly need to fight for share is less desirable than a fair and oligopolized industry (American, Delta and United in roughly equal portions). We believe three is better than two, though clearly our views are at odds with the DOJ."

They added that a scenario in which AA is forced to grow capacity to reach parity with Delta and United "is likely to slow the industry healing process from here, and potentially cause earnings in 2015 and beyond to come under pressure should supply trends worsen. ... While competitor managements will very likely try to assuage investors that they intend to remain disciplined when confronted with a potentially growth-oriented AMR, we have our own doubts."

How Did We Get Here? 

DOJ said it had been scrutinizing the proposed merger for six months.

Bill Baer, assistant attorney general for DOJ's Antitrust Division, during a Tuesday media briefing said, "The parties told us that they wanted us to make a decision before Aug. 15," which is when the court overseeing AMR's bankruptcy would have held a hearing on the plan of reorganization, of course centered on the US Airways merger.

Though DOJ didn't move to prevent mergers between Delta and Northwest, United and Continental, and Southwest and AirTran, it did oppose combinations proposed around the turn of the century: United-US Airways (at least initially, before suggesting remedies) and Northwest-Continental. Baer also noted that DOJ "looked very seriously at US Airways' [2006] hostile bid for Delta before that was abandoned."

"So it's not the first time," he said, adding that "we learned during our investigations about what happened to competition from prior acquisitions."

But observers quickly picked up on how DOJ this time around expanded its arguments. "DOJ has significantly altered its usual M&A analysis to introduce connecting markets and baggage fees into its calculus," according to J.P Morgan analysts. "Granted, connecting competition has been considered in prior regulatory reviews, but in each case the incremental citypair connectivity and improved customer service levels have overshadowed any potential loss of competition in seemingly obscure connecting markets." They concluded that "the rules of engagement appear to have been altered."

DOJ's complaint detailed its competitive concerns about a long list of connecting markets, and Baer on Tuesday also addressed the issue of ancillary fees.

"If the merger goes forward, consumers can also expect to pay higher fees for things like checked bags, flight changes, more legroom and frequent-flyer benefits," he said. For example, "today, American does not charge if you redeem frequent-flyer miles. US Airways charges an average of $40. If the merger is allowed, US Airways is planning to take this frequent-flyer benefit away and make American's frequent flyers pay redemption fees. By eliminating this competitive distinction between American and US Airways, the new airline generates an additional $120 million in revenue. But you pay the price."

What's Next? 

In short, months of litigation. Even if a compromise is hammered out, the intended timing of both AA's emergence from Chapter 11 reorganization and its planned merger with US Airways has been thrown out the window.

But a compromise appears unlikely.

"The scale of the complaint, identifying potential harm to U.S. consumers broadly rather than in specific markets, as seen in the 2010 merger between United and Continental, suggests that changes in the merger plan's scale and scope may not be sufficient to win approval," according to Fitch.

Given the government's expanded focus, including fees and connecting markets, J.P. Morgan analysts wrote that "it is hard for us to envision a meaningful regulatory appeasement that US Airways-American could offer. That isn't to say it can't happen, but the challenges appear formidable and the airlines might not even try." They added that assessing the airlines' chances in court is "difficult," though they are "cautiously optimistic."

If the case goes to trial, it will be heard by Judge Colleen Kollar-Kotelly of the U.S. District Court for the District of Columbia. According to that court, Kollar-Kotelly was appointed in May 1997.

Circling The Wagons 

Meanwhile, the expected volleys of both support for and opposition to the DOJ move came in rapid-fire fashion following the news.

In a letter to employees, AA CEO Tom Horton wrote that "we have maintained that the merger is complementary (only 12 overlapping routes), that it provides significant customer benefits and that it enhances competition in the airline industry. Since the DOJ has formed a contrary view, the matter will now be settled by the courts. In the meantime, American and US Airways will continue to operate as independent companies and competitors. All recent leadership announcements for the new merged American will be on hold until such time as the merger receives final clearance."

In a message to his company's employees, US Airways CEO Doug Parker wrote that "we are extremely disappointed in this action and believe the DOJ is wrong in its assessment. We will fight them. Other companies have found themselves in similar circumstances and gone on to successfully close their merger. In light of today's announcement, the companies no longer expect the merger to close during the third quarter of 2013. However, we are hopeful that the litigation will be successfully concluded and we will close the merger before year-end."

Representing AA's flight attendants, the Association of Professional Flight Attendants blasted DOJ's decision, say its actions "are only serving to prop up the duopoly they created. ... Following major mergers of their own, Delta and United have emerged as the dominant carriers in the aviation industry and their vast networks have attracted the high-value business travelers airlines need in order to be profitable. Frequent flyers have left American in droves in favor of carriers with more routes and destinations. The American/US Airways merger will give these travelers a viable third option."

Similarly, the Allied Pilots Association, representing AA's pilots, expressed disappointment. "Consolidation has enabled our industry to stabilize after a round of Chapter 11 bankruptcies that were the result of various exogenous shocks, including terrorist attacks, fuel price spikes and pandemics," according to APA president Capt. Keith Wilson. "It makes no sense for the Justice Department to conclude now that airline industry consolidation is somehow undesirable."

On the flip side, the Business Travel Coalition conveyed support for the antitrust lawsuit. "DOJ shines a spotlight on how uncompetitive and cozy U.S. airlines have become," according to a statement from BTC chairman Kevin Mitchell. 

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