Potential 2008 Merger: Delta and United

As the media has stated over and over in the past few weeks, Delta Air Lines is rumored to be a very important player in any eventual industry consolidation. And the two most mentioned partners for the carrier are United and Northwest (a scenario detailed in this earlier post). The Wall Street Journal has reported that Delta is seeking to enter formal merger talks soon with both United and Northwest, and the airline hopes to choose between the suitors in the near future. The United merger would create a very different carrier from the one it would create if Northwest were to merge with Delta, and I would argue that in fact, it would create a better company for investors, with a greater focus on business travelers and international expansion and fewer route and fleet synergies to resolve. For more information about the potential merger deals that could occur in the industry, see this post.

United has a lot to offer Delta, including an expanded international presence, especially in the Pacific Rim, as well as loyal legions of business travelers in key markets such as Washington DC, Chicago, and Los Angeles. United offers a very high standard of service (for a US carrier, that is) on international flights, and with international growth becoming increasingly important for carriers as a revenue generator, the competition on such routes will only increase. As a result, having top-notch service and great brand loyalty (which United probably has more than any other US carrier) will help ensure success.

Like with the Northwest merger, if Delta were to merge with United, it would force changes in the route networks of the combined carrier. All of United's hubs would probably be kept in one form or another. And that's a very bold statement, considering that United has five hubs scattered across the country. But all of these are simply too integral to the carrier, in markets that have a critical mass of business travelers, that they need to be kept, although some may be slightly downsized. United's San Francisco and Los Angeles hubs will likely be kept because of the amount of connecting traffic between the US and Asia as well as South America these generate. With large populations of travelers in both cities willing to pay a premium to fly to points in Asia nonstop, United has considerable pricing power. Some regional services from the two hubs, to various smaller markets in California and along the West Coast may be scrapped, but the vast majority of mainline United flights, especially international flights, will likely be kept. United's hubs in Chicago and Washington DC will also likely be kept, because in both those cities, United has great legions of business travelers, and in Washington, many government travelers who pay profitable prenegotiated fares.

Denver is a bit of a wild card because United has been hit really hart in the city with the pressures of Frontier's growth. Frontier offers very competitive fares, amenities, and a consumer-friendly frequent flyer program with low redemption requirements and has hurt United in the market, though to United's credit, industry-leading customer service and more flight options have enabled the carrier to hold its own more than other legacy carriers would have. But with the rapid expansion of Southwest in Denver, it's clear that the city is hungry for more low-cost flights, flights which United probably will not be offering. But Denver is a great hub location geographically, and it will probably be of some benefit to the combined carrier to maintain a hub there. This is especially true because Delta's Salt Lake City hub is smaller and the airline has invested less there, in terms of operations and infrastructure, than United has in Denver.

As a result, Delta may scale back its Salt Lake City operations into a focus city size, but much of their connecting traffic will get shifted to Denver, and Salt Lake City could see greatly reduced air service. This could open up the door for Frontier or Southwest to add additional flights from the city and plug holes that the downsizing of Delta will leave. But it's unlikely that if Delta reduces the size of its hub in SLC that it will maintain as many regional flights as it does now, and many smaller communities could lose some of their vital air service. While Delta probably would not keep its Cincinnati hub, it would keep a number of mainline flights in the city to serve high-yield business travelers, while shedding regional jet service from Comair to most markets. Also, Delta's massive Atlanta hub would likely be kept in its current form, again with the exception that some regional routes could be cut. Simply put, regional routes are important for legacy carriers, but with current yields, they're becoming more and more difficult to sustain and airlines have to be more discriminating with the short routes they serve.

Where the route maps of this merged pair would shift the most, I would guess, would be in focus city markets, cities where the carrier has a reasonable presence, with some point-to-point flights, but is not the dominant carrier. United's Seattle operations or Delta's Orlando operations are characteristic of this. Both companies have numerous point-to-point flights in addition to hub service (United, for instance, offers service to Hawaii and Tokyo, as well as regional feeder flights around the Northwest from Seattle and Delta offers nonstop service from Orlando to a number of East Coast destinations on both mainline and regional aircraft). I suspect that these point-to-point operations may be harder to sustain if the market is low-yield (such as Orlando), or if the carrier isn't dominant on the route. While some point-to-point service will be maintained (for instance, I suspect United will keep flying between Seattle and Tokyo because the flights are so popular with technology firms), many point-to-point routes, especially those operated on smaller aircraft, will need to be dropped if consolidation occurs. Moreover, many focus cities not only offer point-to-point routes, but also a lot of hub flights (perhaps in excess of what a market of that size deserves), and I suspect that some of those flights could be cut as well. At stake is a sizable reduction in United's operations in Seattle and Delta's operations in Boston, Orlando, and Columbus in order to realign their route structure to focus on hubs.

The other way the route systems of these two carriers will likely shift is in their use of regional jets, as alluded to before. Delta has huge regional jet operations in all three of its hubs, but 50-seater aircraft, of which Delta uses well over 100 in its operations, are simply inefficient with high fuel costs. 70- and 90-seat jets are more efficient, and their use will be expanded in the coming years, but many cities in and around Delta's Atlanta hub that currently receive one or two daily 50-seater flights could receive one 70-seat flight or none at all. A lot of smaller markets, in the Southeast and in the Midwest and California, where many of United's regional jet operations are, could lose much of their service, because with fuel prices so high, it simply doesn't make sense to serve them. However, there are certainly exceptions to the cutback mantra. For instance, many of United's regional operations in Denver could be preserved because they generate very high yields or have little competition, such as United's flights from Denver to Aspen. 50-seat regional jets will still make up a considerable portion of the fleets of Delta and United's regional jet contractors, but their use will need to be minimized in the future to save money.

Mainline fleet makeup will be a more challenging question. While the combined carrier would have compatibility with its longhaul fleet, given the prevalence of 777 and 767s in both United's and Delta's fleets, the short-haul fleet of the combined carrier would be a combination of Boeing, Airbus, and McDonald Douglas aircraft. Delta's MD-88s and MD-90s would likely get retired as quickly as the airline could manage, but that could take five years or more because there are so many aircraft (Delta has well over 100 MD-88s and MD-90s). It's hard to say what the merged carrier will do in the long-term to its short-haul fleet, but it may not order new shorthaul planes until Boeing or Airbus releases their next generation narrowbody in a few years or until domestic yields show signs of picking up.

One of the other difficult issues that the combined carrier will need to grapple with is how it chooses to brand itself. United has a very strong brand with business travelers, offering generous amenities, frequent flyer benefits, and seating arrangements (such as its Economy Plus seating, which offers additional legroom to premium travelers). Delta does not have the same loyalty from business travelers, but has instead targeted more leisure travelers, trying to outdo JetBlue and other carriers on amenities that attract families and other budget-conscious travelers, such as personal televisions at every seat on some planes. With increasing pressure on yields, it's likely that the combined carrier will standardize its fleet and do so in a way to minimize costs. I doubt that personal televisions will be put into seats all across the combined fleet. Moreover, I would not be surprised if much of the Economy Plus seating was removed from United's aircraft on domestic flights, so the airline could fit more seats into the cabin and increase revenues. The seats would only be left on international aircraft, where the airline could charge more for the additional legroom in addition to offering it to elite customers at no charge. As a result, to standardize operations, Delta may add premium economy seating on its international fleet. Similarly, United could upgrade some aircraft, likely 757s, with personal televisions at every seat in order to bring them up to Delta's standards.

If this merger goes through, it could create an airline with massive economies of scale in key business markets all across the country. The company will be able to leverage its ability in some markets to raise fares considerably. Look at New York City. Not only is Delta a very important player at LaGuardia, where the company operates its highly-profitable shuttle service, as well as numerous other high-yield flights, but it's one of the largest carriers at JFK, and combined with United's operations there, the airline would become the largest carrier in New York. With an array of destinations from both JFK and LaGuardia that could only be matched from Continental at Newark (and even Continental doesn't serve many of Delta's highly profitable international destinations), the new airline would have massive pricing power, manipulating fares lower on routes with low-cost competition from JetBlue, but likely keeping fares extraordinarily high if the only competition was Continental. New York could become an immensely profitable market for the combined carrier because there is very little connectivity out of LaGuardia (mostly high-yield flights to other cities) and most of the connectivity out of JFK is transferring domestic passengers to international flights, which is increasingly profitable for the carrier.

Similarly in Washington DC, strong market positions at both National and Dulles could create huge market power (and thus, pricing power) for the carrier. In fact, the Washington DC market is the one market where the combined carrier may have to shed some operations in order to appease regulators, because the only sizable competitor at either major DC airport to United and Delta is US Airways, which doesn't offer many point-to-point flights from the city.

Unlike a Delta/Northwest merger, this one would create a carrier with immense profit potential because of its dominance in so many of the nation's key business markets. There would not be as many labor and fleet issues to resolve (though there certainly are some) as with the Northwest deal, and the combined carrier would be able to structure a route system to cover the entire nation much better than a Delta/Northwest combination. But, a Delta/United merger may be harder to get by regulators because it would create a very, very large airline with considerable leverage at a lot of big airports. However, unlike a Delta/US Airways deal, which was proposed late in 2006, this one doesn't have any obvious road blocks with regulators (like the market positions of Delta and US Airways at key slot-controlled airports such as LaGuardia and Washington National in the proposed Delta/US Airways deal), though the Justice Department certainly has reasons for concern. While it's not a guarantee that a Delta/United deal would be approved, I would say the odds are probably greater than if US Airways were to make another bid for Delta.

As a result, a Delta/United merger deal would be an amazing deal for investors and the airlines involved. It's not perfect, but no combination of two legacy carriers, with all their idiosyncrasies, would be. Conversely, while airline consolidation will inevitably leave consumers with higher fares and fewer flight options, this merger could offer one of the worst deals for consumers imaginable. It will hang business travelers out to dry in many key markets, allowing the airline to essentially commit highway robbery against last-minute travelers. Travelers would have little recourse against these high last-minute fares because of the lack of competition. But, unfortunately for customers, this is an industry that desperately needs to cut costs and raise revenues, and even at the expense of consumers, consolidation will probably help salvage companies that otherwise might have to downsize even more, trimming air service in many areas as well as jobs for thousands of people.

The better deal for consumers would be a merger with Northwest. Not only would it minimize market power of the combined carrier in key business markets, but it would also likely improve the dismal customer service record of Northwest, since Delta's organization and employees seem to take customer service, baggage handling, and delay management more seriously. But the better deal for investors, one that would create enormous pricing power in San Francisco, Los Angeles, Denver, Chicago, Cincinnati, Atlanta, Washington DC, and New York, would be a Delta/United merger.

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