'It's going to be very difficult'

Since it was announced in April, the proposed merger of Delta and Northwest airlines has been a high-priority topic on Wall Street, in Congress and at the State Capitol. The Star Tribune recently invited Prof. J. Myles Shaver of the University of Minnesota's Carlson School of Management and Minneapolis attorney Ralph Strangis to discuss the merger and the airline industry with Editorial Page Editor Scott Gillespie. Shaver, who testified before a legislative committee that addressed the merger in April, is chairman of the Department of Strategic Management and Organization at the Carlson School. Strangis, a founding member of Kaplan, Strangis and Kaplan, represented US Airways in a 2001 proposed merger with United as well as Republic Airlines in its 1986 merger with Northwest. The following was adapted from their conversation. Does this merger make strategic sense for the two carriers?

Strangis: This is one of the toughest businesses there is to operate. You have billions of dollars of capital costs. With oil pushing $130 and some people saying it could get to $200 a barrel, that's out of your control. Labor is a whole separate subject. It would be hard to characterize this as an industry in which your labor costs were proportionate to productivity and appropriate given the level of skills and work that people do. You have enormous regulatory burdens. So in my mind, strategically, anything that would allow you to benefit from scale and reduce costs makes sense.

Shaver: Strategically, they're looking for three types of benefits here. There are some cost reductions and efficiencies. The second benefit is the one of network effects: Now we're going to have one global airline. The third benefit that they're arguing is fleet optimization. We had both of these airlines go through bankruptcy and restructuring. If their fleets were out of balance to that extent, I question why they didn't attack it in restructuring. With respect to the network benefits, I think the real key is to compare what we're going to get to the status quo. And the status quo is that these airlines are far from independent. They're part of the same SkyTeam alliance, and they have integrated frequent-flier programs.

I'm not sure you can get to the $400 million a year that they're talking about as an incremental benefit. With respect to the efficiencies, it's true that there will be one less headquarters. But unless we assume that everybody in the Atlanta headquarters is sitting around doing nothing half the day, they're going to have twice as much work to do. We're not going to see a 100 percent reduction there. The strategic rationale for this acquisition has not been convincingly demonstrated to me. A close look at the proposed advantages leaves me with more questions rather than confidence that they exist.

Strangis: As opposed to the alternative, which is that they both have to face the oil crisis, I think they have a greater opportunity to be successful together than they do independently, because independently they have every one of the same issues without any of the benefits. It's clear that there are too many choices for consumers. I shouldn't be able to, at the last minute, fly to New York City for $250. I can do it because of capacity and because of competition. I think this gives the two airlines the opportunity to shift some of their true costs. At the end of the day, fares are too low.

Shaver: We've been spoiled with cheap airfares, and we don't want to pay more. Just as it costs a whole lot more to fill up your car than it did a year ago or two years ago, there has not been a commensurate rise in airline prices. That has to factor down. Otherwise, there is going to be a reckoning at some point.

Doesn't it make sense, when low-cost carriers are taking an increasing share of the domestic market, that the major carriers would look globally to make money?

Strangis: Long-term, they're talking about open skies, and how are we going to compete with Singapore Airlines, which has impeccable service and probably pays its flight attendants and pilots half of what Northwest and Delta will pay and probably has some government subsidies.

Shaver: You have every airline in the world saying, "You know what, we're making money on international routes. What are we doing this year? We're increasing our capacity internationally." Well, they all can't do it and put so much capacity in and expect to earn the same type of margins. They're going to drive that market into the same condition the domestic market is in.

The CEOs of the two airlines have downplayed the impact of the merger on employment, saying that there won't be major cuts. Do you think we're going to see more jobs cut than we've heard so far?

Strangis: If they're going to save money, which they propose to do, they have to take out redundancies. The bulk of the workforce, in numbers of people, is in areas where they probably will not cut. But there are some very large areas where, in terms of dollars, they can achieve some savings in taking those people out and consolidating. They're probably giving honest estimates.

Shaver: This is always a very tricky thing going forward. We're going to be comparing what happens to what would have happened if they would have remained independent. If the price of oil doesn't go down, both airlines would be reducing capacity, and there would be a chance for labor reductions.

Shaver: Not necessarily. Any consolidation that maps route structures that significantly overlap with each other, even though that might pull out capacity and help the profitability a lot, is going to get a whole lot more antitrust scrutiny. I wouldn't be surprised if we see it, but we're already seeing some indications that not everybody else is gung-ho with this idea.

Strangis: The owners of these businesses, which happen to be large institutions, sometimes drive transactions. I think you're going to hear a lot about it. I think it's going to be hard to get done. I wouldn't bet on it, but I wouldn't bet against it.

Shaver: The market didn't react kindly to this announcement, and I'm not so sure that doesn't play in the back of the minds of some of these other carriers, especially those that are motivated largely by financial reasons.

We don't have a good history of airline mergers in this country. How difficult will it be to put these two businesses together?

Shaver: Putting together any two companies is difficult. The bigger those two companies are, independently, the harder it becomes. And this has some unique issues with respect to labor relations. It's hard to predict what will happen, but if it's going to be done well, this is going to have to be a very surgical undertaking.

If I'm an airline passenger in Minneapolis-St. Paul, how is this merger likely to affect me?

Strangis: It's not, in the sense of your ability to get flights to where you want to go. It's going to be hard to separate the fare increases that are necessarily going to come from the impact of the transaction. We're spoiled. You wouldn't start out with a blank sheet of paper and design an airline to operate on the economic model that we have now.

Shaver: I think that's true. If our airfares aren't going up, they ought to be going up. Are there going to be service reductions? Again, in this economic environment, absolutely.

Neither of you sound very confident that the boom-and-bust nature of this industry is going to be fixed.

Shaver: We start to raise these questions when we get real stresses on the system. Now we have oil prices at levels that we've never seen before, and that's a big stress on our system. When times were really good and there were flights all over the place, we had issues of air traffic-control capacity, landing capacity. Those problems have somewhat gone away now, only because we're pulling capacity out of the system with these cost stresses. If oil goes down to $30 a barrel next week, we're going to have all of those problems again.