Allied Air Force

By Stacy Perman

After steadily losing altitude, not to mention money--$13 billion between 1990 and 1994--the airline industry has been getting whole and then some. Last year the airlines posted a record $5.2 billion profit, up from $3.9 billion in 1996, and industry watchers expect earnings to climb to $5.4 billion this year. Passenger loads, averaging 70%, are at their highest in five decades. Alas, profits seem to be inversely proportional to passenger comfort. How else can you explain jumbo jets equipped with the smallest of seats?

That's why the alliance between Northwest and Continental, announced last week, will probably improve the ride for the two companies more than for their passengers. In the unorthodox agreement, Northwest will buy 14% of Continental's common shares--but 51% of the company's voting shares--effectively creating a domestic and international network to compete with megacarriers like United and American. The Continental shares are being sold by Air Partners, controlled by investor David Bonderman. Continental was operating on a wing and prayer five years ago when Air Partners and Air Canada (which since sold its shares) each invested about $50 million to lift the carrier out of bankruptcy. Last week Air Partners sold its remaining shares for $519 million. The alliance will boost Northwest and Continental's U.S. market share to a combined 16.8%, on par with United, American and Delta Air Lines.

More important, the Northwest-Continental link may represent the end of an era of chaos that began with deregulation in 1978. Midsize carriers such as U.S. Airways are viewed as ripe for merger. "In a mature industry, if you want growth you have to acquire your neighbor or form an alliance," explains Kevin Murphy, an analyst at Morgan Stanley, Dean Witter, Discover. "And that's what they've done."

Although Continental is remarkably profitable for a company that practically made bankruptcy court a scheduled stop, CEO Gordon Bethune did not want to be left behind in this latest strategic go-around. "If we are successful, and I think we will be," says Bethune, "this will change the way the industry consolidates."

Under the plan, the carriers will merge their route networks and frequent-flyer programs but keep separate corporate identities and management teams. Passengers stand to get a wider array of flight options from nearly every locale, from Latin America to Asia. The alliance, still subject to regulatory approval, is expected to add some $500 million in revenue three years after implementation by capturing passengers who would otherwise have changed to another airline while making a connection. "Airlines are looking for ways to maximize revenues with existing resources," says Michael Boyd, president of the Boyd Group, a consulting firm in Evergreen, Colo. "In this case, both get incremental revenue at a minimal cost."

The two companies also get the critical mass needed to compete with the aviation blocs created by American and United. The two majors each stitched together a quilt of global partnerships that could potentially outmaneuver smaller carriers like Continental and Northwest, if left to their own devices. Just last week a long-awaited air-service agreement between the U.S. and Japan was reached, opening up significant competition to Northwest's profitable Asian routes. American and United are expected to ink partnerships with major Japanese carriers.

The immediate loser was Delta, whose CEO, Leo Mullin, thought he had a deal with Bethune to buy Continental. But it collapsed over Delta's refusal to guarantee jobs for Continental's top executives or give equal consideration to Continental's pilots when combining the two carriers. Northwest, which was also negotiating with Continental, leaped on the last-minute opportunity and sweetened its offer.

While the Northwest-Continental shift can offer seamless travel from Cleveland, Ohio, to Moscow, the deal probably won't benefit passengers in their wallets. The two carriers do not compete with each other on many routes, and given the current boom, that makes a drive to lower prices unlikely. Bethune, who just a couple of years ago struggled desperately to keep Continental airborne, doesn't think that's such a bad thing. Says he: "We have a 71% load factor. I don't see any reason to reduce fares."

Quite the contrary. The industry has increased revenues while benefiting from cheaper fuel and scaled-back fleet expansion. The upshot: rapidly rising ticket prices. Last year, according to American Express Travel Related Services, the average fare surged 9%, a remarkable jump in an economy with negligible inflation. Business travelers got a harsh lesson in pricing power, experiencing a 17% spike in fares.

The sky-high prices, along with the inability of low-cost airlines to get any traction, are beginning to get some attention in Congress and at the Federal Aviation Administration. Both are making noises about increasing competition and curtailing the megacarriers' pattern of beating up small, low-cost rivals. While Northwest and Continental have not asked for antitrust immunity, which would allow them to set prices on their routes, their agreement probably will not enhance competition. And with more mergers or alliances inevitable, the outlook for those cheapo fares is not promising. "We recognize that this is an alliance and not a merger," says Steve Loucks, spokesman for the American Society of Travel Agents. "But we still have some concerns. If we end up with essentially three carriers, there are fewer choices, and that inevitably drives up prices."