Airline Industry: Potential Mergers and Acquisitions Driven by Financial and Competitive Pressures
Published: 2008-07-31T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The airline industry is vital to the U.S. economy, generating operating revenues of nearly $172 billion in 2007, amounting to over 1 percent of the U.S. gross domestic product. It serves as an important engine for economic growth and a critical link in the nation's transportation infrastructure, carrying more than 700 million passengers in 2007. Airline deregulation in 1978, led, at least in part, to increasingly volatile airline profitability, resulting in periods of significant losses and bankruptcies. In response, some airlines have proposed or are considering merging with or acquiring another airline. GAO was asked to help prepare Congress for possible airline mergers or acquisitions. This report describes (1) the financial condition of the U.S. passenger airline industry, (2) whether the industry is becoming more or less competitive, (3) why airlines seek to merge with or acquire other airlines, and (4) the role of federal authorities in reviewing proposed airline mergers and acquisitions. To answer these objectives, we analyzed Department of Transportation (DOT) financial and operating data; interviewed agency officials, airline managers, and industry experts; and reviewed Horizontal Merger Guidelines and spoke with antitrust experts. DOT and the Department of Justice (DOJ) provided technical comments, which were incorporated as appropriate.
section_title: What GAO Found
paragraphs: The U.S. passenger airline industry was profitable in 2006 and 2007 for the first time since 2000, but this recovery appears short-lived because of rapidly increasing fuel costs. Legacy airlines (airlines that predate deregulation in 1978) generally returned to modest profitability in 2006 and 2007 by reducing domestic capacity, focusing on more profitable markets, and reducing long-term debt. Low-cost airlines (airlines that entered after deregulation), meanwhile, continued to be profitable. Airlines, particularly legacy airlines, were also able to reduce costs, especially through bankruptcy- and near-bankruptcy-related employee contract, pay, and pension plan changes. Recent industry forecasts indicate that the industry is likely to incur substantial losses in 2008 owing to high fuel prices. Competition within the U.S. domestic airline industry increased from 1998 through 2006, as reflected by an increase in the number of competitors in city-to-city (city-pair) markets, the presence of low-cost airlines in more of those markets, lower air fares, fewer dominated markets, and a shrinking dominance by a single airline at some of the nation's largest airports. The average number of competitors in the largest 5,000 city-pair markets rose to 3.3 in 2006 from 2.9 in 1998. This growth is attributable to the increased presence of low-cost airlines, which increased nearly 60 percent. In addition, the number of largest 5,000 markets dominated by a single airline declined by 15 percent. Airlines seek to merge with or acquire other airlines with the intention of increasing their profitability and financial sustainability, but must weigh these potential benefits against operational and regulatory costs and challenges. The principal benefits airlines consider are cost reductions--by combining complementary assets, eliminating duplicate activities, and reducing capacity--and increased revenues from higher fares in existing markets and increased demand for more seamless travel to more destinations. Balanced against these potential benefits are operational costs of integrating workforces, aircraft fleets, and systems. In addition, because most airline mergers and acquisitions are reviewed by DOJ, the relevant antitrust enforcement agency, airlines must consider the risks of DOJ opposition. Both DOJ and DOT play a role in reviewing airline mergers and acquisitions, but DOJ's determination as to whether a proposed merger is likely substantially to lessen competition is key. DOJ uses an integrated analytical framework set forth in the Horizontal Merger Guidelines to make its determination. Under that process, DOJ assesses the extent of likely anticompetitive effects in the relevant markets, in this case, airline city-pair markets. DOJ further considers the likelihood that airlines entering these markets would counteract any anticompetitive effects. It also considers any efficiencies that a merger or acquisition could bring--for example, consumer benefits from an expanded route network. Our analysis of changes in the airline industry, such as increased competition and the growth of low-cost airlines, indicates that airline entry may be more likely now than in the past provided recent increases in fuel costs do not reverse these conditions. Additionally, the Horizontal Merger Guidelines have evolved to provide clarity as to the consideration of efficiencies, an important factor in airline mergers.

section_title: Letter
paragraphs: The passenger airline industry is vital to the U.S. economy, with operating  revenues of nearly $172 billion in 2007, equivalent to over 1 percent of the  U.S. gross domestic product. It also serves as an important engine for  economic growth and a critical link in the nation’s transportation  infrastructure, carrying over 700 million passengers in 2007. The U.S.  airline industry was deregulated in 1978, allowing market forces, rather  than the federal government, to establish fares and service. Since 1978, the  industry has experienced cyclical financial performance and numerous  bankruptcies, mergers, and acquisitions, as the industry adjusted to an  unregulated environment and changing market conditions. In recent  years, the financial condition of legacy, or network, airlines—the largest  segment of the passenger airline industry—deteriorated significantly even  by historical standards. From 2001 to 2005, legacy airlines lost more than  $33 billion, while four of them entered and exited bankruptcy. More  recently, in 2006 and 2007 the airline industry returned to modest  profitability only to confront rapidly increasing fuel costs and the  expectation of renewed losses in 2008. These challenges and structural  changes have spurred some airlines to explore mergers and acquisitions as  a potential way to improve their competitive positions and financial  viability—for example, Delta Air Lines and Northwest Airlines announced  plans to merge on April 14, 2008. Mergers and acquisitions, however,  could also have anticompetitive effects, such as reduced competition and  increased fares in some markets. Generally, before any airline merger or  acquisition can be consummated, the Department of Justice (DOJ) carries  out its antitrust enforcement responsibilities by evaluating whether the  proposed merger is likely to substantially lessen competition and may  challenge in court those that appear to be anticompetitive.
US Airways’ attempt to acquire Delta Air Lines in 2006, the merger  announcement between Delta Air Lines and Northwest Airlines earlier this  year, and the continued focus on potential airline mergers and acquisitions  prompted interest in a broad assessment of the state of the industry, the  factors that are driving continued interest in mergers and acquisitions, and  the process the federal government uses to assess them. In order to assist  Congress in understanding possible future airline mergers and  acquisitions, GAO was asked to describe (1) the financial condition of the  U.S. passenger airline industry, (2) whether the industry is becoming more  or less competitive, (3) why airlines seek to merge with or acquire other  airlines, and (4) the role of federal authorities in considering airline  mergers and acquisitions.
To address these objectives, we conducted analysis using Department of  Transportation (DOT) financial and operating data, reviewed historical  documents and past studies, and conducted interviews. Specifically, to  evaluate the financial condition of the domestic airline industry, we  analyzed airline financial metrics; reviewed financial studies; and  conducted interviews with airline managers, trade associations, financial  analysts, and other industry experts. Our financial analysis relied on  airline financial data reported to DOT by airlines from 1998 through 2007,  as these were the most recent and complete annual data available. To  evaluate changes in airline industry competition, we analyzed data from  DOT’s Origin and Destination Survey, which includes fare and itinerary  information on every 10th airline ticket sold; reviewed studies assessing  competition; and interviewed current and former DOT officials and  aviation industry experts. Our analysis of DOT data focused on passenger  ticket data for the largest 5,000 domestic airline markets from 1998  through 2006. We excluded tickets with international, Hawaiian, or  Alaskan destinations or origins so that we could examine changes within  contiguous domestic markets. To assess the reliability of all DOT data  used by GAO, we reviewed the quality control procedures applied by DOT  and subsequently determined that the data were sufficiently reliable for  our purposes. To identify and evaluate the primary factors that airlines  consider in deciding whether to merge with or acquire another airline, we  reviewed studies and reports; assessed past airline mergers and  acquisitions; and conducted interviews with DOT and DOJ officials, airline  managers, financial analysts, academic researchers, and industry experts.  In addition, to understand the government’s role in evaluating a proposed  merger or acquisition, we discussed the merger review processes with  DOJ officials and antitrust experts and reviewed available documentation  addressing past mergers and acquisitions. We conducted this performance  audit from May 2007 through July 2008 in accordance with generally  accepted government auditing standards. Those standards require that we  plan and perform the audit to obtain sufficient, appropriate evidence to  provide a reasonable basis for our findings and conclusions based on our  audit objectives. We believe that the evidence obtained provides a  reasonable basis for our findings and conclusions based on our audit  objectives.
subsections: section_title: Background
paragraphs: The U.S. airline industry is principally composed of legacy, low-cost, and  regional airlines, and while it is largely free of economic regulation, it  remains regulated in other respects, most notably safety, security, and  operating standards. Legacy airlines—sometimes called network airlines— are essentially those airlines that were in operation before the Airline  Deregulation Act of 1978 and whose goal is to provide service from  “anywhere to everywhere.” To meet that goal, these airlines support  large, complex hub-and-spoke operations with thousands of employees  and hundreds of aircraft (of various types), with service at numerous fare  levels to domestic communities of all sizes and to international  destinations. To enhance revenues without expending capital, legacy  airlines have entered into domestic (and international) alliances that give  them access to some portion of each others’ networks. Low-cost airlines  generally entered the marketplace after deregulation and primarily operate  less costly point-to-point service using fewer types of aircraft. Low-cost  airlines typically offer simplified fare structures, which were originally  aimed at leisure passengers but are increasingly attractive to business  passengers because they typically do not have restrictive ticketing rules,  which make it significantly more expensive to purchase tickets within 2  weeks of the flight or make changes to an existing itinerary. Regional  airlines generally operate smaller aircraft—turboprops or regional jets  with up to 100 seats—and provide service under code-sharing  arrangements with larger legacy airlines on a cost-plus or fee-for-departure  basis to smaller communities. Some regional airlines are owned by a  legacy parent, while others are independent. For example, American Eagle  is the regional partner for American Airlines, while independent Sky West  Airlines operates on a fee-per-departure agreement with Delta Air Lines,  United Airlines, and Midwest Airlines.
The airline industry has experienced considerable merger and acquisition  activity since its early years, especially immediately following deregulation  in 1978 (fig. 1 provides a timeline of mergers and acquisitions for the eight  largest surviving airlines). There was a flurry of mergers and acquisitions  during the 1980s, when Delta Air Lines and Western Airlines merged,  United Airlines acquired Pan Am’s Pacific routes, Northwest acquired  Republic Airlines, and American and Air California merged. In 1988,  merger and acquisition review authority was transferred from DOT to  DOJ. Since 1998, and despite tumultuous financial periods, fewer mergers  and acquisitions have occurred. In 2001, American Airlines acquired the  bankrupt airline TWA, and in 2005 America West acquired US Airways  while the latter was in bankruptcy. Certain other attempts at merging  during that time period failed because of opposition from DOJ or  employees and creditors. For example, in 2000, an agreement was reached  that allowed Northwest Airlines to acquire a 50 percent stake in  Continental Airlines (with limited voting power) to resolve the antitrust  suit brought by DOJ against Northwest’s proposed acquisition of a  controlling interest in Continental. A proposed merger of United Airlines  and US Airways in 2000 also resulted in opposition from DOJ, which found  that, in its view, the merger would violate antitrust laws by reducing  competition, increasing air fares, and harming consumers on airline routes  throughout the United States. Although DOJ expressed its intent to sue to  block the transaction, the parties abandoned the transaction before a suit  was filed. More recently, the 2006 proposed merger of US Airways and  Delta Air Lines fell apart because of opposition from Delta’s pilots and  some of its creditors, as well as its senior management.
Since the airline industry was deregulated in 1978, its earnings have been  extremely volatile. In fact, despite considerable periods of strong growth  and increased earnings, airlines have at times suffered such substantial  financial distress that the industry has experienced recurrent bankruptcies  and has failed to earn sufficient returns to cover capital costs in the long  run. Many analysts view the industry as inherently unstable due to key  demand and cost characteristics. In particular, demand for air travel is  highly cyclical, not only in relation to the state of the economy, but also  with respect to political, international, and even health-related events. Yet  the cost characteristics of the industry appear to make it difficult for firms  to rapidly contract in the face of declining demand. In particular, aircraft  are expensive, long-lived capital assets. And as demand declines, airlines  cannot easily reduce flight schedules in the very near term because  passengers are already booked on flights for months in advance, nor can  they quickly change their aircraft fleets. That is, airplane costs are largely  fixed and unavoidable in the near term. Moreover, even though labor is  generally viewed as a variable cost, airline employees are mostly  unionized, and airlines find that they cannot reduce employment costs  very quickly when demand for air travel slows. These cost characteristics  can thus lead to considerable excess capacity in the face of declining  demand. Finally, the industry is also susceptible to certain external  shocks—such as those caused by fuel price volatility. In 2006 and 2007, the  airline industry generally regained profitability after several very difficult  years. However, these underlying fundamental characteristics of the  industry suggest that it will remain an industry susceptible to rapid swings  in its financial health.
Since deregulation in 1978, the financial stability of the airline industry has  become a considerable concern for the federal government due to the  level of financial assistance it has provided to the industry through  assuming terminated pension plans and other forms of assistance. Since  1978 there have been over 160 airline bankruptcies. While most of these  bankruptcies affected small airlines that were eventually liquidated, 4 of  the more recent bankruptcies (Delta, Northwest, United, and US Airways)  are among the largest corporate bankruptcies ever, excluding financial  services firms. During these bankruptcies, United Airlines and US Airways  terminated their pension plans and $9.7 billion in claims were shifted to  the Pension Benefit Guarantee Corporation (PGBC). Further, to respond  to the shock to the industry from the September 11, 2001, terrorist attacks,  the federal government provided airlines with $7.4 billion in direct  assistance and authorized $1.6 billion (of $10 billion available) in loan  guarantees to six airlines.
Although the airline industry has experienced numerous mergers and  bankruptcies since deregulation, growth of existing airlines and the entry  of new airlines have contributed to a steady increase in capacity.  Previously, GAO reported that although one airline may reduce capacity or  leave the market, capacity returns relatively quickly. Likewise, while past  mergers and acquisitions have, at least in part, sought to reduce capacity,  any resulting declines in industry capacity have been short-lived, as  existing airlines have expanded or new airlines have expanded. Capacity  growth has slowed or declined just before and during recessions, but not  as a result of large airline liquidations. Figure 2 shows capacity trends  since 1979 and the dates of major mergers and acquisitions.
section_title: U.S. Airlines’ Financial Condition Has Improved, but It Appears to Be Short- lived
paragraphs: The U.S. passenger airline industry has generally improved its financial  condition in recent years, but its recovery appears short-lived because of  rapidly increasing fuel prices. The U.S. airline industry recorded a net  operating profit of $2.2 billion and $2.8 billion in 2006 and 2007,  respectively, the first time since 2000 that it had earned a profit. Legacy  airlines—which lost nearly $33 billion between 2001 and 2005—returned  to profitability in 2006 owing to increased passenger traffic, restrained  capacity, and restructured costs. Meanwhile, low-cost airlines, which also  saw increased passenger traffic, remained profitable overall by continuing  to keep costs low, as compared to costs at the legacy airlines, and  managing their growth. The airline industry’s financial future remains  uncertain and vulnerable to a number of internal and external events— particularly the rapidly increasing costs of fuel.
subsections: section_title: Both Legacy and Low-Cost Airlines Improved Their Financial Positions in 2006 and 2007
paragraphs: The airline industry achieved modest profitability in 2006 and continued  that trend through 2007. The seven legacy airlines had operating profits of  $1.1 billion in 2006 and $1.8 billion in 2007, after losses totaling nearly $33  billion from 2001 through 2005. The seven low-cost airlines, after reaching  an operating profit low of nearly $55 million in 2004, also saw  improvement, posting operating profits of almost $958 million in 2006 and  $1 billion in 2007. Figure 3 shows U.S. airline operating profits since 1998.
section_title: Increased Passenger Traffic and Capacity Restraint Have Improved Airline Revenues
paragraphs: An increase in passenger traffic since 2003 has helped improve airline  revenues. Passenger traffic—as measured by revenue passenger miles  (RPM)—increased for both legacy and low-cost airlines, as illustrated by  figure 4. Legacy airlines’ RPMs rose 11 percent from 2003 through 2007,  while low-cost airlines’ RPMs grew 24 percent during the same period.
Airline revenues have also improved owing to domestic capacity restraint.  Some past airline industry recoveries have been stalled because airlines  grew their capacity too quickly in an effort to gain market share, and too  much capacity undermined their ability to charge profitable fares. Total  domestic capacity, as measured by available seat miles (ASM), increased   9 percent, from 696 billion ASMs in 2003 to 757 billion ASMs in 2007.  However, legacy airlines’ ASMs declined 18 percent, from 460 billion in  2003 to 375 billion in 2007, as illustrated by figure 5. Industry experts and  airline officials told us that legacy airlines reduced their domestic  capacity, in part, by shifting capacity to their regional airline partners and  to international routes. Even the faster growing low-cost airline segment  saw a decline in ASMs in 2006 and 2007.
Since 2004, legacy airlines have shifted portions of their domestic capacity  to more profitable international routes. From 1998 through 2003, the  legacy airlines maintained virtually the same 30/70 percent capacity  allocation split between international and domestic capacity. However,  during the period from 2004 to 2007, legacy airlines increased their  international capacity by 7 percentage points to a 37/63 percent split  between international and domestic capacities. International expansion  has proven to be a source of substantial new revenues for the legacy  airlines because they often face less competition on international routes.  Moreover, international routes generate additional passenger flow (and  revenues) through their domestic networks, helping to support service  over routes where competition from low-cost airlines has otherwise  reduced legacy airlines’ domestic revenues.
section_title: Cost Reduction and Bankruptcy Restructuring Efforts Have Also Improved Airline Financial Positions
paragraphs: The airlines have also undertaken cost reduction efforts—much of which  occurred through the bankruptcy process—in an attempt to improve their  financial positions and better insulate themselves from the cyclical nature  of the industry. Excluding fuel, unit operating costs for the industry,  typically measured by cost per available seat mile, have decreased 16  percent since reaching peak levels around 2001. A number of experts have  pointed out that the legacy airlines have likely made most of the cost  reductions that can be made without affecting safety or service; however,  as figure 6 illustrates, a significant gap remains between legacy and low- cost airlines’ unit costs. A recent expert study examining industry trends in  competition and financial condition found similar results, also noting that  the cost gap between legacy and low-cost airlines still exists.
Many airlines achieved dramatic cuts in their operational costs by  negotiating contract and pay concessions from their labor unions and  through bankruptcy restructuring and personnel reductions. For example,  Northwest Airlines pilots agreed to two pay cuts—15 percent in 2004 and  an additional 23.9 percent in 2006, while in bankruptcy—to help the airline  dramatically reduce operating expenses. Bankruptcy also allowed several  airlines to significantly reduce their pension expenses, as some airlines  terminated and shifted their pension obligations to PBGC. Legacy airlines  in particular reduced personnel as another means of reducing costs. The  average number of employees per legacy airline has decreased 26 percent,  from 42,558 in 1998 to 31,346 in 2006. Low-cost airlines, on the other hand,  have added personnel; however, they have done so in keeping with their  increases in capacity. In fact, although total low-cost airline labor costs  (including salaries and benefits) steadily increased from 1998 through  2007—from $2.8 billion to $5.0 billion—labor costs have accounted for  roughly the same percentage (33 percent) of total operating expenses  (including fuel) throughout the time period.
Although cost restructuring—achieved both through Chapter 11  bankruptcy reorganizations and outside of that process—has enabled  most legacy airlines to improve their balance sheets in recent years, it still  leaves the industry highly leveraged. Legacy airlines have significantly  increased their total cash reserves from $2.7 billion in 1998 to $24 billion in  2007, thereby strengthening their cash and liquidity positions. Low-cost  airlines also increased their total cash reserves. Industry experts we spoke  with stated that this buildup of cash reserves is a strategic move to help  the airlines withstand future industry shocks, as well as to pay down debts  or return value to stockholders. Experts, however, also agreed that debt is  still a problem within the industry, particularly for the legacy airlines. For  example, legacy airlines’ assets-to-liabilities ratio (a measure of a firm’s  long-term solvency) is still less than 1 (assets less than liabilities). In 1998,  legacy airlines’ average ratio was 0.70, which improved only slightly to 0.74  in 2007. In contrast, while low-cost airlines have also added significant  liabilities owing to their growth, their assets-to-liabilities ratio remains  better than that of legacy airlines, increasing from 0.75 in 1998 to 1 in 2007.
section_title: Airlines’ Financial Turnaround May Be Short-lived
paragraphs: Because the financial condition of the airline industry remains vulnerable  to external shocks—such as the rising cost of fuel, economic downturns,  or terrorist attacks—the near-term and longer-term financial health of the  industry remains uncertain. In light of increased fuel prices and softening  passenger demand, the profit and earnings outlook has reversed itself, and  airlines may incur record losses in 2008. Although the industry saw profits  in 2007 and some were predicting even larger profits in 2008, experts and  industry analysts now estimate that the industry could incur significant  losses in 2008. In fact, although estimates vary, one analyst recently  projected $2.8 billion in industry losses, while another analyst put  industrywide losses between $4 billion and $9 billion for the year,  depending on demand trends. More recently, the airline trade association,  the Air Transport Association, estimated losses of between $5 billion and  $10 billion this year, primarily due to escalating fuel prices. For the first  quarter of 2008, airlines reported net operating losses of more than $1.4  billion.
section_title: Fuel Costs Are Increasing and Other Costs May Increase
paragraphs: Many experts cite rising fuel costs as a key obstacle facing the airlines for  the foreseeable future. The cost of jet fuel has become an ever-increasing  challenge for airlines, as jet fuel climbed to over $2.85 per gallon in early  2008, and has continued to increase. By comparison, jet fuel was $1.11 per  gallon in 2000, in 2008 dollars (Fig. 7 illustrates the increase in jet fuel  prices since 2000). Some airlines, particularly Southwest Airlines, reduced  the impact of rising fuel prices on their costs through fuel hedges;  however, most of those airlines’ hedges are limited or, in the case of  Southwest, will expire within the next few years and may be replaced with  new but more expensive hedges. In an attempt to curtail operating losses  linked to higher fuel costs, most of the largest airlines have already  announced plans to trim domestic capacity during 2008, and some have  added baggage and other fees to their fares. Additionally, nine airlines  have already filed for bankruptcy or ceased operations since December  2007, with many citing the significant increase in fuel costs as a  contributing factor.
In addition to rising fuel costs, other factors may strain airlines’ financial  health in the coming years. Labor contract issues are building at several of  the legacy airlines, as labor groups seek to reverse some of the financial  sacrifices that they made to help the airlines avoid or emerge from  bankruptcy. Additionally, because bankruptcies required the airlines to  reduce capital expenditures in order to bolster their balance sheets,  needed investments in fleet renewal, new technologies, and product  enhancements were delayed. Despite their generally sound financial  condition as a group, some low-cost airlines may be facing cost increases  as well. Airline analysts told us that some low-cost airline cost advantages  may diminish as low-cost airlines begin to face cost pressures similar to  those of the legacy airlines, including aging fleets—and their associated  increased maintenance costs—and workforces with growing experience  and seniority demanding higher pay.
section_title: Industry Faces Challenging Revenue Environment from Economic Downturns and Consumer Fare Expectations
paragraphs: The recent economic downturn and the long-term downward trend in  fares create a challenging environment for revenue generation.  Macroeconomic troubles—such as the recent tightening credit market and  housing slump—have generally served as early indicators of reduced  airline passenger demand. Currently, airlines are anticipating reduced  demand by the fall of 2008. Additionally, domestic expansion of low-cost  airline operations, as well as an increased ability of consumers to shop for  lower fares more easily in recent years, has not only led to lower fares in  general, but has also contributed to fare “compression”—that is, fewer  very high-priced tickets are sold today than in the past. The downward  pressure on ticket prices created by the increase of low-cost airline  offerings is pervasive, according to a recent study and DOT testimony.  Experts we spoke with explained that the increased penetration of low- fare airlines, combined with much greater transparency in fare pricing, has  increased consumer resistance to higher fares.
section_title: Domestic Airline Competition Increased from 1998 through 2006, as Low- Cost Airlines Expanded
paragraphs: Competition within the U.S. domestic airline market increased from 1998  through 2006 as reflected by an increase in the average number of  competitors in the top 5,000 city-pair markets, the presence of low-cost  airlines in more of these markets, lower fares, fewer dominated city-pair  markets, and a shrinking dominance by a single airline at some of the  nation’s largest airports. The average number of competitors has increased  in these markets from 2.9 in 1998 to 3.3 in 2006. The number of these  markets served by low-cost airlines increased by nearly 60 percent, from  nearly 1,300 to approximately 2,000 from 1998 through 2006. Average  round trip fares fell 20 percent, after adjusting for inflation, during the  same period. Furthermore, approximately 500 fewer city-pair markets (15  percent) are dominated by a single airline. Similarly, competition has  increased at the nation’s 30 largest airports.
subsections: section_title: Average Number of Competitors and Low-Cost Airline Penetration Has Increased in the Top 5,000 Markets
paragraphs: The average number of competitors in the largest 5,000 city-pair market  has increased since 1998. Overall, the average number of effective  competitors—any airline that carries at least 5 percent of the traffic in that  market—in the top 5,000 markets rose from 2.9 in 1998 to 3.3 in 2006. As  figure 8 shows, the number of single airline (monopoly) markets  decreased to less than 10 percent of the top 5,000 markets, while the  number of markets with three or more airlines grew to almost 70 percent  in 2006. Monopoly markets are generally the smallest city-pair markets,  which lack enough traffic to support more than one airline.
Longer-distance markets are more competitive than shorter-distance  markets. For example, among the top 5,000 markets in 2006, longer- distance markets (greater than 1,000 miles) had on average 3.9  competitors, while routes of less than 250 miles had on average only 1.7  competitors (fig. 9). The difference exists in large part because longer- distance markets have more viable options for connecting over more hubs.
For example, a passenger on a long-haul flight from Allentown,  Pennsylvania, to Los Angeles, California—a distance of over 2,300 miles— would have options of connecting through 10 different hubs, including  Cincinnati, Chicago, and Detroit. By comparison, a passenger from Seattle  to Portland, Oregon—a distance of just under 300 miles—has no  connection options, nor would connections be as attractive to passengers  in short-haul markets.
section_title: Low-Cost Airlines Have Increased Their Presence among the Top 5,000 Markets
paragraphs: Low-cost airlines have increased the number of markets and passengers  served and their overall market share since 1998. The number of the top  5,000 markets served by a low-cost airline jumped from approximately  1,300 to over 2,000 from 1998 through 2006, an increase of nearly 60  percent. Most of that increase is the result of low-cost airlines expanding  their service into longer-haul markets than they typically served in 1998.  Specifically, the number of markets served by low-cost airlines that were  longer than 1,000 miles has increased by nearly 45 percent since 1998. For  example, in 1998 Southwest Airlines served about 360 markets over 1,000  miles, and by 2006 it served over 670 such markets.
Low-cost airlines’ expansion increased the extent to which they competed  directly with legacy airlines. In 1998, low-cost airlines operated in 25  percent of the top 5,000 markets served by legacy airlines and provided a  low-cost alternative to approximately 60 percent of passengers. By 2006,  low-cost airlines were competing directly with legacy airlines in 42 percent  of the top 5,000 markets (an additional 756 markets) and provided a low- cost alternative to approximately 80 percent of passengers.
In all, the growth of low-cost airlines into more markets and providing  service to more passengers contributed to the shift in passenger traffic  between legacy and low-cost airlines. Overall, low-cost airlines’ share of  passenger traffic increased from 25 percent in 1998 to 33 percent in 2006,  while legacy airlines’ domestic share of passenger traffic fell from 70  percent to 65 percent from 1998 through 2006 (see fig. 10). Low-cost  airlines carried 78 million passengers in 1998 and 125 million in 2006—an  increase of 59 percent.
section_title: Average Fares Have Declined for Both Legacy and Low-Cost Airlines
paragraphs: Airfares in the top 5,000 markets, one of the key gauges of competition,  have fallen in real terms since 1998. From 1998 through 2006, the round- trip average airfare fell from $198 to $161 (in 2006 dollars), a decrease of  nearly 20 percent. As figure 11 shows, average fares have fallen across all  distances. In 1998, average fares ranged from $257 for trips longer than  1,000 miles to $129 for trips of 250 miles or less. Since that time, however,  fares have fallen considerably on the longest trips, and as of 2006,  averaged just $183, a drop of 29 percent since 1998. Average fares for the  shortest trips have not fallen as much. For trips of 250 miles or less,  average fares as of 2006 have fallen 6 percent, to $121.
Average fares tend to be lower in markets where low-cost airlines are  present. Prior studies have shown that the presence of low-cost airlines in  a market is associated with lower fares for all passengers in that market.  In 1998, over 1,300 of the top 5,000 markets had a low-cost airline present,  with an average fare of $167, as opposed to the 3,800 markets without low- cost competition, where the average fares averaged around $250. This  same relationship was maintained in 2006, when low-cost airlines’  presence grew to over 2,000 markets, and the average fare in these  markets was $153, while the average fare in 2006 legacy airline-only  markets was $194.
section_title: Fewer Markets Are Dominated by a Single Airline
paragraphs: The number of the top 5,000 markets dominated by a single airline has  declined. Since 1998, the number of dominated markets—markets with  one airline with more than 50 percent of passengers—declined as  competitors expanded into more markets. The number of dominated  markets declined by approximately 500 markets, from 3,500 to 3,000 (or 15  percent) from 1998 through 2006, while the number of nondominated  markets correspondingly rose by approximately 500, from approximately  1,400 to 1,900 markets (or 37 percent). (See fig. 12.)
Although there are fewer dominated markets among the top 5,000 markets,  further analysis shows that low-cost airlines have increased their share of  dominated markets while legacy airlines lost share. In 1998 legacy airlines  dominated approximately 3,000 of the top 5,000 markets, but in 2006 that  number fell to approximately 2,400. At the same time, low-cost airlines  increased their share of dominated markets from about 300 markets in  1998 to approximately 500 markets. Appendix III shows the number of  dominated markets by airline in 2006. Low-cost airlines tend to operate in  larger dominated markets than legacy airlines. For example, in 2006,  legacy airlines carried an average of 55,000 passengers per dominated  market, while low-cost airlines carried an average of 165,000 passengers  per dominated market. This difference reflects the low-cost airlines’  targeting of high-density markets and the nature of hub-and-spoke  networks operated by legacy airlines.
section_title: Competition Has Increased at the Nation’s Largest Airports
paragraphs: Competition has generally increased at the nation’s largest airports. Airline  dominance at many of the largest domestic airports in the United States  has decreased as competition has increased in the industry. Although  legacy airlines have a dominant position—carrying at least 50 percent of  passenger traffic—at 16 of the nation’s 30 largest airports. One-half of  these 16 dominated airports saw a decline in passenger traffic from 1998  through 2006 (see app. III). Of the 16 airports dominated by a single airline,  14 were dominated by legacy airlines. At 9 of these airports, the second  largest airline carried less than 10 percent of passenger traffic, while at the  other 5 airports a low-cost airline carried 10 percent or more of passenger  traffic.
section_title: Airlines Seek to Combine to Increase Profits and Improve Financial Viability, but Challenges Exist
paragraphs: Airlines seek mergers and acquisitions as a means to increase profitability  and long-term financial viability, but must weigh those potential benefits  against the operational and regulatory costs and challenges posed by  combinations. A merger’s or acquisition’s potential to increase short-term  profitability and long-term financial viability stems from both anticipated  cost reductions and increased revenues. Cost reductions may be achieved  through merger-generated operating efficiencies—for example, through  the elimination of duplicative operations. Cost savings may also flow from  adjusting or reducing the combined airline’s capacity and adjusting its mix  of aircraft. Airlines may also seek mergers and acquisitions as a means to  increase their revenues through increased fares in some markets— stemming from capacity reductions and increased market share in existing  markets—and an expanded network, which creates more market pairs  both domestically and internationally. Nonetheless, increased fares in  these markets may be temporary because other airlines could enter the  affected markets and drive fares back down. Mergers and acquisitions also  present several potential challenges to airline partners, including labor and  other integration issues—which may not only delay (or even preclude)  consolidation, but also offset intended gains. DOJ antitrust review is  another potential challenge, and one that we discuss in greater detail in  the next section.
subsections: section_title: Airline Mergers and Acquisitions Aim to Increase Profitability by Reducing Costs and Increasing Revenues
paragraphs: A merger or acquisition may produce cost savings by enabling an airline to  reduce or eliminate duplicative operating costs. Based on past mergers  and acquisitions and experts we consulted, a range of potential cost  reductions can result, such as the elimination of duplicative service, labor,  and operations—including inefficient (or redundant) hubs or routes—and  operational efficiencies from the integration of computer systems, and  similar airline fleets. Other cost savings may stem from facility  consolidation, procurement savings, and working capital and balance  sheet restructuring, such as renegotiating aircraft leases. According to US  Airways officials and analyst reports, for example, the merger of America  West and US Airways generated $750 million in cost savings through the  integration of information technology, combined overhead operations, and  facilities closings.
Airlines may also pursue mergers or acquisitions to more efficiently  manage capacity—both to reduce operating costs and to generate  revenue—in their networks. A number of experts we spoke with stated  that given recent economic pressures, particularly increased fuel costs,  one motive for mergers and acquisitions is the opportunity to lower costs  by reducing redundant capacity. Experts have said that industry mergers  and acquisitions could lay the foundation for more rational capacity  reductions in highly competitive domestic markets and could help mitigate  the impact of economic cycles on airline cash flow. In addition, capacity  reductions from a merger or acquisition could also serve to generate  additional revenue through increased fares on some routes; over the long- term, however, those increased fares may be brought down because other  airlines, especially low-cost airlines, could enter the affected markets and  drive prices back down. In the absence of mergers and acquisitions and  facing ongoing cost pressures, airlines have already begun to reduce their  capacity in 2008.
Airlines may also seek to merge with or acquire an airline as a way to  generate greater revenues from an expanded network, which serves more  city-pair markets, better serves passengers, and thus enhances  competition. Mergers and acquisitions may generate additional demand by  providing consumers more domestic and international city-pair  destinations. Airlines with expansive domestic and international networks  and frequent flier benefits particularly appeal to business traffic, especially  corporate accounts. Results from a recent Business Traveler Coalition  (BTC) survey indicate that about 53 percent of the respondents were likely  to choose a particular airline based upon the extent of its route network.  Therefore, airlines may use a merger or acquisition to enhance their  networks and gain complementary routes, potentially giving the combined  airline a stronger platform from which to compete in highly profitable  markets.
Mergers and acquisitions can also be used to generate greater revenues  through increased market share and fares on some routes. For example,  some studies of airline mergers and acquisitions during the 1980s showed  that prices were higher on some routes from the airline’s hubs after the  combination was completed. At the same time, even if the combined  airline is able to increase prices in some markets, the increase may be  transitory if other airlines enter the markets with sufficient presence to  counteract the price increase. In an empirical study of airline mergers and  acquisitions up to 1992, Winston and Morrison suggest that being able to  raise prices or stifle competition does not play a large role in airlines’  merger and acquisition decisions. Numerous studies have shown, though,  that increased airline dominance at an airport results in increased fare  premiums, in part because of competitive barriers to entry. Several recent  merger and acquisition attempts (United and US Airways in 2000,  Northwest and Continental in 1998) were blocked because of opposition  by DOJ because of concerns about anticompetitive impacts. Ultimately,  however, each merger and acquisition differs in the extent to which cost  reductions and revenue increases are factors.
Cost reductions and the opportunity to obtain increased revenue could  serve to bolster a merged airline’s financial condition, enabling the airline  to better compete in a highly competitive international environment. For  example, officials from US Airways stated that as a result of its merger  with America West, the airline achieved a significant financial  transformation, and they cited this as a reason why airlines merge. Many  industry experts believe that the United States will need larger, more  economically stable airlines to be able to compete with the merging and  larger foreign airlines that are emerging in the global economy. The airline  industry is becoming increasingly global; for example, the Open Skies  agreement between the United States and the European Union became  effective in March 2008. Open Skies has eliminated previous government  controls on these routes (especially to and from London’s Heathrow  Airport), presenting U.S. and European Union airlines with great  opportunities as well as competition. In order to become better prepared  to compete under Open Skies, global team antitrust immunity applications  have already been filed with DOT. Antitrust immune alliances differ from  current code-share agreements or alliance group partnerships because  they allow partners not only to code-share but also to jointly plan and  market their routes and schedules, share revenue, and possibly even  jointly operate flights. According to one industry analyst, this close global  cooperation may facilitate domestic consolidation as global alliance  partners focus on maximizing synergies for both increasing revenues and  reducing costs with their global alliance teams.
section_title: Potential Challenges to Mergers and Acquisitions Include Integration Issues and Regulatory Challenges
paragraphs: We identified a number of potential barriers to consummating a  combination, especially in terms of operational challenges that could  offset a merger’s or acquisition’s intended gains. The most significant  operational challenges involve the integration of workforces,  organizational cultures, aircraft fleets, and information technology  systems and processes. Indeed, past airline mergers and acquisitions have  proven to be difficult, disruptive, and expensive, with costs in some cases  increasing in the short term as the airlines integrate. Airlines also face  potential challenges to mergers and acquisitions from DOJ’s antitrust  review, discussed in the next section.
Workforce integration is often particularly challenging and expensive, and  involves negotiation of new labor contracts. Labor groups—including  pilots, flight attendants, and mechanics—may be able to demand  concessions from the merging airlines during these negotiations, several  experts explained, because labor support would likely be required in order  for a merger or acquisition to be successful. Some experts also note that  labor has typically failed to support mergers, fearing employment or salary  reductions. Obtaining agreement from each airline’s pilots’ union on an  integrated pilot seniority list—which determines pilots’ salaries, as well as  what equipment they can fly—may be particularly difficult. According to  some experts, as a result of these labor integration issues and the  challenges of merging two work cultures, airline mergers have generally  been unsuccessful. For example, although the 2005 America West–US  Airways merger has been termed a successful merger by many industry  observers, labor disagreements regarding employee seniority, and  especially pilot seniority, remain unresolved. More recently, labor  integration issues derailed merger talks—albeit temporarily—between  Northwest Airlines and Delta Air Lines in early 2008, when the airlines’  labor unions were unable to agree on pilot seniority list integration.  Recently, the Consolidated Appropriations Act of 2008 included a labor  protective provision that applies to the integration of employees of  covered air carriers, and could affect this issue. Furthermore, the  existence of distinct corporate cultures can influence whether two firms  will be able to merge their operations successfully. For example, merger  discussions between United Airlines and US Airways broke down in 1995  because the employee-owners of United feared that the airlines’ corporate  cultures would clash.
The integration of two disparate aircraft fleets may also be costly.  Combining two fleets may increase costs associated with pilot training,  maintenance, and spare parts. For example, a merger between Northwest  and Delta would result in an airline with 10 different aircraft types. These  costs may, however, be reduced post-merger by phasing out certain  aircraft from the fleet mix. Pioneered by Southwest and copied by other  low-cost airlines, simplified fleets have enabled airlines to lower costs by  streamlining maintenance operations and reducing training times. If an  airline can establish a simplified fleet, or “fleet commonality”—particularly  by achieving an efficient scale in a particular aircraft—then many of the  cost efficiencies of a merger or acquisition may be set in motion by  facilitating pilot training, crew scheduling, maintenance integration, and  inventory rationalization.
Finally, integrating information technology processes and systems can  also be problematic and time-consuming for a merging airline. For  example, officials at US Airways told us that while some cost reductions  were achieved within 3 to 6 months of its merger with America West, the  integration of information technology processes has taken nearly 2 ½  years. Systems integration issues are increasingly daunting as airlines  attempt to integrate a complex mix of modern in-house systems, dated  mainframe systems, and outsourced information technology. The US  Airways-America West merger highlighted the potential challenges  associated with combining reservations systems, as there were initial  integration problems.
section_title: The Department of Justice’s Antitrust Review Is a Critical Step in the Airline Merger and Acquisition Process
paragraphs: The DOJ’s review of airline mergers and acquisitions is a key step for  airlines hoping to consummate a merger. The Guidelines provide a five- part integrated process under which mergers and acquisitions are assessed  by DOJ. In addition, DOT plays an advisory role for DOJ and, if the  combination is consummated, may conduct financial and safety reviews of  the combined entity under its regulatory authority. Public statements by  DOJ officials and a review of the few airline mergers and acquisitions  evaluated by DOJ over the last 10 years also provide some insight into how  DOJ applies the Guidelines to the airline industry. While each merger and  acquisition review is case specific, our analysis shows that changes in the  airline industry, such as increased competition in international and  domestic markets, could lead to entry being more likely than in the past.  Additionally, the Guidelines have evolved to provide clarity as to the  consideration of efficiencies, an important factor in airline mergers.
subsections: section_title: The Department of Justice Uses the Guidelines to Identify Antitrust Concerns
paragraphs: Most proposed mergers or acquisitions must be reviewed by DOJ. In  particular, under the Hart-Scott-Rodino Act, an acquisition of voting  securities and/or assets above a set monetary amount must be reported to  DOJ (or the Federal Trade Commission for certain industries) so the  department can determine whether the merger or acquisition poses any  antitrust concerns. To analyze whether a proposed merger or acquisition  raises antitrust concerns—whether the proposal will create or enhance  market power or facilitate its exercise—DOJ follows an integrated five- part analytical process set forth in the Guidelines. First, DOJ defines the  relevant product and geographic markets in which the companies operate  and determines whether the merger is likely to significantly increase  concentration in those markets. Second, DOJ examines potential adverse  competitive effects of the merger, such as whether the merged airlines will  be able to charge higher prices or restrict output for the product or service  it sells. Third, DOJ considers whether other competitors are likely to enter  the affected markets and whether they would counteract any potential  anticompetitive effects that the merger might have posed. Fourth, DOJ  examines the verified “merger specific” efficiencies or other competitive  benefits that may be generated by the merger and that cannot be obtained  through any other practical means. Fifth, DOJ considers whether, absent  the merger or acquisition, one of the firms is likely to fail, causing its  assets to exit the market. The commentary to the Guidelines makes clear  that DOJ does not apply the Guidelines as a step-by-step progression, but  rather as an integrated approach in deciding whether the proposed merger  or acquisition would create antitrust concerns.
DOJ first assesses competitive effects at a city-pair market level. In its  review of past airline mergers and acquisitions, DOJ defined the relevant  market as scheduled airline service between individual city-pair markets  because, according to DOJ, that is the where airlines compete for  passengers. Second, DOJ assesses likely potential adverse competitive  effects---specifically, whether a merged airline is likely to exert market  power (maintain prices above competitive levels for a significant period of  time) in particular city-pair markets. Generally, a merger or acquisition  raises anticompetitive concerns to the extent it eliminates a competitor  from the markets that both airlines competed in. When United Airlines  and US Airways proposed merging in 2000, DOJ concluded that the  proposed merger would create monopolies or duopolies in 30 markets  with $1.6 billion in revenues, lead to higher fares, and harm consumers on  airline routes throughout the United States and on some international  routes. The department was particularly concerned about reduced  competition in certain markets—nonstop city-pair markets comprising the  two airlines’ hub airports, certain other nonstop markets on the East Coast  that were served by both airlines, some markets served via connecting  service by these airlines along the East Coast, and certain other markets  previously dominated by one or both of these airlines. DOJ estimated that  the merger would have resulted in higher air fares for businesses and  millions of customers. Similarly, in 2000 DOJ sought divestiture by  Northwest Airlines of shares in Continental Airlines after the airline had  acquired more than 50 percent of the voting interest in Continental. DOJ  argued that the acquisition would particularly harm consumers in 7 city- pair markets that linked Northwest and Continental airport hubs, where  the two airlines had a virtual duopoly. DOJ also pointed to potential  systemwide effects of removing a large competitor. Although DOJ  objected to the proposed merger of United and US Airways and the  acquisition of Continental by Northwest, it did not challenge a merger  between America West and US Airways in 2005 because it found little  overlap between city-pair markets served by the two airlines.
DOJ, under the Guidelines’ third element, assesses whether new entry  would counter the increased market power of a merged airline. If DOJ  determines that the merger is likely to give the merging airlines the ability  to raise prices or curtail service in a city-pair market, DOJ assesses  whether a new entrant would likely begin serving the city-pair in response  to a potential price increase to replace the lost competition and deter or  counter the price increase. For such entry to resolve concerns about a  market, the Guidelines require that it be “timely, likely, and sufficient” to  counteract the likely anticompetitive effects presented by the merger.  According to DOJ, the inquiry considers an entry time horizon of 2 years  and is fact specific rather than based on theory. Some factors that may be  considered in assessing likelihood of entry include whether a potential  entrant has a hub in one of the cities in a city-pair market of concern so  that the potential entrant is well placed to begin service, whether there are  constraints (such as slot controls or shortage of gates) that could limit  effective entry, and whether the potential entrant would be able to provide  the frequency of service that would be required to counteract the merged  firm’s presence. For example, if the merging parties operate the only hubs  at both end points of a market, it is unlikely that a new entrant airline  would find it profitable to offer an effective level of service. In its  complaint challenging Northwest Airlines’ attempted acquisition of a  controlling interest in Continental, DOJ alleged that significant entry  barriers limited new competition for the specific city-pair markets of issue.  For example, the complaint alleged that airlines without a hub at one of  the end points of the affected hub-to-hub markets were unlikely to enter  due to the cost advantages of the incumbents serving that market. In city- pair markets where the merging airlines would have a large share of  passengers traveling on connecting flights, DOJ asserted that other airlines  were unlikely to enter due to factors such as the light traffic on these  routes and the proximity of Northwest’s and Continental’s hubs to the  markets as compared to other airlines’ more distant hubs.
Fourth, DOJ considers whether merger-specific efficiencies are  “cognizable,” that is, whether they can be verified and do not arise from  anticompetitive reductions in output or services. Cognizable efficiencies,  while not specifically defined under the Guidelines, could include any  consumer benefit resulting from a merger—including enhanced service  through an expanded route network and more seamless travel—as well as  cost savings accruing to the merged airline (for example, from reducing  overhead or increased purchasing power that may ultimately benefit the  consumer). Because efficiencies are difficult to quantify and verify, DOJ  requires merger partners to substantiate merger benefits. DOJ considers  only those efficiencies likely to be accomplished by the proposed merger  and unlikely to be achieved through practical, less restrictive alternatives,  such as code-sharing agreements or alliances. For example, in its October  2000 complaint against Northwest Airlines for its acquisition of a  controlling interest in Continental, DOJ noted that Northwest had not  adequately demonstrated that the efficiencies it claimed from the merger  could not be gained from other, less anticompetitive means, particularly  their marketing alliance, which DOJ did not challenge.
Finally, DOJ considers the financial standing of merger partners—if one of  the partners is likely to fail without the merger and its assets were to exit  the market. According to the Guidelines, a merger isn’t likely to create or  enhance market power or facilitate its exercise if imminent failure of one  of the merging firms would cause the assets of that firm to exit the  relevant market. For instance, the acquisition of TWA by American  Airlines in 2001 was cleared because TWA was not likely to emerge from  its third bankruptcy and there was no less anticompetitive purchaser.
In making its decision as to whether the proposed merger is likely  anticompetitive—whether it is likely to create or enhance market power  or facilitate its exercise—DOJ considers the particular circumstances of  the merger as it relates to the Guidelines’ five-part inquiry. The greater the  potential anticompetitive effects, the greater must be the offsetting  verifiable efficiencies for DOJ to clear a merger. However, according to  the Guidelines, efficiencies almost never justify a merger if it would create  a monopoly or near monopoly. If DOJ concludes that a merger threatens  to deprive consumers of the benefits of competitive air service, then it will  seek injunctive relief in a court proceeding to block the merger from being  consummated. In some cases, the parties may agree to modify the  proposal to address anticompetitive concerns identified by DOJ—for  example, selling airport assets or giving up slots at congested airports—in  which case DOJ ordinarily files a complaint along with a consent decree  that embodies the agreed-upon changes.
section_title: The Department of Transportation Also Reviews Proposed Mergers to Ensure That They Are in the Public Interest
paragraphs: DOT conducts its own analyses of airline mergers and acquisitions. While  DOJ is responsible for upholding antitrust laws, DOT will conduct its own  competitive analysis and provide it to DOJ in an advisory capacity. In  addition, presuming the merger moves forward after DOJ review, DOT can  undertake several other reviews if the situation warrants it. Before  commencing operations, any new, acquired, or merged airlines must  obtain separate authorizations from DOT—“economic” authority from the  Office of the Secretary and “safety” authority from the Federal Aviation  Administration (FAA). The Office of the Secretary is responsible for  deciding whether applicants are fit, willing, and able to perform the  service or provide transportation. To make this decision, the Secretary  assesses whether the applicants have the managerial competence,  disposition to comply with regulations, and financial resources necessary  to operate a new airline. FAA is responsible for certifying that the aircraft  and operations conform to the safety standards prescribed by the  Administrator, for instance, that the applicants’ manuals, aircraft,  facilities, and personnel meet federal safety standards. Also, if a merger or  other corporate transaction involves the transfer of international route  authority, DOT is responsible for assessing and approving all transfers to  ensure that they are consistent with the public interest. DOT is responsible  for approving such matters to ensure that they are consistent with the  public interest. Finally, DOT also reviews the merits of any airline merger  or acquisition and submits its views and relevant information in its  possession to the DOJ. DOT also provides some essential data that DOJ  uses in its review.
section_title: Changes in the Airline Industry and in the Guidelines May Affect the Factors Considered in DOJ’s Merger Review Process
paragraphs: Changes in the airline industry’s structure and in the Guidelines may affect  the factors considered in DOJ’s merger review process. DOJ’s review is not  static, as it considers both market conditions and current antitrust thinking at  the time of the merger review. According to our own analysis and other  studies, the industry has grown more competitive in recent years, and if that  trend is not reversed by increased fuel prices, it will become more likely that  market entry by other airlines, and possibly low-cost airlines, will bring fares  back down in markets in which competition is initially reduced due to a  merger. In addition, the ongoing liberalization of international markets and, in  particular, cross-Atlantic routes under the U.S.-European Union Open Skies  agreement, has led to increased competition on these routes. Finally, as DOJ  and the Federal Trade Commission have evolved in their understanding of  how to integrate merger-specific efficiencies into the evaluation process, the  Guidelines have also changed.
section_title: Increased Competition Indicates That Airline Entry May Be More Likely than in the Past
paragraphs: A variety of characteristics of the current airline marketplace indicate that  airline entry into markets vacated by a merger partner may be more likely  than in the past, unless higher fuel prices substantially alter recent  competitive trends in the industry. First, as we have noted, competition on  airline routes—spurred by the growth and penetration of low-cost  airlines—has increased, while the dominance of legacy airlines has been  mitigated in recent years. According to our study, about 80 percent of  passengers are now flying routes on which at least one low-cost airline is  present. Moreover, some academic studies suggest that low-cost carrier  presence has become a key factor in competition and pricing in the  industry in recent years. Two articles suggest that the presence of  Southwest Airlines on routes leads to lower fares and that even their  presence—or entry into end-point airports of a market pair—may be  associated with lower prices on routes. Another recent study found that  fare differentials between hub and nonhub airports—once measured to be  quite substantial—are not as great as they used to be, which suggests a  declining relevance of market power stemming from airline hub  dominance. The study did find, however that when there is little presence  of low-cost airlines at a major carrier’s hub airport, the hub premium  continues to remain substantial. However, our competition analysis and  these studies predate the considerable increase in fuel prices that has  occurred this year and, if permanent, could affect competition and airlines’  willingness to expand into new markets.
In some past cases, DOJ rejected the contention that new entry will be  timely, likely, and sufficient to counter potential anticompetitive effects.  For example, in 2000, when DOJ challenged Northwest Airline’s proposed  acquisition of a controlling interest in Continental Airlines, a DOJ official  explained that the department considered it unrealistic to assume that the  prospect of potential competition—meaning the possibility of entry into  affected markets by other airlines—would fully address anticompetitive  concerns, given network airline hub economics at the time.
section_title: Merger Guidelines Have Evolved to Reflect Federal Antitrust Authorities’ Greater Understanding of Efficiencies
paragraphs: The Guidelines have been revised several times over the years, and  particularly the most recent revision, in 1997, reflects a greater  understanding by federal antitrust authorities in how to assess and weigh  efficiencies. In 1968, the consideration of efficiencies was allowed only as  a defense in exceptional circumstances. In 1984, the Guidelines were  revised to incorporate efficiencies as part of the competitive effects  analysis, rather than as a defense. However, the 1984 Guidelines also  required “clear and convincing” evidence that a merger will achieve  significant net efficiencies. In 1992, the Guidelines were revised again,  eliminating the “clear and convincing” standard. The 1997 revision  explains that efficiencies must be “cognizable,” that is, merger-specific  efficiencies that can be verified and are net of any costs and not resulting  solely from a reduction in service or output. In considering the  efficiencies, DOJ weighs whether the efficiencies may offset the  anticompetitive effects in each market. According to the Guidelines, in  some cases, merger efficiencies are not strictly in the relevant market, but  are so inextricably linked with it that a partial divestiture or other remedy  could not feasibly eliminate the anticompetitive effect in the relevant  market without sacrificing the efficiencies in other markets. Under those  circumstances, DOJ will take into account across-the-board efficiencies or  efficiencies that are realized in markets other than those in which the  harm occurs. According to DOJ and outside experts, the evolution of the  Guidelines reflects an attempt to provide clarity as to the consideration of  efficiencies, an important factor in the merger review process.
section_title: Agency Comments
paragraphs: We provided a draft of this report to DOT and DOJ for their review and  comment. Both DOT and DOJ officials provided some clarifying and  technical comments that we incorporated where appropriate.
We provided copies of this report to the Attorney General, the Secretary of  Transportation, and other interested parties and will make copies  available to others upon request. In addition, this report will be available  at no charge on our Web site at http://www.gao.gov.
If you or your staff have any questions on matters discussed in this report,  please contact me on (202) 512-2834 or at heckerj@gao.gov. Contact points  for our Offices of Congressional Relations and Public Affairs may be found  on the last page of this report. Key contributors to this report can be found  in appendix IV.
section_title: Appendix I: Scope and Methodology
paragraphs: To review the financial condition of the U.S. airline industry, we analyzed  financial and operational data, reviewed relevant studies, and interviewed  industry experts. We analyzed DOT Form 41 financial and operational data  submitted to DOT by airlines between the years 1998 through 2007. We  obtained these data from BACK Aviation Solutions, a private contractor  that provides online access to U.S. airline financial, operational, and  passenger data with a query-based user interface. To assess the reliability  of these data, we reviewed the quality control procedures used by BACK  Aviation and DOT and subsequently determined that the data were  sufficiently reliable for our purposes. We also reviewed government and  expert data analyses, research, and studies, as well as our own previous  studies. The expert research and studies, where applicable, were reviewed  by a GAO economist or were corroborated with additional sources to  determine that they were sufficiently reliable for our purposes. Finally, we  conducted interviews with government officials, airlines and their trade  associations, credit and equity analysts, industry experts, and academics.  The analysts, experts, and academics were identified and selected based  on literature review, prior GAO work, and recommendations from within  the industry.
To determine if and how the competitiveness of the U.S. airline industry  has changed since 1998, we obtained and stratified DOT quarterly data on  the 5,000 largest city-pair markets for calendar years 1998 through 2006.  These data are collected by DOT based on a 10 percent random sampling  of tickets and identify the origin and destination airports. These markets  accounted for about 90 percent of all passengers in 2006. We excluded  tickets with interlined flights—a flight in which a passenger transfers from  one to another unaffiliated airline—and tickets with international,  Alaskan, or Hawaiian destinations. Since only the airline issuing the ticket  is identified, regional airline traffic is counted under the legacy parent or  partner airline. To assess the reliability of these data, we reviewed the  quality control procedures DOT applies and subsequently determined that  the data were sufficiently reliable for our purposes. To analyze changes in  competition based on the size of the passenger markets, we divided the  markets into four groupings. Each group is composed of one-quarter of the  total passenger traffic in each year. To stratify these markets by the  number of effective competitors operating in a market, we used the  following categories: one, two, three, four, and five or more effective  competitors, where a airline needed to have at least a 5 percent share of  the passengers in the city-pair market to be considered an effective  competitor in that market. To stratify the data by market distance, we  obtained the great circle distance for each market using the DOT ticket  data via BACK Aviation and then grouped the markets into five distance  categories: up to 250 miles, 251-500 miles, 501-750 miles, 751-1,000 miles,  and 1,001 miles and over. For the purposes of this study, we divided the  airline industry into legacy and low-cost airlines. While there is variation in  the size and financial condition of the airlines in each of these groups,  there are more similarities than differences for airlines in each group.  Each of the legacy airlines predate the airline deregulation of 1978, and all  have adopted a hub-and-spoke network model, can be more expensive to  operate than a simple point-to-point service model. Low-cost airlines have  generally entered interstate competition since 1978, are smaller, and  generally employ a less costly point-to-point service model. Furthermore,  the seven low-cost airlines (Air Tran, America West, ATA, Frontier,  JetBlue, Southwest, and Spirit) had consistently lower unit costs than the  seven legacy airlines (Alaska, American, Continental, Delta, Northwest,  United, and US Airways). For this analysis, we continued to categorize US  Airways as a legacy airline following its merger with America West in 2005,  and included the data for both airlines for 2006 and 2007 with the legacy  airlines and between 1998 through 2005 we categorized America West as a  low-cost airline.
To determine if competition has changed at the 30 largest airports, we  analyzed DOT T-100 enplanement data for 1998 and 2006 to examine the  changes in passenger traffic among the airlines at each airport. The T-100  database includes traffic data (passenger and cargo), capacity data, and  other operational data for U.S. airlines and foreign airlines operating to  and from the United States. The T-100 and T-100(f) data files are not based  on sampled data or data surveys, but represent a 100 percent census of the  data. To assess the reliability of these data, we reviewed the quality  control procedures DOT applies and subsequently determined that the  data were sufficiently reliable for our purposes.
To determine the potential effects on competition between the merger of  Delta Air Lines and Northwest Airlines explained in appendix II, we  examined whether the merger might reduce competition within given  airline markets. We defined an effective competitor as an airline that has a  market share of at least 5 percent. To examine the potential loss of  competition under the merger, we determined the extent to which each  airline’s routes overlap by analyzing 2006 data from DOT on the 5,000  busiest domestic city-pair origin and destination markets. To determine  the potential loss of competition in small communities, we analyzed origin  and destination data (OD1B) for the third quarter of 2007 to determine the  extent to which airlines’ routes overlap. We defined small communities as  those communities with airports that are defined as “nonhubs” by statute  in 49 U.S.C. § 47102(13).
To identify the key factors that airlines consider in deciding whether to  merge with or acquire another airline, we reviewed relevant studies and  interviewed industry experts. We reviewed relevant studies and  documentation on past and prospective airline mergers in order to identify  the factors contributing to (or inhibiting) those transactions. We also met  with DOT and Department of Justice (DOJ) officials, airline executives,  financial analysts, academic researchers, and industry consultants to  discuss these factors and their relative importance.
To understand the process and approach used by federal authorities in  considering airline mergers and acquisitions, we reviewed past and  present versions of the Guidelines, DOT statutes and regulations, and  other relevant guidance. We also analyzed legal documents from past  airline mergers and published statements by DOT and DOJ officials to  provide additional insight into how DOJ and DOT evaluate merger  transactions. Finally, we discussed the merger review process with DOJ  and DOT officials and legal experts. We conducted this performance audit  from May 2007 through July 2008 in accordance with generally accepted  government auditing standards. Those standards require that we plan and  perform the audit to obtain sufficient, appropriate evidence to provide a  reasonable basis for our findings and conclusions based on our audit  objectives. We believe that the evidence obtained provides a reasonable  basis for our findings and conclusions based on our audit objectives.
section_title: Appendix II: Delta and Northwest Merger
section_title: Appendix III: Number and Size of Dominated Markets by Airline in the Top 5,000 Markets, 2006
section_title: Appendix IV: GAO Contact and Staff Acknowledgments
subsections: section_title: Staff Acknowledgments
paragraphs: In addition to the contact named above, Paul Aussendorf, Assistant  Director; Amy Abramowitz; Lauren Calhoun; Jessica Evans; Dave Hooper;  Delwen Jones; Mitchell Karpman; Molly Laster; Sara Ann Moessbauer;  Nick Nadarski; and Josh Ormond made key contributions to this report.
section_title: Related GAO Products
paragraphs: Airline Deregulation: Reregulating the Airline Industry Would Likely  Reverse Consumer Benefits and Not Save Airline Pensions. GAO-06-630.  Washington, D.C.: June 9, 2005.
Commercial Aviation: Bankruptcy and Pension Problems Are Symptoms  of Underlying Structural Issues. GAO-05-945. Washington, D.C.: Sept. 30,  2005.
Private Pensions: The Pension Benefit Guaranty Corporation and Long- Term Budgetary Challenges. GAO-05-772T. Washington, D.C.: June 9,  2005.
Private Pensions: Government Actions Could Improve the Timeliness  and Content of Form 5500 Pension Information. GAO-05-294.  Washington, D.C.: June 3, 2005.
Private Pensions: Recent Experiences of Large Defined Benefit Plans  Illustrate Weaknesses in Funding Rules. GAO-05-294. Washington, D.C.:  May 31, 2005.
Commercial Aviation: Legacy Airlines Must Further Reduce Costs to  Restore Profitability. GAO-04-836. Washington, D.C.: August 11, 2004.
Private Pensions: Publicly Available Reports Provide Useful but Limited  Information on Plans’ Financial Condition. GAO-04-395. Washington,  D.C.: March 31, 2004.
Private Pensions: Multiemployer Plans Face Short- and Long-Term  Challenges. GAO-04-423. Washington, D.C.: March 26, 2004.
Private Pensions: Timely and Accurate Information Is Needed to  Identify and Track Frozen Defined Benefit Plans. GAO-04-200R.  Washington, D.C.: December 17, 2003.
Pension Benefit Guaranty Corporation: Single-Employer Pension  Insurance Program Faces Significant Long-Term Risks. GAO-04-90.  Washington, D.C.: October 29, 2003.
Commercial Aviation: Air Service Trends at Small Communities since  October 2000. GAO-02-432. Washington, D.C.: March 29, 2002.