On May 3, 2010, United and Continental announced an agreement to merge the two airlines. The new airline would retain the United name and headquarters in Chicago while the current Continental Chief Executive Officer would keep that title with the new airline. The proposed merger will be financed exclusively through an all-stock transaction with a combined equity value of $8 billion split roughly with 55 percent ownership to United shareholders and 45 percent to Continental shareholders. The airlines have not announced specific plans for changes in their networks or operations that would occur if the proposed merger is not challenged by DOJ. 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 seven largest surviving airlines). 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 Airlines and Air California merged. In 1988, merger and acquisition review authority was transferred from the Department of Transportation (DOT) to DOJ. Since 1998, despite tumultuous financial periods, fewer mergers and acquisitions have occurred. In 2001, American Airlines acquired the bankrupt airline TWA, in 2005 America West acquired US Airways while the latter was in bankruptcy, and, in October 2008, Delta acquired Northwest. Certain other attempts at merging in the last decade failed because of opposition from DOJ or from employees and creditors. For example, in 2000, an agreement was reached that allowed Northwest to acquire a 50 percent stake in Continental (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 fell apart because of opposition from Delta’s pilots and some of its creditors, as well as its senior management. Since deregulation in 1978, the financial stability of the airline industry has become a considerable concern for the federal government owing, in part, to the level of financial assistance it has provided to the industry by assuming terminated pension plans and other forms of assistance. Between 1978 and 2008, 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 and US Airways terminated their pension plans and $9.7 billion in claims was shifted to the Pension Benefit Guarantee Corporation (PGBC). Furthermore, 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, as measured by available seat miles. Previously, we 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. Volatile earnings and structural changes in the industry have spurred some airlines to explore mergers as a way to increase their profitability and financial viability. Over the last decade, the U.S. passenger airline industry has incurred more than $15 billion in operating losses. Several major airlines went through bankruptcy to reduce their costs and restructure their operations, while others ceased to operate or were acquired. Most recently, U.S. airlines responded to volatile fuel prices and then a weakening economy by cutting their capacity, reducing their fleets and workforces, and instituting new fees, but even with these actions, the airlines experienced over $5 billion in operating losses in 2008 before posting an operating profit of about $1 billion in 2009. Furthermore, over the last decade, airfares have generally declined (in real terms), owing largely to the increased presence of low-cost airlines, such as Southwest Airlines, in more markets and the shrinking dominance of a single airline in many markets. One of the primary financial benefits that airlines consider when merging with another airline is the cost reduction that may result from combining complementary assets, eliminating duplicative activities, and reducing capacity. A merger or acquisition could enable the combined airline to reduce or eliminate duplicative operating costs, such as duplicative service, labor, and operations costs—including inefficient (or redundant) hubs or routes—or to achieve operational efficiencies by integrating 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. Airlines may also pursue mergers or acquisitions to more efficiently manage capacity—both to reduce operating costs and to generate revenue—in their networks. Given recent economic pressures, particularly increased fuel costs, the opportunity to lower costs by reducing redundant capacity may be especially appealing to airlines seeking to merge. 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 significant impact that economic cycles have historically had on airline cash flow. The other primary financial benefit that airlines consider with mergers and acquisitions is the potential for increased revenues through additional demand, which may be achieved by more seamless travel to more destinations and increased market share and higher fares on some routes. Increased demand from an expanded network: An airline may 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 and better serves passengers. 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 on 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. Increased market share and higher fares on some routes: Capacity reductions in certain markets after a merger could also serve to generate additional revenue through increased fares on some routes. Some studies of airline mergers and acquisitions during the 1980s showed that prices were higher on some routes from the airline’s hubs soon after the combination was completed. Several studies have also shown that increased airline dominance at an airport results in increased fare premiums, in part because of competitive barriers to entry. At the same time, though, 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. Cost reductions and the opportunity to obtain increased revenue could bolster a merged airline’s financial condition, enabling the airline to better compete in a highly competitive international environment. 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. Despite these benefits, there are several potential barriers to successfully consummating a merger. The most significant operational challenges involve the integration of workforces, aircraft fleets, and information technology systems and processes, which can be difficult, disruptive, and costly as the airlines integrate. Workforce integration: 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 for a merger or acquisition to be successful. Some experts also note that labor has often opposed 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 over employee seniority, and especially pilot seniority, are not fully resolved. More recently, labor integration issues derailed merger talks—albeit temporarily—between Northwest and Delta in early 2008, when the airlines’ labor unions were unable to agree on pilot seniority list integration. 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 and US Airways broke down in 1995 because the employee-owners of United feared that the airlines’ corporate cultures would clash. Fleet integration: 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. These costs may, however, be reduced after the merger by phasing out certain types of aircraft from the fleet mix. Pioneered by Southwest Airlines 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. Information technology integration: Finally, integrating information technology processes and systems can also be problematic and time- consuming after a merger. 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 took 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 reservation systems, as there were initial integration problems. DOJ’s review of airline mergers and acquisitions is a key step for airlines hoping to consummate a merger. For airlines, as with other industries, DOJ uses an analytical framework set forth in the Horizontal Merger Guidelines (the Guidelines) to evaluate merger proposals. 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. Most proposed airline mergers or acquisitions must be reviewed by DOJ as required by the Hart-Scott-Rodino Act. In particular, under the act, an acquisition of voting securities or assets above a set monetary amount must be reported to DOJ (or the Federal Trade Commission (FTC) 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 entity 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 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. In deciding whether the proposed merger is likely anticompetitive 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 merged airline 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 with the court along with a consent decree that embodies the agreed-upon changes. DOT conducts its own analyses of airline mergers and acquisitions. While DOJ is responsible for upholding antitrust laws, DOT conducts its own competitive analysis and provide it to DOJ in an advisory capacity. DOT reviews the merits of any airline merger or acquisition and submits its views and relevant information in its possession to DOJ. DOT also provides some essential data that DOJ uses in its review.. In addition, presuming the merger moves forward after DOJ review, DOT can undertake several other reviews if the situation warrants. 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. If not challenged by DOJ, the merged United-Continental would surpass Delta as the largest U.S. passenger airline. As table 1 indicates, combining United and Continental Airlines would create the largest U.S. airline based on 2009 capacity as measured by available seat miles, and a close second based on total assets and operating revenue. The combined airline would also have the largest workforce among U.S. airlines based on March 2010 employment statistics, with a combined 76,900 employees as measured by full-time-equivalent employees (table 2). The airlines’ workforces are represented by various unions, and in some cases the same union represents similar employee groups, such as the union for the pilots (table 3). Finally, the combined airline would need to integrate 692 aircraft (table 4). The two airlines share some of the same aircraft types, which could make integration easier. If not challenged by DOJ, the airlines would attempt to combine two distinct networks, United with major hubs, where the airline connects traffic feeding from smaller airports, in San Francisco (SFO), Los Angeles (LAX), Denver (DEN), Chicago O’Hare (ORD), and Washington DC Dulles (IAD) and Continental with hubs in Houston Intercontinental (IAH), Cleveland (CLE), Guam (GUM), and New York Newark (EWR), as shown in figure 2. The amount of overlap in airport-pair combinations between the two airlines’ networks is considerable if considering all connecting traffic; however, for most of the overlapping airport-pair markets there is at least one other competitor. Based on 2009 ticket sample data, for 13,515 airport pairs with at least 520 passengers per year, there would be a loss of one effective competitor in 1,135 airport-pair markets affecting almost 35 million passengers by merging these airlines (see fig. 3). However, only 10 of these airport-pair markets would not have any other competitors in after a merger. In addition, any effect on fares would be dampened by the presence of a low-cost airline in 431 of the 1,135 airport pairs losing a competitor. The combination of the two airlines would also create a new effective competitor in 173 airport-pair markets affecting almost 9.5 million passengers. For further information on this testimony, please contact Susan Fleming at (202) 512-2834. Individuals making key contributions to this statement include Paul Aussendorf (Assistant Director), Amy Abramowitz, Lauren Calhoun, Elizabeth Eisenstadt, Delwen Jones, Mitch Karpman, Heather Krause, Sara Ann Moessbauer, Dominic Nadarski, and Josh Ormond. Airline Industry: Airline Industry Contraction Due to Volatile Fuel Prices and Falling Demand Affects Airports, Passengers, and Federal Government Revenues. GAO-09-393. Washington, D.C.: April 21, 2009. Airline Industry: Potential Mergers and Acquisitions Driven by Financial Competitive Pressures. GAO-08-845. Washington, D.C.: July 31, 2008. Commercial Aviation: Bankruptcy and Pension Problems Are Symptoms of Underlying Structural Issues. GAO-05-945. Washington, D.C.: September 30, 2005. Commercial Aviation: Preliminary Observations on Legacy Airlines’ Financial Condition, Bankruptcy, and Pension Issues. GAO-05-835T. Washington, D.C.: June 22, 2005. 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. Private Pensions: Airline Plans’ Underfunding Illustrates Broader Problems with the Defined Benefit Pension System. GAO-05-108T. Washington, D.C.: October 7, 2004. Commercial Aviation: Legacy Airlines Must Further Reduce Costs to Restore Profitability. GAO-04-836. Washington, D.C.: August 11, 2004. Transatlantic Aviation: Effects of Easing Restrictions on U.S.-European Markets. GAO-04-835. Washington, D.C.: July 21, 2004. Commercial Aviation: Despite Industry Turmoil, Low-Cost Airlines Are Growing and Profitable. GAO-04-837T. Washington, D.C.: June 3, 2004. Commercial Aviation: Financial Condition and Industry Responses Affect Competition. GAO-03-171T. Washington, D.C.: October 2, 2002. Commercial Aviation: Air Service Trends at Small Communities since October 2000. GAO-02-432. Washington, D.C.: March 29, 2002. Proposed Alliance Between American Airlines and British Airways Raises Competition Concerns and Public Interest Issues. GAO-02-293R. Washington, D.C: December 21, 2001. Aviation Competition: Issues Related to the Proposed United Airlines-US Airways Merger. GAO-01-212. Washington, D.C: December 15, 2000. This is a work of the U.S. government and is not subject to copyright protection in the United States. The published product may be reproduced and distributed in its entirety without further permission from GAO. However, because this work may contain copyrighted images or other material, permission from the copyright holder may be necessary if you wish to reproduce this material separately.

Summary: Earlier this month, United Air Lines (United) and Continental Airlines (Continental) announced plans to merge the two airlines and signed a merger agreement. This follows the acquisition of Northwest Airlines by Delta Air Lines (Delta) in 2008, which propelled Delta to become the largest airline in the United States. This latest merger, if not challenged by the Department of Justice (DOJ), would surpass Delta's merger in scope to create the largest passenger airline in terms of capacity in the United States. The passenger airline industry has struggled financially over the last decade, and these two airlines believe a merger will strengthen them. However, as with any proposed merger of this magnitude, this one will be carefully examined by DOJ to determine if its potential benefits for consumers outweigh the potential negative effects. At the Committee's request, GAO is providing a statement for the record that describes (1) an overview of the factors that are driving mergers in the industry, (2) the role of federal authorities in reviewing merger proposals, and (3) key issues associated with the proposed merger of United and Continental. To address these objectives, GAO drew from previous reports on the potential effects of the proposed merger between Delta and Northwest and the financial condition of the airline industry, and analyzed Department of Transportation (DOT) airline operating and financial data. As GAO has previously reported, airlines seek to merge with or acquire other airlines to increase their profitability and financial sustainability, but must weigh these potential benefits against operational 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. DOJ's antitrust review is a critical step in the airline merger and acquisition process. DOJ uses an integrated analytical framework set forth in the Horizontal Merger Guidelines to determine whether the merger poses any antitrust concerns. Under that process, DOJ assesses the extent of likely anticompetitive effects of reducing competition in the relevant markets--in this case, between cities or airports. 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. Finally, it examines whether one of the airlines proposing to merge would fail and its assets exit the market in the absence of a merger. One of the most important issues in this merger will be its effect on competition in the airline industry. For example, GAO's analysis of 2009 ticket data showed that combining these airlines would result in a loss of one effective competitor (defined as having at least 5 percent of total traffic between airports) in 1,135 markets (called airport pairs) affecting almost 35 million passengers while creating a new effective competitor in 173 airport pairs affecting almost 9.5 million passengers. However, in all but 10 of these airports pairs there is at least one other competitor.