United Airlines and Continental Merger

Running head: UNITED AIRLINES AND CONTINENTAL MERGER

United Airlines and Continental Merger

Jared Dickson, Jordan Lopez, Kayce Jones

April 16th, 2015

Oklahoma Christian University

Authors’ Note

This paper was prepared for Advanced Accounting II 4213, section 01, taught by

Professor Kelly.

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UNITED AIRLINES AND CONTINENTAL MERGER

United Airlines and Continental Merger

Introduction

The world’s largest airline appeared in 2010 with the merger of United and Continental.

After surpassing the largest airline at the time, which was Delta, United would now fly under

United’s name with Continental’s old logo and colors (Koenig). With the merge of two large

airlines that had been operating separately for over 90 years, the outcome resulted in various

successes and failures. Discussion will continue with the merger between United and Continental

along with the aftermath of the merge. Finally, what does the merger mean for the future of the

company and will all of the kinks be worked out? However, to understand the merge fully, it is

crucial to first look at the history behind United and Continental Airlines each as individual

companies.

History

Continental, originally known as Varney Airlines, began under the control of Walter T.

Varney. Four years later Robert Forman took over the airline and gave it the name Continental.

The airline grew quickly flying routes from Chicago, Miami, and New Orleans to Hawaii, Far

East, and even south to Venezuela. In the 80’s and early part of the 2000s, Continental began to

struggle and was forced to join with many Texas subsidiaries and also was acquired by Air

Canada and a group of private investors (Encyclopedia Britannica). This caused the airline to

have many more routes and aircraft, but the company was still debt-ridden. Continental filed for

bankruptcy in 1990 but continued to press on.

United began as both an air transport and an aircraft manufacturing company in 1929, but

was forced to dissolve and become United Airlines Inc., an independent operating company, in

1934. With the end of WWII, United greatly expanded its routes and embarked on a number of

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corporate mergers including its new parent and holding company, UAL. Throughout the 70s and

80s United acquired many hotels and car rental companies but later they were sold off to focus

on its’ parent company, United Airlines, which was one of the largest carriers in the world. With

the attacks on September 11th, the airline was forced to file for bankruptcy but emerged from it in

2006 (Encyclopedia Britannica).

Both United and Continental had survived powerful blowouts from the recession to the

rising of fuel costs. Still, airlines were struggling to find a business model that made sense.

“Consolidation gives them more leverage,” Scott Sconenshein said, who is a professor at Rick

University. Throughout the late 2000s both United and Continental were going through a period

of restructuring but beginning to become more financially stable airlines. With the economy

starting to improve and more people flying, the airline industry was becoming a lot healthier

(Mouawad). Analysts were also starting to describe the airline industry as “suffering from excess

capacity, due to the left-over effects of new entries and retaliatory expansion by incumbents.”

Consolidation was viewed as vital and a strong possibility (Parthasarthy). Sure enough, in early

2010 United and Continental announced its plans to merge. The two companies would form into

one, creating an airline that would have 7% of the entire market share. Now that the background

of each individual airline has been covered, it is important to understand the previous

relationship between the airlines and the details of the merge.

THE MERGER

Moving on to what actually occurred throughout the merging process, one should

understand the relationship between these two companies before the merge was completed.

United Airlines and Continental Airlines originally discussed the possibility of a merge in 2008.

The reason the merge was not finalized at this time was due to Continental management’s belief

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that United was not financially strong enough to better their future in the airline industry.

Originally in 2008, Continental held more weight in the discussions because of their stronger

financial position. However, throughout the merging discussions in 2010, United led the way in

discussions. United grew over the time from the original discussions into the more powerful

company (Smith).

In mid-2010, when the merge was completed, both chief executive officers of the

companies met together for a press conference. Jeff Smisek, the CEO of Continental and future

CEO of the combined United-Continental stated, “Combining these two companies is the best

way to position ourselves and allow us to thrive in the changing and competitive airline

industry”. Smisek later goes on to say, “Continental is strong, where United is weak; United is

strong where Continental is weak. Putting these two carriers together is a match made in heaven”

(Smith). It is clear that when the merge was complete, both companies were very satisfied and

excited to see what the future had in store for the combined entities. According to the New York

Times’, this merge was completed in a span of three weeks and was going to give the combined

company the power to fend off low-cost domestic competitors, while also giving them power to

compete with large foreign carriers abroad. Both companies believed a merge would be a great

opportunity to become the largest carrier and possibly result in over $2 billion of additional

revenue. The idea of reducing an estimated $1 to $1.2 billion of costs, which would come from

eliminating the other as a competitor, was another enticing attribute that was believed to come

from the merge (Mouawad).

While there were many pros that pushed both CEO’s to the decision of a merge, they also

expected some cons. A disadvantage could involve loyal Continental Airline customers shying

away if United Airlines becomes the name that represents both entities. Another disadvantage is

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the concerns potential flyers will have because they may believe that the consolidation will mean

an increase in ticket prices. Unfortunately, history shows that airline consolidation also increases

fleet-trimming which makes this a disadvantage for airline employees (Smith). Scott Sonenshein,

an assistant professor at the Jones Graduate School of Business at Rice University, stated,

“Consolidation gives them more leverage. As a consumer, you will have less choices, fewer

routes, higher prices and more fees” (Mouawad). This can be seen as an advantage for United-

Continental, but it can also create a negative mindset in consumers toward the combined

company.

Now that the reasoning for the merger has been explained, it is important to understand

how the merge was carried out. The merge was to be an all-stock transaction. United’s parent

company, UAL Corporation, would issue 1.05 shares for every Continental share. This would

value the entire acquisition at roughly $3.17 billion (Mouawad). The merge was to be completed

sometime before 2011, which would give the companies about seven months to get everything

situated. The existing United shareholders were to own 55 percent of United-Continental, while

Continental shareholders would own the remaining 45 percent (Smith).

The merge did include a large amount of goodwill. According to the 2010 annual report,

United Airlines estimated the fair value of Continental Airline’s assets and liabilities as of the

closing date of the merge and determined that goodwill would amount to $4,523,000,000, which

was actually larger than the acquisition cost. After three weeks, the merge was closed on October

1, 2010. The goodwill was primarily due to expected synergies to be gained from an enhanced

route network along with other operating efficiencies. The goodwill was not deductible for tax

purposes. The goodwill was also to be amortized and tested for impairment annually, or on an

interim basis whenever triggering events occur. The goodwill carrying amount has remained the

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same $4.5 billion since the date of the merge. Therefore, no impairments have been determined

(Annual Report).

In order to comply with Sarbanes-Oxley requirements, the combined company would

have to decide which public accounting firm would perform their independent audits. According

to United Airlines and Continental’s previous annual reports, the independent auditors that

performed quarterly reviews and year-end audits consisted of Ernst and Young and Deloitte and

Touche. In 2009, the last full year before the merge in October 2010, Ernst and Young audited

Continental Airlines and Deloitte and Touche audited United Airlines. After the merge, Deloitte

and Touche audited the company in 2010. From 2011 to present, Ernst and Young have provided

United Airlines with independent auditing services (Annual Report).

The initial reaction of investors seemed positive for the most part. While there were

multiple lawsuits scattered around with both companies, there were not any signs of shareholder

opposition (Grant). Some of Continental’s investors were not fully on board with the idea of

using the United “tulip logo, while others did not like the idea of the merge creating job losses in

some areas. Regardless of these worries, when investors met to vote on the merge in

Continental’s Houston headquarter and United’s Chicago-based headquarter, the votes came out

98 percent in favor of the merge. CEO Jeff Smisek expressed the following on the topic, “We are

grateful for our stockholders' strong vote of confidence in this merger. Our stockholders

recognized the value of bringing together Continental and United to create a platform for

increased profitability and sustained long-term value" (Clark). Now that there is basic

understanding of what occurred through the merging process, it is time to see how the combined

companies have performed moving forward.

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After the Merger

It is naive to think that a merger will be problem free with the immense amount

integration required by both companies, especially when the new entity is the largest in the

industry. United and Continental Airlines have been dealing with some of these integration

problems on a large scale. One of the primary integration issues has been glitches in the

computer system, which has caused flight delays. “United has the worst operational record

among the nation’s top 15 airlines. Its on-time arrival rate in the 12 months through September

was just 77.5 percent — six percentage points below the industry average and 10 percentage

points lower than Delta Air Lines.” (Mouawad). This is of course a problem in the airline

industry.

The new entity has also been dealing employee issues caused by the varying cultures of

the two companies in the combination. There is resentment on behalf of the employees because

of varying work rules for their pilots. The problem is currently being worked out through

implementing a single contract for all pilots, flight attendants, and mechanics. The labor issues

are particularly concerning considering United’s history of poor labor conditions. It is hoped that

the top-notch operational and customer-oriented nature of Continental will be the model used for

the new combined entity.

Customers have been disappointed in the customer service they have received through the

now merged United Airlines. The merger was intended to create an unparalleled global network,

further enhanced by Jeff Smisek of Continental, which is known for his specialization and

attention in customer service. “The result has been hobbled operations, angry passengers and

soured relations with employees” (Mouawad). A key problem causing poor customer service is

derived from the poor employee relations between former companies United and Continental and

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between the new merged company. Unhappy employees do not create a good customer service

environment for customers. It remains to be seen if Continental's former successes in operations

and customer service can be recreated with the new United Airlines.

As stated previously, Investors were initially excited about the opportunities of the new

largest airline and global network in the airline industry. However, the merger has not met

investor expectations because of merger costs, poor on-time arrival, and disappointing earnings.

“It took a $60 million charge in the third quarter for merger-related expenses, including

repainting planes. It also took a $454 million charge to cover a future cash payment to pilots

under a tentative deal reached in August.” (Mouawad). To make matters even worse, United had

reported losses in the first three quarters of 2012, when most large airlines were reporting profits.

Also in 2012 United’s shares were only up 7 percent compared to a 12 percent gain on the S&P

500 and a 24 percent gain by Delta. Investors have to hope that the kinks will be worked out and

that the new planes with enhanced features can help solve some of these issues. The enhanced

features include the following: satellite-based Wifi, carbon-fiber technology to reduce jet lag,

flatbed seats in business class, and larger overhead bins.

“Some analysts agree United is turning things around by cutting costs and adding more

fuel-efficient planes on its regional flights” (Sasso). It is hard to say how much of this

improvement is due to efficiency of low oil prices. United is also improving by implementing

Wi-Fi on all of its’ planes and upgrading it’s food and drink services for premium cabins. United

have also been cutting costs through layoffs as well as the change from 50-seat jets to more

comfortable and fuel-efficient 76-seat planes. “The moves helped United earn $919 million and

$1.1 billion, respectively, in 2014’s second and third quarters, excluding extraordinary items. Its

July announcement that it will buy back $1 billion in shares within three years surprised

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investors. Some analysts now are giving United a second look. Of 18 recommendations on the

stock, 13 analysts rate it a buy” (Sasso). It is important to also realize that a portion of United’s

turnaround is due to favorable economic conditions, such as low oil prices.

Even with United Airline's improvements, the company has been disappointing from the

CEO’s initial goal in 2010 of working out all of the kinks from the merger in 18 months. “Nearly

four years after United Continental Holdings Inc. began its bumpy takeoff as a merged airline, it

still is struggling to reach cruising altitude” (Carey). It is clear now that the timetable initially

stated was too aggressive. United also has been unable to unify its’ labor contracts, eliminate all

of the smaller regional jets, and get its’ airplane mechanics on one information-technology

system for maintenance to this point. The merger’s goals are being completed, but at slower than

expected speeds. United has hired consultants from McKinsey & Co, and Boston Consulting

Group to assist in cost reduction and improved business practices. As part of the improvement,

United may have to consider cutting a few of its’ inefficient hubs for the best of the company in

the long-term. It is hoped by United that management will make better decisions like finalizing a

unified employee contract and getting all the mechanics on the same information-technology

system as soon as possible. Based off what has occurred with the combined entity thus far, one

may wonder how the airline will perform in the years to come.

What Does the Merger Mean for the Future?

Four years after the merger between United and Continental Airlines, the company has

still been hobbled by integration problems and underperformance. “It ranked next to last in J.D.

Power’s 2014 airline satisfaction ranking, is No. 1 among major airlines in bumping passengers

involuntarily and ranked only eighth or ninth out of 14 carriers in on-time arrivals through most

of last year” (Sasso). These ratings are quite disturbing considering that United had five years to

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correct these issues. The true heart of United’s continued integration problems is their handling

of employee relations and their slowness to get a unified contract. “Even the negotiation of a new

joint contract for pilots in December 2012 failed to extinguish friction from the two former work

groups” (Sasso). It will take more effort from management to get all of their employees to act as

a cohesive unit and to stop causing problems.

After the merger United’s customer relations have been very poor indeed. “First off, it's

no secret, when it comes to customer service, United is commonly regarded as one of the worst

airlines in the business” (Fagin). The poor customer service is just another problem for an

already struggling company. The CEO has also made enemies with customer by removing

Economy Plus seating policy that used to be available to elite members. The policy previously

allowed for “extra leg room” to be requested when booking a flight. Customers have also been

angered by United’s new pet policy, which made the cost of shipping a dog overseas go from a

few hundred dollars to several thousand. Lastly, United’s coast-to-coast flights have been lacking

by the use of older planes without power adaptors, Direct TV, or WiFi. “It definitely seems,

instead of raising United to the level where Continental used to be, Mr. Smisek is content in

lowering the expectations of Continental's employees and customers to that of United's

employees and customers” (Fagin). The future success of United is dependent on the truth of this

statement.

It is hard to say if the new United Airlines will right the ship and be successful within the

next few years. There are some serious doubts considering the current state of customer service

and employee morale at United. The largest airline in the world has some major problems to fix

to prove that the merger between United and Continental was a good move. United is a company

with a lot of potential, but looks to be making the improvements to slowly. If United is to prove

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its’ success after the merger it will be through an enhanced effort toward employee cohesiveness,

morale, and customer service. There will also need to possibly be changes in management to try

to follow Continental’s pattern of customer service and operational excellence instead of

United’s way of doing things.

In the future, United plans to evaluate the efficiency and strategic worth of its’ hubs.

“Some analysts think the carrier also operates too many hubs, which adds expense” (Carey). This

is a relevant thought considering the size of United and the fact that they are operating out of

eight major hubs and serving almost 400 destinations. United also has plans of switching from

smaller regional jet to larger upgraded planes to improve customer satisfaction and reduce

operational costs. “United says it has improved passenger experience with lie-flat seats and

WiFi, as well as better airport facilities like new clubs and terminals” (Carey). These are good

signs for investors and a step in the right direction for the company. United is also hopeful that

their consultants will come through in their plan to boost earnings and cut costs significantly by

2017. Lastly, United is also adding new destinations such as San Francisco to Chengdu, China

and revamping Asian routes.

Conclusion

Now that it is clear how both of the individual entities came about, what the merge

consisted of, what has occurred in the years after the merge, and what the future looks like for

United Airlines, it is safe to say the combined company will still continue to stay afloat for a

while. The question is whether the company will figure out how to correct its issues and fulfill its

original goal of becoming the most dominant force in the industry. In the end, United’s future

success will be gauged by the success of Delta after their merger with Northwest in 2008. It is

still possible that United will make the turn around and eventually report numbers like Delta did

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in 2013. However, the company cannot sit back and be satisfied with the position it is in.

Management needs to keep working hard to get the airline to meet investor and passenger

expectations in order to reach its ultimate goal.

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l

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Documents

United Airlines and Continental Merger