United, Continental Merge Into World's Largest Airline

United Airlines parent UAL Corp. (Nasdaq: UAUA) and Continental Airlines, Inc (NYSE: CAL) announced today (Monday) that they plan to merge and create the world's largest airline in a stock swap valued at $3.17 billion.

The merger is the is the biggest airline deal since Delta Air Lines, Inc. (NYSE: DAL) bought Northwest Airlines Corp. in 2008, and it further demonstrates how an industry plagued by losses has devolved into a pattern of consolidation.

The "merger of equals," as described by the companies, would top Delta as the biggest global carrier, have combined annual revenue of $29 billion, and $7.4 billion in unrestricted cash. The deal should yield cost savings of $1 billion to $1.2 billion by 2013.

"With the recovery of the economy, fuel prices moderating, capital markets opening and both companies having solid liquidity, it was the right time to get involved in merger discussions," Continental Chief Executive Officer Jeff Smisek - who will run the new company - told Bloomberg.

The deal would form a domestic leader with 21% market share in terms of available seat miles - beating Delta's 20% of the cut - and a global competitor with 7% worldwide market share. The United-Continental combo would have 10 domestic hubs, flying to 370 destinations in 59 countries.

Continental shareholders, if the deal is approved, will receive 1.05 UAL shares for each Continental common share. UAL shareholders will own 55% of the new United Continental entity, which will operate under the United name and Continental's logo and colors.

The lack of route overlap makes the airlines a strategic match. The deal led Standard & Poor's Financial Services LLC to upgrade United shares' rating to "buy" from "hold" Monday and raise the 12-month price target to $30 from $26.

"We think the merger would combine Continental's strength in Europe and Latin America with United's strong Pacific network," S&P analyst Jim Corridore told MarketWatch.

The deal still has to win approval from the Justice Department's antitrust division and employee unions.

A United-Continental merger almost went through two years ago but collapsed when Continental decided United's financial health was too unstable as the industry faced higher oil prices and a slowing economy.

Airline stocks lifted on the news. UAL was up 2.37% to $22.11 and Continental 2.28% to $22.86. The NYSE Arca Airline Index rose 2.23% to $38.49. AirTran Holdings, Inc (NYSE: AAI) was up 3.41% to $5.46 and Alaska Air Group, Inc. (NYSE: ALK) climbed 9.15% to $45.20

Merging for Survival

The United-Continental is a case study in how an industry plagued by losses has turned to consolidation to cope.

"We think this merger is extremely positive for both companies and for the industry," said Morningtsar analyst Basili Alukos. "With the reduction of another management team, the industry should have tighter control on capacity, as the top four airlines (United-Continental, Delta, American (NYSE: AMR) and Southwest Airlines Co. (NYSE: LUV) will control roughly 70% of the domestic capacity in the United States."

The big "legacy carriers" that used to run the industry have seen their profits eaten up by higher fuel costs and smaller, cheaper airlines. Discount carriers like Southwest and JetBlue Airways Corp. (Nasdaq: JBLU) have less debt and more fuel-efficient planes.

"Airlines have lost billions, even in good economic times, and they've tried everything to become profitable: wage cuts, capacity cuts, new fees, and higher fares. Consolidation may be their last hope to stop losing money," George Hobica, president of airfarewatchdog.com, told ABC News.

Consolidation means flight cuts and fewer seats in the sky. Pair that with a post-financial crisis increase in travel demand and air fares are likely to go up - great news for airlines and investors, bad news for travelers.

This opens the door for smaller airlines to fill in where United and Continental flights disappear due to redundancy.

"In general, as consolidation progresses, there will be fewer flights between small cities and these will be operated by regional jets, if at all," Hobica said. "But nature abhors a vacuum and Southwest, AirTran and other discounters will come to the rescue on some routes if other airlines eliminate service."

The remaining legacy carriers, American Airlines and US Airways Group, Inc (NYSE: LCC), could look to consolidate down the road. Analysts have named Alaska Air and JetBlue as ideal merger partners for American. US Airways considered a deal with United but those talks ended when Continental stepped ahead.

"Unfortunately, it looks like US Airways is the odd person out in merger musical chairs," Rick Seaney, CEO of farecompare.com, told ABC News.

The merger could also mean good news for The Boeing Co. (NYSE: BA) or Airbus SAS as they compete to win future deals for fleet replacement. All of Continental's aircrafts are Boeing-made while United's fleet is split between the two manufacturers and it is expected to renew more of the fleet later this year.

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