Tuesday, April 17, 2012

Merger hangover continues to pain United

April 17, 2012: 11:46 AM ET

A battle is brewing in Houston between United Continental Holdings and Southwest Airlines. Consumers hoping to fly south of the border may end up the victors.

By Cyrus Sanati

FORTUNE -- United Continental Holdings is learning the hard way that it isn't wise to mess with Texas. The recently merged airline's decision to choose Chicago as its corporate headquarters over Continental's hometown of Houston appears to have resulted in a big loss of political capital with the city and its airport authority. The move could end up hitting United's bottom line hard as rival Southwest Airlines targets Houston to be its first international hub.

There are a lot of unintended consequences when it comes to merging two companies, especially two major international airlines. When Chicago-based United (UAL) announced its merger with Houston-based Continental at the end of 2010, the decision to move the newly combined airline's headquarters up to Chicago wasn't given much thought. United had struck what it had said was a sweetheart tax and rental deal with Chicago city officials a year earlier to keep the airline's headquarters in the Windy City in the event of a merger with a rival airline. Houston, apparently, never had a chance.

The loss of Houston as Continental's headquarters meant moving most of its major corporate functions to Chicago. Continental's then chief executive, Jeff Smisek, not even a year into the job, became the combined airline's chief executive. Smisek was quick to make the move out of Houston but the mood at Continental's headquarters in downtown Houston was somber, as much of the staff did not want to move to Chicago.

Continental has always enjoyed a very good relationship with the city of Houston. The airline's chief executives were tight with the city's mayors and the airline got basically whatever it wanted – both big and small. When the airline's logo on its downtown headquarters violated a city ordinance that banned corporate advertising on skyscrapers, Houston's city council quickly voted to change the law, allowing Continental's blue logo to fly high. The city let Continental build itself a whole new terminal at Houston's Bush Intercontinental Airport last decade and is contributing a third of the $1 billion needed to build out another terminal for the airline, which is currently under construction.

The strong relationship helped the airline flourish. Eventually, Continental controlled around 80% of the air traffic in and out of Houston's Bush Intercontinental Airport, which is located on the north side of town. This total domination in air traffic gave Continental strong pricing power that has padded its bottom lines for years. Its only real competition in the city was with Dallas-based Southwest Airlines, but it operated out of Houston's smaller airport, Hobby, located 30 miles southeast of Intercontinental, and was limited to only short-haul domestic flights.

Perhaps most importantly, Continental dominated Houston's international market. The vast majority of these flights were jumps into Mexico, the Caribbean, Central America and the Northern part of South America. Eventually, Continental controlled 97% of the short to medium-haul international air traffic out of Houston. Its position as the main feeder airline into the city's only international airport allowed it to have a virtual monopoly on all international air traffic going to and from the city.

Gordon Bethune, former CEO of Continental, recently said that while he was chief executive, he had a sort-of gentleman's agreement with the mayors of Houston that Intercontinental would be the city's only international gateway and that Hobby, which was the hub for Southwest Airlines, would only be a domestic airport. In return, Continental would continue to be a good corporate citizen and work to improve air traffic at the big airport.

But all that intangible political capital was trashed when the airline merged with United. The loss of the Continental name was bad enough for the city, but the loss of the headquarters was a big blow to its ego. While Houston is still United's largest hub with over 17,000 employees living and working in the city, the loss of the C-suite appears to have been an unforgivable sin.

Southwest Airlines (LUV) is hoping to cash in on United throwing away its golden goose. It has brazenly asked Houston's airport authority to pay nearly $100 million to upgrade Hobby to receive international flights. The upgrade would allow Southwest to use Hobby to launch truly competitive international air service to the same locations where Continental has held an almost near-monopoly in non-stop service for years. This would, invariably, force Continental to lower prices on competing routes or to even pull out of some them completely if Southwest is able to put enough pressure on its margins.

This possible Southwest expansion also has larger implications for the airline industry. Southwest inherited international air service to a few destinations south of the border and to the Caribbean when it acquired AirTran in 2010. It has just started to put plans in motion to expand international service - under the Airtran banner, for now - launching routes to Mexico from Orange County, CA and San Antonio, TX. But unlike those locations, Houston is a major hub for Southwest and is seen as a major gateway to Latin America. If Hobby does go international, Southwest will be able to fill its Latin America-bound planes with passengers from any of the 36 domestic destinations it already serves through Hobby.

United is understandably upset about Southwest's attempt to move in on its cash cow. Southwest could target 85% of United's international routes out of Houston if the city signs off on the expansion at Hobby. United says that a Southwest expansion could force it to lay off hundreds of workers and could force it to end its support for the $1 billion expansion at Intercontinental that is already underway. The airline would also discontinue plans to introduce air service to four new international destinations and would not add to additional frequencies in existing markets in Houston over the next three years, a United spokesperson told Fortune.

Southwest believes United is overreacting and says that competition would be good for Houston. It would only have five gates dedicated to international service at Hobby- with expansion up to nine if all goes well. United currently serves 54 destinations in Mexico, the Caribbean and South America, with 103 daily departures. With five gates, Southwest claims that it could offer just 25 international flights out of Hobby per day, a quarter of that of United.

But it could still do damage if those flights were targeted at Continental's biggest money makers, which it surely would. It its defense, Southwest has launched a website dedicated to its struggle to "free" Hobby Airport. The airline plays up its Texan roots and makes it a point to say that it is competing against "Chicago-based United-Continental Airlines," and not the beloved Houston-based Continental.

Last week, Houston's airport authority recommended that the city council approve the Southwest expansion, saying that it would add millions to the local economy and would create, not decrease, jobs in the Houston area. United has struck back saying that the Airport authority's study was flawed. The city council is expected to vote on the matter in May. It looks like, for now, that Southwest is going to get their wish. Meanwhile, United executives are left wondering how different things would have played out if they had just chose to stay in Texas.

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