The Johnson School at Cornell University just held its capstone event for 1st year MBAs, an “Integrative Case Competition”. The case? Essentially, “What airline should Continental acquire and why?”. The case was set up from and investment banker’s perspective, pitching the deal to Continental. Given all the talk of consolidation within the airline industry the case was both relevant and timely, although I don’t think that many expect CAL to be the first to initiate a deal.

Before reading on, take a second to consider who you think would be the best acquisition target for CAL.

The winning case team pitched that CAL, NWA, and a European Private Equity firm partner up for a Joint Venture to establish a Special Purpose Acquisition Vehicle and acquire BMI. A highly improbable deal, to put it mildly, but certainly the most creative recommendation.

I believe the most popular pitch was that CAL acquire Alaska Airlines. Their homogeneous fleets of Boeings (increasingly dominated by 737-800s), complementary route structure, and similar reputations seemed to make the most sense from a long-term strategic point of view. Alaska Airlines would give CAL a west coast presence from which to further expand internationally.

The next most-pitched deal was a CAL-NWA merger. Few would argue this doesn’t make any sense from a “synergies” point of view, but I question if CAL is in a position to lead such a deal, or could come out a winner if Delta decided to join the bidding. I have similar doubts for CAL’s ability to acquire United or Delta, which were also pitched.

The best part of the competition was the quality of the judges panel, which included professionals from Citi, Northwest Airlines, AWAS, and McKinsey, among others. Several of the judges have been working in the airline industry for 20 years or more.

The MBA students got a crash course in the airline industry and quickly discovered its inherent difficulties from a management perspective. Unsteady cash flows, very high debt to equity ratios, heavy use of operating leases, regulatory constraints, and labor issues make it very difficult to place a value on an airline, and also limit the many of the strategic alternatives management has available. Like most industry watchers, I believe we’ll see some M&A activity within the industry within the next year or two. I am tempted to say that it is an exciting time for the airline industry, but then again, when isn’t it?

I was struck by the seeming contradiction in the October 16th conference call with Delta Airlines. Namely, Richard Anderson, CEO of Delta, spoke of consolidation within airline industry and then later implied that Delta is likely to divest its regional subsidiary, Comair. So, consolidation “makes sense” to Mr. Anderson, but so too does spinning off its regional? On the surface, this seems contradictory, but a closer look at how competition within the airline industry works reveals that, at least superficially, this makes a lot of sense.

The distinction that must be made here is between the different relationships that mainline carriers have with regional airlines compared to other mainline carriers. Other mainline carriers are direct competitors whereas regionals are really act as suppliers to mainline carriers. Thus, when a mainline carrier acquires a regional, it is essentially an act of vertical integration. Although the airlines avoid trying to say it out loud, the primary benefits from mainline consolidation are anticompetitive in nature. I.e., cancel overlapping flights and hopefully raise prices. The benefits from integrating a regional into a mainline are, supposedly, lower costs and more control. However, most of the benefits from such a relationship would appear to befall the regional more so than the acquiring mainline. The biggest downside from a mainline owning a regional subsidiary is that they can not employ the thumbscrews when it comes time for the next contract negotiation. Delta, for example, has contracts with several regional carriers, including Comair. These regionals have to compete against each other for Delta’s business and regionals live or die by their relationships with the majors. Mainline carriers clearly have the advantage at the bargaining table as they can easily make a credible threat of flying the routes themselves. Regionals lost the credibility of making a similar threat when Independence Air went bankrupt after striking out on its own. Competition for these contracts is fierce. So, it should not be surprising that Delta feels it would be better off with Comair as a separate entity. As such, Delta will be able to put outside pressure on Comair that it likely can’t do as the owner.

American Airlines seems to share the same view as Delta, as Gerard Arpey indicated in their last conference call that they are also considering selling their regional subsidiary, American Eagle. Unlike Delta, however, American seems more realistic about the difficulties of consolidation of mainline carriers and projected a more pessimistic tone for such transactions.

There is one other timely reason for mainline carriers to spin off their regionals: airport congestion. Given the increased traffic delays and increasingly louder outcry from public officials, there has been a call on airlines to replace regional jets with larger aircraft making fewer flights. Shifting the ownership of those regional jets gives the mainlines a little bit more “plausible deniability” for their role in the problem.

Thus, the industry is left in an awkward position where it makes little sense for mainline carriers to own their own regional carrier when it is easier for them to pit the regionals against each other for their business. This, in turn, leads me to believe that consolidation within the regionals is the next logical step. Only when there are fewer regionals at the bargaining table with the majors will the regionals have the ability to negotiate from a position of power. Of course, if that happens, then it will make sense for the mainlines to consider acquiring regionals again….