Question

The merger between United Airlines and Continental Airlines. Although the merger was initiated in 2010 many issues still exist today in 2020 related to that merger.

What items of value did Continental bring to the merger that will not be recorded in the acquisition? How will the items of value that Continental brought to the merger in #3 affect future reported income for the combined firm?

Answer 1

US-based United Airlines and Continental Airlines have agreed a deal to merge, creating the world's biggest carrier.

The loss-making companies said they expected the deal, worth $3.2bn (£2.1bn), to deliver savings of more than $1bn a year.
The goal of a United-Continental merger is to create annual cost savings and increased revenue of up to $1.2 billion.

In May 2010, Continental and United were again at the bargaining table, and this time the talks came to fruition. The proposed merger involves a $3.63 billion stock-for-stock deal in which Continental shareholders will receive 1.05 shares of United’s common stock for each share of Continental stock they own. Therefore, United shareholders will own about 55 percent of the combined company. The airline will be called United Airlines, and Chicago will be the corporate headquarters. Prior to the announced merger, United had a 10.5 percent share of the airlines market and Continental’s market share was 7.7 percent

The combined group will be named United Airlines.

But new branding will combine the current Continental colours with the United Airlines name.

United's parent UAL Corporation saw its shares rise by 51 cents, or 2.37%, to close in New York at $22.11, while Continental shares were up 51 cents, or 2.28%, to $22.86.

Although United is seen as the dominant partner, the merger was described as "a merger of equals".

In order to determine the transaction’ value and estimate the premium that the acquirer firm is able to pay in order to induce the target firm to engage in the deal is important to determine the share of each of the parties in the estimated synergies.
In the case of United-Continental merger, as was analyzed, each of the parties will contribute with similar capabilities and resources which will allow the new airline to benefit of a complementary relation. However, due the similarity and complementary relation is difficult to estimate concretely the percentage of the synergies that each airline will contribute. Given this, the most appropriate method to calculate it, is by assuming that each of the airlines will generate and have right over the synergy percentage that equals to its weight in the total merged airline’ enterprise value without considering the synergies.
The enterprise value of the merged airline without considering the synergies is $16,037 million. By taking in account the individual valuation of each airline can be stated that the United will have a weight of 54% in the merged airline’ enterprise value while the Continental will have a weight of 46%. So, from this is stipulated that the United will receive 54% of the net synergies while the Continental will receive 46% of it.
6.2. Estimation of the premium to be offered
As is already known the percentage of each airline in the estimated synergies, in this section is calculated and explained the premium that United will offer to Continental. As merger of equals is assumed that will have a premium to be paid to Continental’s
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shareholders in order to induce them to engage in the merger ‘deal and reinforce the friendly nature of the transaction.
The Continental Airlines presented a market capitalization of $2,483 million at December 31, 2009 however, as stated in the standalone valuation conducted in the previous sections, the estimated equity value is lower in around 11% value with an estimated value of $2,237million. When considered the Continental equity value with its share in the estimated synergies, the value increases to $2,885 million representing an upside potential of around 34,9% in relation to the standalone valuation. By taking in account all these aspects is calculated a premium of 21,6% in relation to the Continental’s market cap.

Continental Airlines is a US major airline established in 1934 being in 2009, the US’ fourth largest airline in terms of RPM (App. 5) and the fourth US largest airline in terms of market capitalization (App. 3). It’s operations focus on the transportation of passengers, cargo and mail operating not only own flights but also regional flights under capacity purchase agreements with other airlines and a wholly-owned subsidiary, the Continental Micronesia. It provides around to 2,000 daily departures having in 2009 flights to 118 domestic and 124 international destinations including Trans-Atlantic,
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Pacific and South America destinations. At this time, the airline accounted with 337 mainline jets and 264 regional aircrafts and a total of 39,640 employees.
Regarding the domestic operations, the airline operates their routes mainly through the hubs of the Newark, Houston and Cleveland airports, thus concentrating their activity in large population centers in order to provide a large number of connections with other cities. Additionally, the regional operators under capacity purchase agreements offers flights to US destinations to complement the Continental ‘offer and at the same time realize short-distance flights in which Continental using their aircrafts would not be profitable. According with airline’ information, Continental was responsible for 75%, 84% and 65% of the average daily departures of the Newark, Houston and Cleveland airports respectively in 20096. In this year, it was responsible by the transportation of 10% of total passengers in the domestic market7 representing around 63 million passengers (App. 21).
In terms of international operations, the airline also concentrates their activities mostly in the previous hubs and in the Guam being the main gateways for international destinies. According with Continental’ information, 51% of the airline’ mainline operations (in terms of ASM) was committed with international services being the third US airline with more passengers transported to international destinies (App. 4). In order to extend their offer in the international segment, the airline has several codeshares agreements with foreign airlines and became a Star Alliance’ member in 2009.
Continental Airlines also provides services of cargo’ transportation in the domestic and international segments. It was responsible for 3% of the total RTM’s of the US airline industry in 2009 (App. 6).
3.2.2.2. Operational revenues and expenses
The major percentage of the Continental’s operating revenue comes from the passenger ‘transport that accounted for 88,5% of the total operating revenues in 2009 while the cargo transportation, the second most important revenues ‘component, only accounted with 2,9%. The passenger ‘revenues suffered a decreased of around 18,9% in 2009 relatively to 2008 after a constant increase trend observed since 2005 (App. 23).
6 These percentages include the mainline and regional operations.
7 Includes the regional operations. This percentage decrease for 7% when considered only the mainline operations (Fig.1).
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This reflected the impact of the global recession which implied a decreased of passenger’ demand (App. 21) namely of the business passenger segment, the highest yield segment, and the low fares. This can be stated also by the evolution of the Continental’s RPM that suffered a decrease in 2008 and 2009 as well as in terms of ASM that decreased 5,2% in 2009 due the cuts in the total capacity in order to minimize the lower demand (App. 21).
The domestic segment is the one that most contributes for the passenger revenues accounting for 36,4% of the total operating revenue in 2009. In the international segment can be highlighted the Trans-Atlantic and Latin America flights that represent 17,9% and 11,8% respectively of the operation revenue of that year. Additionally, the regional operations contributed for 15,1% of the operational revenue, thus demonstrating once more the importance of the domestic market (Fig. 14).
Figure 14. Evolution of the Continental’s operating revenue components (2005-2009)
Source: Continental’ Annual Reports
All of these segments suffered a significant decrease in 2009 namely the domestic segment that saw their revenues decrease 18,7%, the Trans-Atlantic segment that decreased 24,6% and the regional operations which decreases of 19,6% (App. 23). In terms of cargo revenues they suffered also a decrease of 26% in 2009 relatively to 2008 (App. 23) that according with the airlines is related primarily due the decrease in the cargo volume and the lower fuel surcharge rates.
Concerning with operating expenses, the fuel and wages are the components that most contributes for it (Fig. 15) representing 51% of the total operating expenses in 2009. The fuel costs increased since 2005 however, in 2009 this cost dropped in 32,3% (App. 25) due the lower level of the jet fuel price that decreased from $3,27 in 2008 to $1,97 in
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2009 per gallon8. Relatively to the wages costs they increased 6% in 2009 after a decrease in 2008, being this costs strictly correlated with the level of collective bargain power demonstrated by the number of employees represented by unions which in 2009 was 97%.
Figure 15. Evolution of the Continental’s operating expenses components (2005-2009)
Source: Continental’ Annual Reports
3.2.2.3. Profitability
A key performance ‘measure is the EBITDA which after two years of growth trend, it dropped drastically in 2008 with a decrease of around 145% due primarily the record fuel prices observed in that year (App. 25). In 2009, the trend improved but remained negative due the decrease in the operational revenues that was attenuated by the lower level of fuel prices (Fig. 16).
Figure 16. Evolution of the Continental’s EBITDA and net profit (2005-2009)
Source: Continental’ Annual Reports
8 Average consolidated of the airline
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In terms of net profit, they followed the same trend of the EBITDA with a significant drop in 2008 of around 175% and a recovery in 2009 but still remaining in a negative level (Fig. 16) mainly drove by the previous mentioned factors. Through this results can be stated that Continental saw their profitability fall in last periods reflecting the global recession however, is already visible a slight recovery trend.
3.2.2.4. Liquidity
The Continental’ current ratio decreased in 2007 and 2008 which meant a decrease in the firm ‘ability of pay the short-term obligations and a reduction of it liquidity. However, in 2009 was visible a slight recovery achieving a current ratio of 0,9964. Despite this event, Continental presented between 2005 and 2009 a higher ratio than the industry one (App. 13) which had an average value of 0,8544 in this period. Regarding with quick ratio was observed the same trend of the current ratio with a decrease in the firm’s ability to meet its short-term obligation with the most liquid assets in 2007-2008.
Figure 17. Evolution of Continental’s current ratios, quick ratios and Net Working Capital (2005- 2009)
(a)
(b)
Source: Continental’s Annual Reports
In terms of Net Working Capital (NWC) it suffered a drop of around 213% in 2008 reflecting a decrease in the firm ‘ability to pay its current liabilities due mainly the global recession that, as mentioned previously, affected the Continental’s operations. Keeping the same trend of the previous liquidity indicators, the NWC situation improved in 2009 nevertheless keeping in a negative level.
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3.2.2.5.Assets and equity
The Continental’ return on assets (ROA) had a decrease trend since 2006 with the lowest returns observed in 2008 with -5% and 2009 with -2% (Fig. 18 (a)). Before this results, it is visible that the firm’s ability to use its assets to create profit decrease in this period as can be stated by the net profits observed in the last two years that was affected by the revenue ‘decrease and instability of fuel prices. This evolution follows the overall trend of the US industry airline (App. 14) that was deeply affected by the previous factors.
Figure 18. Evolution of Continental’s return on assets and return on equity (2005-2009) (a) (b)
Source: Continental’s Annual Reports
Following the same trend, the return on equity (ROE) suffered a decline trend since 2006 being also 2008 and 2009 the years with worst performance relatively to this measure with -70% and -79% respectively (Fig. 18 (a)), thus reflecting the deterioration of the firm’s ability in generate return to the shareholders mainly drove by the factors above mentioned which affected all the industry (App.14).
3.2.2.6. Debt
Continental presented a relatively stable debt ratio between 2005 and 2009 with an average ratio of 48%, higher than the 30% average debt ratio observed in the industry in this period (App. 15). The lowest debt ratio was observed in

2007 with 41% being observed a moderate increase trend after this year until achieve a ratio of around 50% in 2009 (Fig. 18 (b)). In this year, the debt totaled $6,266 million in a total assets of $12,788 million. From the total debt value, $5,291 million are related with long-term debt and capital leases which were primarily incurred to purchase or lease facilities or equipment, mainly aircrafts, to run the firm activity.
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Figure 19. Evolution of Continental’s debt ratio and debt to equity ratio (2005-2009) (a) (b)
Source: Continental’s Annual Reports
Regarding with debt-to-equity ratio, the airline presented a quite high ratio in the period between 2005 and 2009. The most critical year was 2008 in which the firm presented a debt-to-equity ratio of more 5000% (Fig. x), being evident that the firm relies more in financing external sources than in financing from the shareholders. This trend also was observable in the US airline industry, however in a lower proportion with an average debt-to-equity ratio of 134% in the period 2005-2009 (App. X). Once more is evident the importance of debt in order to get the needed funds to realize the required investments.
3.2.2.7. Capital Expenditures
The Continental’s capital expenditures basically can be classified in fleet and non- fleet expenditures which represent the majority of this expenditures (App. 26). The fleet expenditures consisted mostly in aircraft acquisitions (the share of the total acquisition cost that is not cover by financing), in acquisition of flight simulators and training equipment as well as capital expenditures incurred to improve the passenger travel’ condition (e.g. entertainment systems). In terms of non –fleet expenditure they are mostly related with ground support equipment and terminal improvements. Beside of these two main components, a small percentage is related with the rotable parts that are restored.
The capital expenditures increased significantly until to 2008 (Fig. 20) suffering a substantial decrease of around 24% in 2009 thus reflecting the hard economic environment. The economic condition is the main driver of the capital expenditures as
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stated by the firm, however exists commitments taken by it, namely acquisition of aircrafts, which cannot be easily reverted thus influencing the future capital expenditures.
Figure 20. Evolution of the Continental’s capital expenditures (2005-2009)
Source: Continental’ Annual Reports
3.2.2.8. Stock performance
The Continental’s shares are traded in the NYSE with the symbol ‘CAL’ having around 18,890 holders of its common stocks at February 16, 2010 with 123,264,534 outstanding shares. Analyzing its stock’ performance in last five years (Fig. 21) it is visible a decrease trend in its price since 2007. The highest price was achieved in 2007, around $51 per share however, since this year Continental’s saw their stock price drop drastically achieving a price of around $7 during 2008 and 2009 due the negative impact of the global recession on the firm’s operations. At the end of 2009 was already visible a slight recovery trend with the share price in around $18, mainly drove by the signs of improvement of Continental’s results and by the news about the merger with the United Airlines. Comparing with the S&P 500 index performance is visible that both followed a similar trend namely from 2008 reflecting the crisis ‘impact (Fig. 21).
Figure 21. Continental stock’ performance (2005-2009)
Source: Bloomberg
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4. Firms’ valuation as standalone
The United and Continental Airlines are both US major airlines with similar dimensions and which, as analyzed previously, serve the same geographic segments. This leads to the fact of both have the main performance drivers and are exposed to the same market conditions and risks. For these reasons, the assumptions and indicators taken in consideration are identical for both companies in order to calculate the components of their free cash flow (equation 2.6) which are described in the following sections and which are also present in the forecast balance sheet and income statement of each airlines.