SPECIAL REPORT

Royal Canadian Air Wars

A PROPOSAL FOR A SHOTGUN MARRIAGE BETWEEN THE TWO MAJOR CARRIERS PROVOKES ALARM

DEIRDRE McMURDY August 10 1992
SPECIAL REPORT

Royal Canadian Air Wars

A PROPOSAL FOR A SHOTGUN MARRIAGE BETWEEN THE TWO MAJOR CARRIERS PROVOKES ALARM

DEIRDRE McMURDY August 10 1992

Royal Canadian Air Wars

SPECIAL REPORT

A PROPOSAL FOR A SHOTGUN MARRIAGE BETWEEN THE TWO MAJOR CARRIERS PROVOKES ALARM

It was one of the most difficult telephone calls that Rhys Eyton ever had to make. On Saturday, July 25, the 56-year-old chairman of PWA Corp., the Calgary-based holding company that owns Canadian Airlines International Ltd., telephoned his archrival, Claude Taylor, chairman of Air Canada in Montreal, and offered to resume the merger negotiations that PWA had terminated on March 19. Despite the bitter words and aggressive competition between Canada’s two national carriers in the intervening months, Eyton had reached the end of the line in his attempts to save his faltering airline. Just hours before, his board of directors had overruled him and abruptly stopped a long-anticipated deal with American Airlines Inc. of Dallas. And both federal and provincial levels of government had rejected appeals from PWA for financial assistance earlier that week. “We are proceeding [to talk to Air Canada] with regret,” said PWA spokesman Jack Lawless. “Our 15,000 employees are very shocked and disappointed by this development.”

The concerns of PWA’s employees were similar to those of many other Canadians as the negotiations between the two airlines, shrouded in secrecy, began last week. The most immediate cause for alarm was the looming prospect of a monopoly in a sector that Ottawa began to deregulate just eight years ago to promote more airline competition. That was part of a general government program of deregulation that has

caused significant upheavals in Canadian businesses ranging from finance to trucking. Now, with the prospect of having only one major airline in Canada, consumer groups and government opposition critics complained about soaring airfares, the reduction of service to remote areas of Canada and the survival of frequent-flyer plans. And unions for employees of both companies were reeling over forecasts that a merger would eliminate 10,000 jobs across the country. Said John Manley, transportation critic for the federal Liberals: “The government of Canada should have intervened some time ago to stop the war of attrition that has led to this. They

should not have stood by and watched the airlines fight to the death.” Although neither airline has been pronounced dead yet, they are both on the critical list. A fierce domestic rivalry has grown more intense because of the recession-shrivelled air-travel market and by mounting international competition. And while they have been fighting each other with cutthroat seat sales, the companies have also had to slash operating costs and eliminate thousands of jobs. PWA has been struggling to digest its $248-million acquisition of Wardair Inc. in 1989, while Air Canada, a former Crown corporation, has had difficulties adjusting to life as a public company.

Losses: The toll of those efforts is reflected in the airlines’ respective financial performances: Air Canada lost $218 million in 1991, while PWA lost $162 million. In the first three months of this year alone, Air Canada lost $164 million and PWA $74 million. Those losses, combined with previous debt levels, amount to more than $4.5 billion. Over the past five years, investors have bought about $1 billion in the Canadian airlines’ equity, but about $1.6 billion of it has eroded because of capital losses. Through the sale of assets, however, Air Canada has recently managed to improve its cash reserves, giving it the advantage in a deal with PWA. Company officials say that by autumn, those reserves will rise to about $1 billion.

The 1 lth-hour decision by PWA’s board of directors to reject the terms of a $236-million equity infusion from American Airlines left the company unable to continue operating with nowhere else to turn. According to provincial government sources, Alberta Premier Donald Getty refused to sanction loans to PWA, whose predecessor company, Pacific Western Ltd., the province owned from 1974 to 1983, because of recent public criticism of his government’s controversial investments in other Alberta corporations, including NovAtel Communications Inc. Getty has declined to comment on both the talks between PWA and Air Canada and the loan guarantees that PWA requested. The company also failed to obtain assistance from Ottawa despite the fact that Finance Minister Donald Mazankowski, a native of Alberta, was reportedly expected to protect PWA at the cabinet level and promote plans to keep the troubled airline aloft.

Ties: Whatever Mazankowski’s regional allegiances to PWA may be, they are balanced by both political and personal ties to Air Canada. Mazankowski is a personal friend of Air Canada chairman Taylor. Both Baptists, the two men share strong religious convictions and Mazankowski was highly supportive when Taylor was injured in a 1984 automobile accident. The connections also extend to Air Canada’s Ottawa-based lobbyist, Hugh Riopelle, who plays tennis with the finance minister.

But Mazankowski’s statement last week that “the only other option is

a merger” between the two airlines was a hardwon admission. When he held the federal transportation portfolio from 1984 to 1986, the minister vigorously pressed for the deregulation of the transportation sector, a key part of the government’s economic policy. Since it won office in 1984, the Tory government of Prime Minister Brian Mulroney has also deregulated the financialservices business and the energy industry. Said Donald Brownie, executive director of the Alberta provincial transportation authority in Calgary: “We have gone full circle now and Air Canada has a stranglehold on Canada again.” He added: “PWA tried to buck that. Alber-

tans are upset about this tragedy—all Canadians should be upset.” Despite the regional and political overtones, there was little public debate over the urgency of the task at hand. In order to survive in the rapidly changing international arena, a Canadian airline has to be wellfinanced and strongly allied. Industry experts, including Sir Colin Marshall of British Airways PLC, forecast that by the end of the decade, only 12 of the current 150 international air carriers will still be in business. Instead, there will be an intricate network of global alliances between mega-carriers in an increasingly deregulated international environment.

In the past two years, that trend has accelerated as airlines have lost huge amounts of money and banded together to survive. In 1991, the airline industry worldwide posted record losses of $5.2 billion. “It’s not just two Canadian companies cannibalizing each other,” said Tae Oum, chairman of the transportation division at the University of British Columbia’s faculty of commerce. “All the U.S. carriers are losing money. Even American Airlines, the best-managed airline in the world, is losing.”

The scramble to find strategic foreign partners has intensified further in recent weeks. Air Canada announced a year ago that it intended to join forces with USAir Inc. of Arlington, Va. But on July 21, it was pre-empted

Il' ASSETS REVENUES 1991 LOSS LONG-TERM DEBT EMPLOYEES FLEET SIZE (APPROX.) FOREIGN DESTINATIONS

Air Canada Canadi $4.9 billion 3.6 billion 218 million 2.3 billion 18,200 102 Europe, the United States and the Caribbean

Canadian Airlines (PWA CORP.) $2.8 billion 2.9 billion 162 million 1.5 billion 15,000 88 d The Far East, Europe and 3ribbean South America

when British Airways announced an $870million deal with USAir that gives the Londonbased carrier direct access to the U.S. domestic market. Although industry analysts say that USAir is unlikely to still be interested in a deal, Air Canada spokesman Denis Couture said that his company is “reviewing its options and studying the implications of the new situation.” Air Canada also has until Aug. 5 to examine the books of bankrupt Continental Airlines Inc. of Dallas and make a bid for the fifth-largest airline in the United States.

Offers: Even if the proposed merger between PWA and Air Canada is approved, few analysts expect that the resulting company will be besieged by partnership offers from major international carriers. Said Frederick Lazar, an economics professor at York University in Toronto: “No Canadian airline will ever be a senior, equal partner in an international deal. Most of its routes are of no value to a foreign company at all.” Indeed, he blames much of the Canadian industry’s lack of appeal on Ottawa’s decision to split international routes between the two airlines, weakening both at a critical time on the global stage.

In addition to contending with a staggering debt load, the allure of a merged airline would be initially limited by its internal upheavals. According to calculations by investment analyst Frederick Larkin of Bunting Warburg Inc. in Toronto, up to 10,000 employees would have to be laid off and about 50 aircraft sold in a depressed market. And commerce professor Oum said that “It will require three to five years to streamline operations and improve efficiencies.” But Oum is convinced that the combined operating costs could be cut by 15 per cent without radically reducing airline service. Cur-

rently, both of Canada’s major airlines have cost bases that are as much as 20 to 30 per cent higher than those of their U.S. counterparts.

Because of concerns about the effect an airline monopoly will have on the Canadian market, several industry analysts have voiced a preference for PWA and Air Canada to make separate deals with U.S. carriers instead of with each other. Oum maintains, however, that only another Canadian airline would be willing to pay a premium in a deal for PWA assets. “PWA has the option of liquidating or giving in to the demands of American Airlines,” said Oum.

“But Air Canada will value its assets higher than a foreign company, and that gives PWA more bargaining power than it would otherwise have.” For the past four years, Air Canada has been vocal about its desire to gain PWA’S lucrative Asian routes.

Government sources in Ottawa indicate that rather than slowing or even derailing the process, a pending merger could hasten the negotiation of a so-called open-skies agreement between Canada and the United States. Increased North American competition in air travel, said one transport official who spoke on condition of anonymity, is one key way to dilute the influence of a domestic monopoly. The fifth round of those negotiations takes place on Aug. 31. Depending on the progress in merger talks by then, that meeting could be an opportunity to establish a time frame for a new treaty, setting a deadline for the merged company to work towards. Said the official: “We can’t throw them into open skies right away, but notice should be served that they have until a certain date to get their act together.”

Fares: The direct impact of a merger on Canadian consumers is no more certain than the deal’s ultimate conclusion. But analysts say that if it proceeds, domestic fares will rise, seat sales will be reduced and service to small and remote communities will decrease when competition ends. Internationally, there is already a good deal of foreign competition exerting pressure on Canadian carriers. Said Kevin Doucette, research director for the Consumers’ Association of Canada: “The protection for Canadian consumers is very limited beyond the government’s action. It’s their role, their responsibility to ensure that the outcome is fair.” Indeed, the second call Eyton made after the one to Air Canada was to Transport Canada in Ottawa. And included in the July 27 announcement about the two airlines’ resumption of negotiations was a statement that Ottawa was “closely monitoring” the situation.

Any agreement between the two airlines will have to run a regulatory gauntlet that could take until 1993 to finalize. Both the National Transportation Agency and the Bureau of Competition Policy will simultaneously review it, and the National Transportation Agency is expected to insist on public hearings because of national and regional sensitivities. To create an environment that encourages the emergence of new independent carriers, a merged national airline may be asked to divest itself of certain assets, including its regional feeder airlines and some international routes. Existing independent carriers, including Nationair of Montreal and Canada 3000 of Toronto, could also gain greater access to foreign investment, which might strengthen their presence in the market. Currently, non-Canadians are allowed to own a maximum stake of only 25 per cent in a domestic airline.

Gang: For his part, York’s Lazar says that he is skeptical that new competition will be fostered under a monopoly, even if federal measures encourage it. “You’re never going to see that here,” he said. “Here, the big guys always gang up and knock out the littler one. That’s what happened to Wardair and that’s what’s happening now to PWA.” He added that there would be minimal interest in financing a rival airline in a market as small as Canada’s.

But there have been cases where modified monopolies have served consumers well. After the Conservative government of Prime Minister Margaret Thatcher privatized British Airways in 1986, it bought out its major domestic rival, British Caledonian Airways Ltd. But the government forced the combined airline to make concessions to competition. British Airways had to give up international routes and arrival and departure time slots at London’s main airport, Heathrow, to domestic and international competitors.

Before the overhaul of the structure of Canada’s airlines can begin, PWA and Air Canada have to come to an agreement. Industry watchers say that there are issues that could delay it for months. Mahmud Jamani, a corporate finance partner at Ernst & Young in Toronto, says that early progress may be possible if there is a meeting of minds on a basic framework for the merger. But he added that where there is a tradition of intense corporate rivalry, it can be difficult to “modify

the mindset” and establish the trust to proceed.

As well, both management and employees of PWA have been open about their reluctance to join forces with Air Canada. Said Christopher Anderson, airline general chairman of District 721 of the International Association of Machinists and Aerospace Workers, which represents about 7,000 Canadian Airlines employees: “Management always made it clear that a deal with Air Canada was the worst-case scenario for them as well as for us.”

Jobs: Indeed, as the talks began, several obvious areas of potential conflict loomed. One is the location of the new company’s corporate headquarters and the jobs attached to it. According to the incorporation charters of both airlines, PWA’s and Air Canada’s head offices must be maintained in Calgary and Montreal, respectively. The fate of airport facilities, especially the new PWA Terminal 3 at Lester Pearson International Airport in Toronto, will also be of special interest. Another obstacle could be the disposition of partial interests in several regional airlines. The collapse of PWA’s share price following reports of the possible merger could also complicate the valuation of the company, especially if a share exchange or a new share issue becomes involved. By the end of last week, PWA’s share price had fallen 49 per cent over the week to close at $2.57.

Clearly, as Air Canada and PWA management try to negotiate a merger, there will be a crowd of politicians, consumers and rivals looking over their shoulders. And for both Eyton and Taylor, there may be many more difficult telephone calls to make.

DEIRDRE McMURDY