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American's labor unions may end up worse off

April 30, 2012: 11:24 AM ET

How did US Airways come to a swift agreement with American Airlines unions, when American's own failure to do so put it in bankruptcy? It's all about bargaining chips.

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By Cyrus Sanati

FORTUNE -- The unions representing bankrupt American Airlines may come to regret agreeing to hook up with US Airways. Merging with a smaller carrier that has its own severe labor troubles looks far more painful and disruptive to American employees than would be the case if they just stuck it out with their current bosses. Given all the question marks surrounding this pact, the unions' move here looks more like a bargaining tactic than an earnest defection in what has become a high stakes game of chicken with American management over wages, benefits and pensions.

For now, American management isn't blinking. But eventually they may need to be a little bit more accommodating to their employees and pensioners and look for cuts elsewhere if they want to put all this merger talk to bed. If not, American's creditors could start feeling nervous about supporting an airline with a hostile workforce and end up siding with US Airways by default.

American Airlines' three main labor unions support a tie up with US Airways (LCC), a development that came as a bit of a shock to many in the airline industry. But it was no surprise that labor would be at the center of the battle for control of American -- after all, it was the airline's high labor costs that forced it into bankruptcy in the first place. American's labor cost is equivalent to around 28% of its revenue, the highest of any major airline operating in the U.S. today. That compares with Delta (DAL), United (UAL) and US Airways where labor costs are 18%, 20% and 17% of revenue, respectively. This huge cost disadvantage meant that American paid annually around $600 million more in wages compared to its peers.

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American management had tried for years to come to an agreement with the unions for a new contract that would bring labor costs in line with the rest of the industry but failed as the unions didn't want to let go of their juicy perks and fat pensions. But US Airways revealed on a conference call with analysts last week that they were able to effortlessly come to an agreement with American's unions, which would involve slashing just $800 million off American's annual labor bill in a merger. They noted that this would put American workers pay and benefits in line with industry standards.

The agreement would be around $190 million less than the $990 million American tentatively plans to cut in labor costs. US Airways says its plan saves "at least" 6,200 positions out of the 13,000 positions American plans on cutting under its plan. It promised that the synergies created in a merger would yield $1.25 billion in additional revenue each year, which would be roughly equal to the $1.2 billion in cuts American has proposed so far.

It's hard to say where all these savings would come, and US Airways didn't specifically say. What it did say is that other airlines that have merged in the recent past have netted a gain as much as 6% to 7% of the newly combined carrier's revenues by choosing to merge rather than remain stand alone entities.

But merging also creates a lot of headaches for airlines, especially for labor, which usually comes out the loser in any deal. Probably the most painful part in merging an airline is dealing with integrating seniority lists among its employees, especially its pilots. US Airways knows this all too well as it is still trying to merge its seniority lists seven years after its merger with America West. So while the public sees US Airways as an integrated unit, it actually must operate as two separate carriers in which legacy US Air pilots and flight attendants can only fly on legacy US Air planes and legacy America West pilots and flight attendants can only fly on legacy America West planes. This prevents US Airways from achieving maximum fleet utilization that management says costs the airline $10 million a year.

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US Airways continues to have a contentious relationship with its own employees. Perhaps no one was more surprised by how swift US Airways was able to come to an agreement with American's unions than its own unions. US Airways pilots have been pushing for a wage increase for years and have been negotiating a new contract with management since December of 2009. The flight attendants are also negotiating with the airline as their contract ran out in November of last year.

But US Airways claims the $1.25 billion in synergies that will come out of the merger reflects an increase in pay for its employees, which would bring them in line with American employees. It also claims that it would not significantly cut routes or eliminate capacity as a result of the merger, either. So for all this to be true, US Airways must be anticipating high revenue synergies through stronger growth or fatter profit margins. Unfortunately, there is little to no evidence that merged airlines end up experiencing significantly stronger growth rates relative to the rest of the industry.

So for US Airways to be successful it will need to present a very convincing plan to the creditors committee overseeing American's bankruptcy, which has a big influence on whether the airline merges or flies solo. Three of the nine members of the committee are representatives from American's unions, so US Airways can claim them, at least for now. Three represent American's unsecured creditors, so they will want the best deal they can can get in the shortest amount of time possible. The rest of the committee is made up of one member from the Pension Benefit Guarantee Corporation, Boeing, and Hewlett-Packard, respectively.

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US Airways has been down this road before when it unsuccessfully tried to snap up Delta in bankruptcy. In that case, US Airways presented a plan that saw greater benefits flowing down to the members of the creditors committee with promises of strong revenue synergies. While it was on paper a better plan than the one presented by Delta's management, it was also considered riskier. There was concern that those revenue synergies would never materialize and that the government could challenge the merger on anti-trust grounds. And US Airways would have started the long and painful merger while Delta was still in bankruptcy, pushing back the date at which the creditors would get paid.

This time, US Airways has three votes right off the bat. It is hoping to use that leverage to convince the other creditors that they will be able to quickly integrate the two companies so that they won't have to wait much longer to get paid than if they went with American's plan.

It is now up to American to diffuse the situation and possibly bring more money to the table to appease its unions. With American's unions by its side, US Airways' plan looks far more actionable than it would if it went in alone. The difference between the plans right now appears to be just $190 million. American is expected to present its bankruptcy plan to the courts in a couple of weeks but it could get an extension to stretch out the process for several months. American may need to give in a bit to win its unions back, but not too much. If it is too weak, the airline could wind up right back in bankruptcy court in a few years.

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