Don't Expect to Profit From an AMR-US Airways Merger

On Wednesday, The Wall Street Journal reported that American Airlines parent AMR (UNKNOWN: AAMRQ.DL  ) and US Airways (NYSE: LCC  ) were finally closing in on a merger agreement. Other sources, such as CNBC, have recently followed suit. US Airways, led by CEO Doug Parker, has been pursuing a merger with American since the latter filed for bankruptcy in November 2011. While American's management initially resisted merging with US Airways, pressure from labor unions and creditors has apparently worn down AMR CEO Tom Horton. Reports have suggested that AMR creditors will own 72% of the merged carrier, while US Airways shareholders will receive the remaining 28%.

A merged American Airlines-US Airways would leap over Delta Air Lines (NYSE: DAL  ) and United Continental (NYSE: UAL  ) to become the largest airline in the world by passenger traffic. This would be a big boon for American and US Airways, as their smaller networks have put them at a disadvantage, compared to Delta and United, when competing for lucrative corporate contracts. These potential benefits have been reflected in the US Airways share price, which has more than tripled since American filed for bankruptcy.

LCC Chart

US Airways Stock Price, data by YCharts

Nevertheless, merger integration costs are likely to be substantial, and employees are owed massive pay raises, particularly at US Airways. As a result, investing in US Airways now would be a dubious proposition. Moreover, since AMR is currently in bankruptcy, the company's creditors have "absolute priority" over AMR common stockholders. AMR stock could very well be declared worthless when the company exits bankruptcy (although there is a possibility, due to legal technicalities, that the stock could have some value). On the whole, if you are a long-term investor, the best thing for you to do now is stay on the sidelines.

Integration costs are massive
Merging two major airlines is a long and costly process. Labor groups need to be integrated, check-in counters need to be co-located, signage needs to be changed, planes need to be repainted, IT systems must be updated or replaced, etc. United and Continental formally merged on Oct. 1, 2010, and the two still have not fully completed the integration process. In the past three years, United Continental has already recognized a whopping $1.85 billion of merger integration costs, as well as $600 million in severance and labor agreement costs that were directly related to the merger. By the time that merger is complete, integration costs could be close to $3 billion.

For American and US Airways, merger integration costs are likely to be similar. Labor integration costs could be particularly steep because US Airways pilots and flight attendants have been working under bankruptcy-era contracts that were imposed almost a decade ago. As a result, US Airways pilots are currently earning as much as 50% less than the industry average. Since management has promised to raise pay levels to industry standards in a merger scenario, significant cost increases are guaranteed to occur.

In addition to increasing future pay rates, it is typical for new labor contracts to include substantial signing bonuses to make up for raises that workers have missed. For United Continental pilots, the signing bonuses totaled $400 million. For US Airways and American Airlines, the long duration of the previous "concessionary" contracts could push the bonuses even higher.

Benefits are uncertain
According to US Airways, a merger with American will produce $1.2 billion of annual revenue and cost synergies. If the savings are as great as advertised, then a $3 billion merger integration tab may be an acceptable price to pay. However, there is no guarantee that the advertised benefits will materialize. Revenue synergies are particularly tricky to forecast, because competitors' strategies can have a major impact on passenger behavior.

The United Continental merger is a case in point. As I recently wrote, the company promised revenue synergies totaling $800 million-$900 million due to the combination of the United and Continental networks. However, integration snafus led to technology meltdowns, massive flight delays, and particularly poor customer service (even for an airline!). As a result, United saw revenue dis-synergies in 2012; the company lost ground to each of its major competitors. There is no guarantee that the same problems would affect American and US Airways. However, given the complexity of large airline mergers, it would not be prudent to assume that their merger will produce "smooth sailing."

Valuation
If one wanted to invest in the American-US Airways merger, the natural way to do so would be to buy US Airways stock. Shares have recently been trading near $15. At that price, based on a diluted share count of around 200 million (which may be too low – the diluted share count was 205 million last quarter), US Airways is worth $3 billion. Based on its 28% ownership in the merged carrier, the "new American" would need to be valued at $10.7 billion for current US Airways shareholders to break even. By contrast, Delta is the most valuable U.S. airline, with a market cap of $12.3 billion, whereas United is only worth $8.4 billion.

Certainly, $10.7 billion would be a "stretched" valuation for a merged American-US Airways. The "new American's" situation would be much closer to that of United than that of Delta. Delta has already completed its merger with Northwest, and has been showing industry-leading unit revenue growth over the past two years. By contrast, United Continental's lower valuation accurately reflects the costs and risks of merger integration.

US Airways could choose to repurchase its convertible notes with cash (this would require $500 million-$600 million) in order to reduce the diluted share count. This would permit shareholders to break even at a lower market cap (perhaps as low as $9 billion for the combined entity). However, that would create its own set of risks. Due to the costs of merger integration, it is prudent to enter the process with a very strong cash position; United Continental had over $9 billion of cash and investments when it closed its merger on Oct. 1, 2010.

Effect on competitors
The merger does not promise a clear effect on competitors, either. The further "rationalization" of the airline industry into four major competitors (American/US Airways, United, Delta, and Southwest Airlines) could help all of the carriers by improving pricing power. Competitors could particularly benefit if merger integration leads to poor operational performance, as was the case for United Continental. However, there is no way to know in advance if American and US Airways will be doomed to repeat United Continental's mistakes.

On the other hand, if the merger really does permit American and US Airways to boost their corporate revenue share, this would clearly come at the expense of Delta and United in particular. Together, American and US Airways have hubs or focus cities in seven of the eight largest U.S. metro areas, which could be a major selling point for business travelers. At best, it will take several years for American to capitalize on this opportunity, but if it does, Delta and United could lose high-value corporate contracts.

Conclusion
It is too late to profit from the likely US Airways-American Airlines merger by buying US Airways stock. The additional upside is minimal, whereas the downside is substantial if the merger falls through (which is still a real possibility). Even if the merger is approved by all of the relevant parties, integration costs could be $3 billion or more, based on United's experience, and the expected revenue benefits may not materialize. The best thing to do now is to sit tight on the sidelines. If you are looking to invest in an airline stock, Delta's strong performance run over the past two years makes it a more compelling investment candidate anyway.

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Read/Post Comments (8) | Recommend This Article (17)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 07, 2013, at 7:44 PM, modestfool13 wrote:

    A little too pessimistic for my taste....I can assure you this deal will not fall through. Everyone wins with this merger.

    I have it on good authority that the signing bonuses will be much smaller than with United. You also give no credit to CEO Doug Parker and US Airways management for returning a twice bankrupt airline to respectable profitability, albeit by underpaying employees relative to industry norms.

    American will be coming OUT of bankruptcy with Lower variable costs... aren't they the larger company here, the one ? Look at what has happened to the pensions with these companies... its easier to make a profit than ever before, even when oil prices increase again.

    I believe LCC hits $17 before the big players get out.

  • Report this Comment On February 08, 2013, at 1:07 AM, stocks69 wrote:

    Alaska Air is sitting up there coining cash every quarter I would buy them on dips. I am a Usair employee who has worked under the tyranny for over two decades. Doug parker makes a living off his employees....

    I did buy 50 12.50 Jan calls and took delivery for an average cost of 12.85.

  • Report this Comment On February 08, 2013, at 12:40 PM, jabiru95 wrote:

    I have American shares, with the quote "sit by the sidelines" in the article should I get out now with loss and forget about it or hold for the long term?

  • Report this Comment On February 08, 2013, at 4:29 PM, TMFGemHunter wrote:

    If you own American shares, now would be a good time to get out. Creditors are going to get the vast majority of American's new stock. Whether it's 95% or 100% is not certain yet. You should recognize that there's a substantial probability of a total loss; in my opinion, the upside isn't worth it.

  • Report this Comment On February 08, 2013, at 4:34 PM, TMFGemHunter wrote:

    @modestfool: Thanks for the comment. I think Parker has done a very good job with the hand he's been dealt. However, as you said, it's all been done through lower labor costs. I did some back of the envelope calculations last month which lead me to believe that US Airways is paying $300-$500 million under market to employees. That's a lot for a company expected to earn around $600 million this year.

    American's cost structure will be improved coming out of bankruptcy, but I don't expect it to be materially better than Delta or United.

  • Report this Comment On November 20, 2013, at 2:25 PM, meched49 wrote:

    Don't expect to profit your a real hoot!

  • Report this Comment On November 20, 2013, at 2:25 PM, meched49 wrote:

    Should have buying 1000's at .50 it's people like you who ruin peoples dreams.

  • Report this Comment On February 22, 2014, at 9:44 AM, Icemanpdx wrote:

    I'm sure glad I didn't follow the authors advice or the people that replied about it, cus I held my AMR stock and now I'm sitting pretty and counting my money with all my shares of AAL :) glad I did my own research and didn't listen to other peoples opinions

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