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.
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."
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.
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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