AMR Surges to Record Profits

An American Airlines plane in the carrier's old livery

Two years ago, AMR (UNKNOWN: AAMRQ.DL  ) -- the parent of American Airlines -- was spiraling toward bankruptcy, and its future looked very bleak. For many months, it looked like the best AMR could hope for was to be rescued through a merger with US Airways (NYSE: LCC  ) . This would give it better scale to compete against global giants United Continental (NYSE: UAL  ) and Delta Air Lines (NYSE: DAL  ) .

However, the company successfully reorganized itself in bankruptcy court, and on Thursday, AMR reported a record Q3 profit of $530 million excluding special items. AMR's profitability is likely to improve still further going forward, as the company continues replacing its dated MD-80, Boeing (NYSE: BA  ) 757, and Boeing 767 aircraft with more efficient planes. In addition, some favorable contracts will not go into effect until the company emerges from bankruptcy protection.

However, AMR's record results could backfire for the company. The Department of Justice has challenged its planned merger with US Airways, and one of AMR's main justifications for the merger was that it needed more scale to compete with United and Delta. Given that American and US Airways have both become quite profitable despite their small size, the two are having more trouble in their antitrust review than expected.

Strong quarter
The summer quarter is seasonally the strongest for almost all airlines, but AMR's results were impressive even after accounting for this factor. Unit revenue increased 3.4% on a small capacity increase, while unit costs fell 6.6% due to lower fuel prices and significant cost cuts made during the company's bankruptcy. This helped AMR post an impressive 10.2% operating margin last quarter.

For comparison purposes, Delta -- which has been the most successful of the legacy carriers recently -- projected an 11%-13% operating margin for Q3. (Delta will report its results this week.) By contrast, United Continental's most recent guidance implied an operating margin of perhaps 7%-8% for Q3.

In other words, AMR's profitability is already well within the "normal" range for large legacy carriers. In fact, since American is continuing to reduce its cost structure, it is on pace to close the gap with Delta over time, while improving its margin advantage over United.

Merger questions
This is where things get tricky for AMR's management. The company is still determined to merge with US Airways to create a global carrier rivaling United and Delta in scale. However, the DOJ claims that the spate of recent airline mergers such as Delta-Northwest, United-Continental, and Southwest Airlines (NYSE: LUV  ) -AirTran have eroded competition. Regulators fear that the American-US Airways merger would worsen that trend.

Previous airline mergers faced much less scrutiny from U.S. regulators for a number of reasons, but most importantly because the airline industry was much less healthy than it is today. For example, Delta and Northwest had only recently emerged from bankruptcy protection and were inconsistently profitable in the year leading up to their 2008 merger.

Meanwhile, United and Continental both lost lots of money in 2009, as the U.S. struggled through the Great Recession, before agreeing to merge in 2010. Southwest and AirTran were not in such dire straits when they merged, but AirTran was tiny compared to the other carriers that have merged, which lessened competition concerns.

By contrast, the U.S. airline industry is quite healthy and profitable today. Moreover, US Airways and AMR are both stable, profitable companies now. When the alternative to an airline mega merger was to see one or both carriers go bankrupt, it was easy for regulators to view the merger as pro-competitive. In this case, the decision is not quite so simple.

Looking ahead
While AMR and US Airways can't convincingly claim that they need a merger to be competitive, they still have at least a 50-50 chance of success in the trial that begins next month. While the merger reduces competition on a variety of domestic routes, for international travelers it's almost certainly better to have three big carriers rather than two mega airlines and two smaller network carriers.

AMR and US Airways can also make a reasonable argument that the reduction in domestic competition would not have much impact on fares due to the growth of smaller carriers. The trial judge has also seemed relatively sympathetic to their concerns thus far. Still, AMR's resurgent profitability makes the case for a merger much less compelling that it would otherwise have been.

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