Jim Cramer did the unthinkable this week, recommending an airline stock to "Mad Money" viewers. Cramer admits that he has never been a fan of airlines, but he is now bullish on the sector and especially US Airways (NYSE:LCC). He thinks that the company's planned merger with American Airlines (NASDAQOTH:AAMRQ) will be a rousing success and send the stock higher. However, negotiating a merger with American Airlines was the easy part for US Airways: now CEO Doug Parker and his team need to integrate two major airlines, which will be incredibly difficult. As an investor, it's probably best to stay away until the integration is complete and the company proves its profitability.
As an investor, if you had put some US Airways stock in your grocery cart along with your turkey on the day before Thanksgiving in 2011, you would be sitting on a better than 250% gain today. US Airways has rallied from below $4 then to $14.57 as of Wednesday's close.
Cramer is thus late to the action, and investors who follow him will be late as well. The current US Airways trading price implies that the post-merger American Airlines will be worth approximately $10.5 billion. While that's less than Delta Air Lines' (NYSE:DAL) $13.3 billion valuation, it is higher than United Continental's (NYSE:UAL) $9.8 billion market cap. United is a much better comparison case, because it is in the midst of a merger integration, just as US Airways and American will be for the next few years. On that basis, US Airways stock doesn't seem like such a bargain.
Cramer's main justification for liking the airline industry now is that consolidation has greatly reduced competition. Following the American-US Airways merger, 80% of domestic traffic will be handled by just four carriers: American, United, Delta, and Southwest Airlines (NYSE:LUV). However, competition among those four will remain fierce, and the new American could find itself threatened by the others in certain markets. Furthermore, new competition is arising, particularly the rapid growth of ultra-low-cost carrier Spirit Airlines (NYSE:SAVE).
Delta is making a push to grow in two key markets where American maintains hubs: New York and Los Angeles. American's joint venture with British Airways currently dominates the JFK-Heathrow route, which is by far the most important international route from the U.S. However, Delta recently bought a 49% stake in Virgin Atlantic, and announced a joint venture that will give the two carriers seven daily nonstop flights from JFK to Heathrow, along with two nonstops from nearby Newark Airport to Heathrow. This will make Delta's offering much more competitive, and complements its "win in New York" strategy. Delta now dominates LaGuardia Airport and is the leading carrier at JFK, while United dominates Newark; the "new" American is clearly behind in New York. American is also under threat in Los Angeles, where it already trails United, and Delta is expanding capacity by more than 10% this summer.
Furthermore, competition from Southwest is poised to ramp up in two markets that American and US Airways currently dominate: Charlotte and Dallas. Southwest has never served Charlotte, but it "acquired" a few flights from Atlanta and Baltimore when it bought AirTran in 2011. Next month, it will begin serving Charlotte with Southwest airplanes for the first time, with four initial destinations. This is a small start, but Southwest has grown rapidly in other markets where it has attacked an entrenched legacy carrier, such as Denver. Meanwhile, the repeal of the Wright Amendment in late 2014 will allow Southwest to grow its operations in Dallas, whereas Southwest was previously barred from flying nonstop from its base at Love Field to the West Coast, the East Coast, and the Midwest.
Lastly, Spirit Airlines is attacking American's hubs in Dallas and Chicago with its "ultra-low-cost" model. While Spirit is a niche carrier with only 45 aircraft at the end of 2012, it is growing rapidly and has ordered more than 100 additional aircraft for delivery over the next decade. Spirit entered Dallas (a market dominated by American) in May 2011 with just two destinations and four flights a day. Less than two years later, it offers 22 nonstops to fifteen destinations, with seven more destinations to be added this spring. With costs approximately 40% below legacy carriers (including American), Spirit can underprice them to rapidly gain market share. Spirit's rapid growth in some of American's core markets is thus a worrisome trend.
Merger integration pain
Cramer's supposition that competition is decreasing seems incorrect. However, at an even more basic level, the process of integrating American and US Airways will involve significant costs, and mistakes are virtually inevitable. Management currently expects $1.2 billion of one-time integration costs, as well as $400 million of increased pay annually, primarily for US Airways workers who have long earned well below the industry average.
These known costs are expected to be offset by nearly $1.5 billion in revenue and cost synergies by 2015. If integration goes well, that target may be achievable. However, the case of United Continental shows how difficult merger integration can be. Leading up to the March, 2012 integration of United and Continental technology systems, the United management team was confident that the "cutover" would be smooth, after having done several dry runs. Instead, the cutover was a disaster, and the resulting fallout was a major reason why United's adjusted profit dropped by more than 50% in 2012.
The moral of the story is that even when management thinks it has planned for every integration contingency, major problems can crop up. Integrating two large and complex organizations is an extremely difficult task. The resulting risk of owning US Airways as it tries to integrate with American Airlines makes it unwise to invest in the company right now.
I have dealt here with just two of the potential stumbling blocks ahead of US Airways and American Airlines. Other possible problems include its weak position in Asia (you can count the combined carriers' routes to Asia on your fingers) and a low ranking in the Airline Quality Rating survey.
Consolidation is helping the airlines, but that benefit is offset in the case of US Airways by the costs and risks of integration, as well as the entry of Southwest and Spirit into several US Airways and American Airlines hubs, where they may put pressure on fares and depress margins. That's why I think you should ignore Cramer, and stay away from US Airways for now. Do you disagree? Leave a comment for me below.
Fool contributor Adam Levine-Weinberg owns shares of Delta Air Lines and is short Mar $14 calls on Delta Air Lines. Adam Levine-Weinberg is short shares of United Continental Holdings. The Motley Fool recommends Southwest Airlines. The Motley Fool owns shares of Spirit Airlines. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.