While I normally don't like to speculate on short-term price movements, the market reaction to news surrounding the potential merger between US Airways (NYSE:LCC) and American Airlines' parent company, AMR (NASDAQOTH:AAMRQ), may give clues as to long-term values for shareholders of all airlines. The piece of news that emerged was similar to what would eventually be a possible solution to the merger battle and is important to examine for all airline industry investors.
The proposed merger between US Airways and AMR hit a roadblock in August when the Department of Justice joined with several states to file a lawsuit to block the tie-up. Since then, much of the speculation about the merger has related to the possibility of a settlement whereby the airlines grant some concessions in exchange for the DOJ's stamp of approval.
With AMR shareholders likely to realize the most value in the event of a merger, any news of a settlement would be a strong positive development for shares. Additionally, US Airways has been pursuing this merger on and off since 2011 and would be expected to see a share-price bump if a settlement is announced.
And on Oct. 30, we got a brief taste of how the market may react.
Market case study
Ultimately, the effects of a settlement on these stocks can only be definitively determined if a settlement is actually reached. But the news on Oct. 30 provides a small case study on how the market could potentially react if a real settlement is announced.
Reports have emerged that US Airways and American Airlines are preparing a settlement proposal that would involve the surrendering of some slots at Washington Reagan National Airport. It should be noted that this is merely a settlement being drawn up by the airlines for presentation to the DOJ and the latter has in no way agreed to the settlement.
Even so, this news has had quite an effect on airline share prices. Shares of AMR popped more than 5% to hit a new 52-week high of $7.60 before cooling off to settle more than 4% higher at $7.30 apiece.
But perhaps the more critical share price rise came from US Airways. Since the value of AMR common shares is determined based upon the share price of US Airways stock, the end return for shareholders of a merged airline will be determined by the value of US Airways shares.
And this talk of a settlement being written up by the airlines took US Airways shares out of the red from under $22 each to nearly $23 before they cooled off settling at $22.58, up $0.21 on the day. Even shares of other major airlines rose on the news, with both Delta Air Lines (NYSE:DAL) and United Continental Holdings (NYSE:UAL) experiencing strong end of day rallies.
Clearly, even talk of a potential settlement by one party in this case was enough to boost airline stocks. Seeing that Delta and United Continental both fell after the DOJ's August announcement that it would file the lawsuit, and then rose higher on talks of a settlement, it would be reasonable to assume that an agreed-upon settlement allowing the US Airways-AMR merger would move Delta and United Continental shares higher. With this in mind, Delta and United Continental could be good plays for investors wanting to play a settlement while distancing themselves from the merging parties.
As I mentioned earlier, the primary factor that would determine the value of AMR shares in a successful merger is the value of US Airways shares. With US Airways shares at $22 each, AMR shares would be worth approximately $14 each in the event of a merger based upon the calculations laid out in AMR bankruptcy documents.
But the upside potential here is likely much more than a $14 AMR share price. If a whiff of a settlement could drive US Airways shares up more than 5%, an official announcement of a settlement is likely to result in an even larger gain. With AMR shares essentially being a leveraged play on US Airways stock, the value of AMR shares could quickly rise beyond $14 each if a settlement drives US Airways shares significantly higher, as this market action has shown is possible.
Risks and upside
Investors in AMR shares, or those of any airline for that matter, should understand the risks that accompany their investments. I have laid out the case for larger-than-expected potential upside for AMR shares, but investors must still consider the risk that the merger will never happen. As is always the case with speculative stocks like AMR, do your own research and never invest money you cannot afford to lose.
Alexander MacLennan owns shares of AMR and Delta Air Lines and has the following options: long January 2015 $22 calls on Delta Air Lines, long January 2015 $25 calls on Delta Air Lines, long January 2015 $30 calls on Delta Air Lines, and long January 2015 $17 calls on US Airways Group. The Motley Fool has no position in any of the stocks mentioned. 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.