On Tuesday morning, AMR (NASDAQOTH: AAMRQ) and US Airways (NYSE: LCC) announced that they had finally reached a settlement with the Department of Justice that will allow them to merge. This allows them to avoid the risk of a trial, which could have potentially killed the merger outright.

AMR and US Airways are now permitted to merge (Photo: AMR)

However, AMR and US Airways will pay a big price to avoid the hassle and uncertainty of litigation. The companies are giving up a significant number of slots at Washington's Reagan National Airport, which was a primary focus of the DOJ's complaint. They will also dispose of a smaller number of slots at LaGuardia Airport in New York, and will turn over two gates at each of five other airports.

Clearly, the two companies' management teams believe that the potential merger synergies outweigh the downsides of this settlement. Presumably, the combined company will also get a significant influx of cash from auctioning off these assets. However, the increased competition in several of the combined company's top markets will make the merger much less profitable than many investors expect.

An unexpected fight
The Department of Justice gave AMR and US Airways a nasty surprise in August when it objected to their plan to merge. Most people in the airline industry had assumed that the DOJ would not raise any objections because it had approved several other large airline mergers in recent years.

After several months of posturing by both sides, the two companies and the DOJ began working with a mediator earlier this month, on the recommendation of the trial judge. Many people speculated that the talks might just be a formality needed to satisfy the judge. However, the parties reached a settlement in just two weeks.

Big asset divestitures
Incoming American Airlines CEO Doug Parker has argued extensively in recent months that his company should not have to give up slots at Washington's Reagan Airport (or elsewhere). By contrast, JetBlue Airways (NASDAQ:JBLU) CEO Dave Barger argued in September that American and US Airways should give up all of American's roughly 50 slot pairs at Reagan Airport. Barger claimed that US Airways' 55% share of slots was a "ceiling" on what should be permissible at the popular airport.

JetBlue pushed hard for big slot divestitures as part of a merger settlement (Photo: JetBlue Airways)

Meanwhile, Southwest Airlines (NYSE:LUV) CEO Gary Kelly has also expressed interest in adding slots at capacity-constrained airports. On a conference call last month, he stated that US Airways and American should be forced to give up some slots at New York's LaGuardia Airport as well as at Reagan Airport.

Parker and the rest of the American-US Airways team appear to have accepted a total defeat on this issue. According to the terms of the settlement, the two carriers will give up 44 slot pairs that they operate at Reagan Airport, and 12 slot pairs that they operate at LaGuardia Airport. (They will also sell several slot pairs owned by American that are already leased to JetBlue and Southwest.)

The divestitures at Reagan Airport came very close to the request made by JetBlue's Barger. The 44 slot pairs that the combined carrier is giving up represent the vast majority of American's current service at Reagan Airport.

The other notable divestiture included in the settlement is a pair of gates at Dallas Love Field. Neither American Airlines nor US Airways has any flights there today, but American still holds two gates there. Love Field is already a major base for Southwest Airlines, which competes with American's top hub a few miles away at Dallas-Fort Worth International Airport.

Southwest is potentially a big beneficiary of the merger settlement (Photo: Southwest Airlines)

JetBlue has also previously been interested in serving Love Field, but could not do so due to a lack of gates, and a piece of legislation preventing long-distance flights called the Wright Amendment (which is disappearing next year).

The two extra gates will most likely be snapped up by one of these two low-cost-carrier competitors. This, along with the full repeal of the Wright Amendment, will lead to more competition for American's Dallas-Fort Worth hub, which currently dominates the region.

Low-cost carriers are the big winners
Low-cost carriers are salivating today, due to the widespread asset divestitures that AMR and US Airways have agreed to. Right now, US Airways enjoys considerable immunity from competition at Reagan Airport, as do the other legacy carriers (to a lesser extent). Low-cost carriers have very few slots there, so they can only fly to a handful of cities, usually with infrequent service.

The slots going up for sale at Washington Reagan would allow Southwest or JetBlue to establish a much more meaningful presence there. It will also be easier for smaller carriers to access the other major airports covered by the settlement.

The likely expansion of low-cost-carrier service at Reagan will lead to much lower airfares for travelers, but that will undermine the profitability of US Airways' most lucrative hub. American and US Airways will therefore need to generate revenue synergies in the rest of their combined network very quickly for the company to hit its aggressive earnings targets.