Rock icon Tina Turner probably isn’t the first name that comes to mind if you’re mulling whether a marriage of US Airways (NYSE:LCC) and American Airlines’ parent AMR (PINK:AAMRQ) would be better or worse for the two carriers’ investors. But as the courtship dance between US Air’s Doug Parker and AMR’s Tom Horton gives way to frayed tempers, it’s worth remembering that in airline mergers as in rock-star relationships, “What’s love got to do with it?”
Parker has ardently pursued a combination with AMR since the latter entered bankruptcy on Nov. 30. And Horton has rebuffed his advances, noting that his priority is for American to emerge from Chapter 11 as a viable, stand-alone carrier — and only then consider any mergers.
But Parker’s charm offensive to gain support of the airline’s unsecured creditors’ committee — including its three largest unions — influenced Horton’s decision about three weeks ago to conduct a “merger review,” in which he’s reaching out to “several” potential partners. Among those reported to be on his list are JetBlue (NASDAQ:JBLU), Alaska Air Group (NYSE:ALK), Republic Airways’ (NASDAQ:RJET) Frontier Airlines subsidiary and Virgin America.
Since then, the CEOs have played out their tiff in the press, with Parker telling a National Press Club audience on July 18: “US Airways is here now and we are ready to do this now. There is no guarantee that will be the case forever.” It didn’t hurt Parker’s case that leaders of AMR’s three unions were seated with him — or that LCC purchased about $1 million in AMR debt at $600,000 to gain status as a creditor.
Horton fired back in an AP interview last week that he — not Parker — first broached the topic of a merger two months before AMR filed for bankruptcy. He characterized Parker’s pursuit as “desperate” and a “race against the clock” for US Air to save itself from high labor costs that could be offset if it picks up American’s international routes.
At this point, there’s little love lost between Parker and Horton, who were friends and former colleagues at American more than two decades ago. But here’s where it makes sense to heed the words of Tina Turner when it comes to airline mergers: Love is one thing; value proposition is another thing entirely.
So let’s break down two scenarios: US Air and AMR merge, or they go their separate ways.
If US Airways and AMR Merge
Airline mergers like Delta (NYSE:DAL) and Northwest, United (NYSE:UAL) and Continental, and Southwest (NYSE:LUV) and AirTran have been positive developments because of their potential to deliver economies of scale and a stronger competitive position.
From Parker’s perspective, a combined AMR–US Airways makes the most sense if the deal is done while AMR is still in bankruptcy. That would make it easier for the combined airline to shed older, gas-guzzling planes and unprofitable routes. It also would be able to negotiate better terms with airports and revise labor contracts.
Horton counters that emerging from bankruptcy as a stand-alone carrier gives AMR greater control over its destiny — and puts it in a position to deliver greater value to shareholders. Both sides agree that if there were a merger, the surviving airline would go by the name American and its headquarters would remain in Fort Worth, Texas.
What US Air Gets: In a merger, US Air gains American’s profitable international routes and would participate in American’s oneworld Alliance — a global airline network that can substantially boost interline revenues. LCC also gains the iconic carrier’s name and systemic strength and reach. And any merger most likely would end up with Parker running the combined airline.
US Air also would benefit from the deal AMR inked with Boeing (NYSE:BA) and Airbus last year for a total of 460 new fuel-efficient planes, with extremely attractive financing terms. Boeing and Airbus earmarked $13 billion in lease financing to fully cover the first 230 planes so American wouldn’t have to try to raise financing on its own deteriorating credit.
Downside: Parker may have charmed American’s unions, but that’s no guarantee of wedded bliss once a deal is done. He’s had plenty of labor trouble since the America West– US Air merger in 2005. Unresolved problems have led to lawsuits last year and the characterization of US Air’s labor relations as “toxic.”
What AMR Gets: A merger would strengthen American’s domestic network, particularly in lucrative East Coast business travel markets. LCC has a strong presence in Washington, D.C., and its hubs in Charlotte, N.C., and Philadelphia also could help AMR better compete with Delta and United Continental for corporate accounts.
Willie Walsh, CEO of Iberia and British Airways parent IAG (as well as American’s oneworld Alliance partner), said in June that a merger with US Air would make American “stronger” and “better.”
US Airways is a big enough potential partner to significantly expand the size and scope of American, but not to the level that antitrust regulators would quash the deal (the likely outcome of any attempt by Delta or UAL, which is still working through its integration with Continental). It doesn’t hurt that US Air and American have fewer than two dozen overlapping routes.
Downside: Horton didn’t take the helm of American last year to let outsiders decide his airline’s destiny. He believes wholeheartedly that the carrier is in a position of strength and that its many assets shouldn’t be sold off at fire-sale prices.
The most recent quarterly earnings appear to bolster Horton’s claim that American could emerge from bankruptcy as a viable carrier. AMR reported record quarterly revenue of nearly $6.5 billion in July. If bankruptcy-related costs were excluded, the carrier would have earned $95 million.
If US Airways and AMR Go Their Separate Ways
What Happens to US Air: US Air would be the biggest loser in the short term, if only because its stock has risen 190% on the merger speculation.
American is the last, big merger target for LCC. Since US Airways completed the America West deal, Parker has lost out on high-profile bids for United and Delta. Without AMR, it doesn’t have the size and reach of DAL and UAL and still faces higher labor costs. No other potential merger candidates are large enough to give US Air the consolidation benefits it needs.
But without AMR, US Air still announced last week it had tripled its quarterly profit to a record $306 million. Revenue rose more than 7% to $3.8 billion. While the airline has debt of nearly $4.5 billion, it also has $2.5 billion in cash.
One wild-card scenario bears mentioning: If Delta were to acquire US Air (and if it were to clear antitrust scrutiny), the surviving entity could be a blockbuster competitor against UAL and effectively create a legacy airline duopoly that locks out American. Rest assured, though, Parker isn’t looking for a deal that would leave him jobless or reporting to Delta’s Richard Anderson.
What Happens to American: AMR has the exclusive right — at least until Dec. 28 — to present its own reorganization plan without considering third parties. It seems likely to milk the clock for now.
But regardless of timing, AMR needs a merger to survive as a major legacy carrier — that’s why it has sent out nondisclosure agreements to a number of carriers. And despite the recent bout of mud-slinging, Horton did send a merger packet to US Air last Friday for its review.
If you take US Air off the table, AMR’s viable merger partners are limited at this point. Alaska Air is profitable and boasts strong West Coast market share, but it’s not big enough to boost AMR’s ability to compete. Merging with Frontier Airlines is more akin to adding a second American Eagle, and Virgin America is losing money.
Merging with JetBlue is an intriguing idea because it would boost American’s East Coast presence, but with JBLU’s improving performance and profitability, I don’t see the overall value proposition, particularly since the combined carrier would have to shed routes out of New York to appease regulators.
How Investors Should Play It: Love may not have much to do with airline mergers, but there’s a lot to love about the opportunity this courtship offers investors. Now that the CEOs of American and US Air are talking — or at least duking it out in the press — I expect LCC share prices to slow their ascent.
Deal or no deal, this process will be a marathon, and it’s in AMR’s best interest to take as much time as it can to come away with the best deal possible. That could mean little resolution until next year, unless Parker manages to sweeten the pot.
If a deal does get done, I see LCC shares making it to between $16 and $20. Much depends on the merger’s precise structure, particularly the equity split, as Reuters reports.
If Parker fails in his bid for American, expect LCC to drop hard. A big enough knee-jerk reaction could push the stock back into the $5 to $6 range, at least in the short term.
Given the dramatic rise in US Airways shares on the merger talk (and the possible descent if it doesn’t happen), I think a covered call strategy is the best way to play this opportunity now. Buying call options on LCC along with a corresponding quantity of LCC shares is a good way to play the merger’s opportunity, while gaining downside protection.
US Air shares are trading around $11.50 now. The September 2012 call options, particularly at the strike prices of $11 (which is in the money) and $12, look good.
As of this writing, Susan J. Aluise did not hold a position in any of the aforementioned securities.