Shares of bankrupt AMR Corporation (AAMRQ.PK), the parent company of American Airlines, nearly doubled in value last week, closing at $1.60 on Friday. Since the company filed for bankruptcy in November, 2011, most informed observers have believed that the shares are likely to be canceled when AMR leaves bankruptcy, and are therefore worthless. On numerous occasions, AMR has warned that this is likely to be the case. Nevertheless, on Wednesday, lawyers for the company informed the bankruptcy court that there was a chance that AMR shares would still have value after the bankruptcy. "Depending upon the ultimate strategic alternative adopted and pursued, there exists a reasonable possibility that there may be value for AMR equity holders consistent with the absolute priority rule," they wrote. This spurred substantial speculative buying through the rest of the week.
However, I still believe that current AMR shareholders are likely to receive 1% or less of the new company's stock, and will therefore suffer a nearly total loss on their investments. The U.S. bankruptcy process ensures that all debt holders (and other claimants) have absolute priority over shareholders. In other words, shareholders are only entitled to receive whatever is left after everyone else has been paid in full.
AMR's Unsecured Liabilities
AMR entered the bankruptcy process in order to reduce its debt and amend various other contracts (particularly with labor unions) to improve the company's profitability. However, the company creates unsecured claims every time it amends a contract. The only currency that AMR has to compensate the claim holders is stock in the new (post-bankruptcy) company. As a result, AMR shareholders will only receive a significant stake post-bankruptcy if the new company is worth more than the total of all the unsecured claims.
As of November 30, 2012, AMR listed $13.05 billion in "liabilities subject to compromise" (unsecured claims). This was significantly higher than the $4.84 billion the company listed in its most recent 10-K. The total increased primarily because of the inclusion of pension liabilities of $7.7 billion, as well as a $1.8 billion increase in the company's estimate of allowed claims (these additional claims were created by AMR's rejection of various leases and other contracts over the course of 2012).
That said, I believe that the pension liabilities will ultimately be excluded from the list of claims, because of AMR's decision to freeze its defined benefit pension plans, rather than terminating them. While employees will no longer accrue additional benefits, they will receive all of the benefits to which they are already entitled. With AMR keeping these liabilities post-bankruptcy, the total of unsecured claims drops to approximately $5.3 billion.
While it is possible that this total could drop further (through AMR contesting claims), it could also increase if the company continues to reject contracts before exiting bankruptcy. I believe $5.3 billion is a good conservative estimate of the value of AMR's unsecured claims that will remain when the company exits bankruptcy, with $5 billion probably being a best case scenario for equity holders.
Valuing the new AMR
The estimated $5.3 billion in unsecured claims must be fully met by an equivalent value of post-bankruptcy stock (or cash) for current AMR shares to retain any value. It is therefore necessary to estimate the value of the company post-bankruptcy. However, some of the new shares are already "spoken for". Members of American's labor unions are being compensated for their concessions with equity stakes in the new company. Pilots will receive 13.5% of the new stock, according to their recently signed contract. Flight attendants will receive 3%, and members of the Transport Workers Union (mechanics, baggage handlers, and various other ground staff) will receive 4.8%. Thus, 21.3% of the new AMR's stock has already been promised to American's workers.
To value the new company, it is useful to look at the valuations of competitors. American's two largest competitors are United Continental Holdings (NYSE:UAL) and Delta Air Lines (NYSE:DAL). As of Friday's close, United had a market cap of $8.64 billion and Delta had a market cap of $11.29 billion. However, Delta has become very successful over the past few years, whereas American has no such track record of success. United has had its share of bumps in the road, and is thus probably better to use for comparison purposes. (United and American also compete head to head much more heavily than Delta and American, as they share hub airports in Chicago and Los Angeles). However, United is approximately 50% larger than American by revenue. This would imply a valuation of $5.8 billion for the new AMR. Using a combination of United and Delta as the reference and adjusting for American's smaller size would lead to a somewhat higher $6.7 billion valuation.
However, there is a strong possibility that American will merge with US Airways (LCC) either before or right after it exits bankruptcy. US Airways management has suggested that the combined value of the two companies would be $9.5 billion (which places it in between the valuations of United and Delta), and has proposed that US Airways shareholders would own 30% of the combined company, with AMR creditors owning the remaining 70%. This would put the value of AMR's stake at $6.65 billion. While some AMR creditors have been pushing for as much as an 80% stake in the combined company, this is unlikely to occur, as it would value US Airways at less than the current fully diluted market value. (In other words, it would value US Airways at a discount to the current market price, and force US Airways shareholders to write down the value of their investments.) $7 billion is a reasonable estimate of the upper bound of AMR's post-bankruptcy valuation.
In the best case scenario (involving a merger with US Airways on favorable terms), AMR will have $7 billion worth of stock to meet its unsecured claims. After deducting the 21.3% promised to workers, the remaining total of $5.5 billion would fully meet the company's estimated $5.3 billion in unsecured claims. Equity holders could thus receive $200 million worth of stock. Even if the total of unsecured claims was cut down to $5 billion, equity holders would still only receive $500 million of new stock (slightly less than AMR's current market value at $1.60 per share). By contrast, if AMR receives a valuation of $6.65 billion in accord with the US Airways proposal, then equity holders would be wiped out entirely based on the estimate of $5.3 billion in unsecured claims. In a standalone scenario, the likely valuation of $5.8 billion would not leave anything for current AMR shareholders.
This analysis demonstrates why AMR's lawyers said that equity holders may be able to recover some value. In an absolute best case scenario, AMR shareholders might be entitled to $500 million of new stock. However, this is still somewhat below AMR's current market cap. However, this "best case" is extremely unlikely to materialize. Other unsecured creditors have a strong incentive to push for a conservative valuation of the new company. If the bankruptcy court were to give current equity holders new stock based on an unsustainably high valuation, creditors would be unable to recover the full value of their losses. This would violate their rights of absolute priority over shareholders.
Thus, while there is some "option value" in AMR shares, the most likely value is still zero. I believe the main reason why shares have spiked is that it is difficult to "short" shares of over the counter securities like AMR, and so there were not enough sellers in the market when speculators jumped in this week. Nevertheless, when AMR exits bankruptcy, shareholders will face a moment of truth, and are likely to see the value of their holdings wiped out (or very nearly so). If you have been waiting to sell your shares: now is the time! AMR is also a good short candidate again (for risk tolerant investors), if your broker will allow you to short it.
Additional disclosure: I am also long DAL and have sold March $14 calls against my DAL position.