On Monday, new details regarding the US Airways (LCC) - American Airlines (AAMRQ.PK) merger came to surface. It looks like a deal between the two companies is very close and the final details are being discussed. I was expecting this story to be cheered by a lot of investors of US Airways, but it didn't happen. Since Monday, US Airways is down by 6% (as Wednesday evening). Does that mean investors of US Airways aren't really into the idea of a merger with American Airlines?
The merged company would have some advantages as well as some setbacks. The first advantage is obviously the size. A combination of US Airways and American Airlines would become the largest airline in the US and one of the largest in the world by traffic. In the airline industry, the bigger a company is, the more pricing power it gets. Size is very important for margins if used right. Obviously, if the size advantage is not used right, things can get bad very rapidly like they did for American Airlines.
The biggest challenge in front of the merged company would be in the organizational development side. US Airways and American Airlines have very unique corporate cultures and they both have thousands of employees that are used to doing things one way. Now things will have to change drastically for many employees from entry level personnel to senior managers, and this may take a lot of time, effort and resources. It will be very interesting to see how this will turn out, and I can totally understand if this makes some of the investors worry.
Doug Parker, the current CEO of US Airways, is very likely to become the CEO of the new company, although, the CEO of American Airlines Tom Horton's role in the new company is not clear at the moment. Doug Parker has strong backing of employees of both companies, whereas many of American Airlines' employees are skeptical of Tom Horton.
By the way, investors who are holding shares of American Airlines might not be too happy with the outcome of the merger. Many times I have readers ask me about the possible fate of American Airlines shares after the merger. These shares will be worth next to nothing after the merger. The new company will be owned by current US Airways shareholders and American Airlines' current bondholders. So far, we don't know what percentage of the new company will belong to each party, because the companies haven't made the information public due to the non-disclosure agreement that was signed last year.
Currently, US Airways is reporting great financial results. Even without the merger, the company is undervalued. There is obviously a lot of uncertainty regarding the merger and there is absolutely no way of telling how much each share of US Airways will be worth after the merger. I can totally understand if some investors of US Airways don't like the idea of going through a lot of uncertainty when the company is doing really well by itself. On the other hand, the merger might result in great returns for the company's stockholders. Since the idea of a merger was first brought up, the share price of US Airways is up by nearly 250%. During the same period, the income of US Airways also grew by more than 300%, so it is difficult to tell how much of the share price appreciation was due to the merger and how much of it was due to the company's financial performance. I always advocated that the company's share price appreciation was mostly due to the company's financial performance rather than the merger.
At the end of the day, investors of US Airways will be happy with the merger because the merged company will probably be run by Doug Parker. Many people in the industry know and love Mr. Parker and he is the man behind the recent successes of US Airways. Dan McKenzie of Buckingham Research Group, argues that: "Bondholders report that the leader must have a demonstrated ability to maximize shareholder value, which is a nod to US Airways management in our view. Our view aside, we've had a hard time finding investors in favor of AMR management, hence our conclusion is that a consensus is in favor of an US Airways led management team running the merged airline." I completely agree with this. At the end of the day, Doug Parker can confidently say that he maximized shareholder value in the recent years. Tom Horton was named the CEO in November of 2011, on the day after American Airlines filed for bankruptcy, and hasn't been in the role for long enough to prove that he is the better option.
Did Mr. Horton’s play a role in American Airlines’ bankruptcy? It is difficult to tell. On Mr. Horton’s defense, under his leadership, the company has been performing better since the bankruptcy. In the fourth quarter of 2012, American Airlines posted net profit of $262 million, which is much better than the fourth quarter of 2011 when the company announced a large loss. In 2012, the company generated $24.9 billion in revenues, which is an all-time high for American Airlines. Excluding special items, the operating profit for the full year was $494 million for the company.
I think investors of US Airways should just sit back and enjoy the ride. If you don't feel completely confident about the fate of your US Airways shares, I suggest writing some calls to bring your breakeven price down a little. Currently, the options market is extremely bullish with US Airways such that some out of money calls expiring towards the end of the year are able to draw premiums yielding as much as 20% at the moment. The options traders seem to think that it is very likely that US Airways will trade above $17 by the end of the year.
At this point, it is difficult to set a target price for this company because the share price will be mostly determined in the negotiations between the bondholders of American Airlines and stockholders of US Airways. I don't see how they can be lower than today's share price though. The share price of US Airways is far more likely to go up than to go down.
Disclosure: I am long LCC.