Merger With AMR May Send US Airways Shares Surging

| About: American Airlines (AAL)

Over the past few weeks, merger talks between AMR Corp (AAMRQ.PK) and US Airways (LCC) have intensified. The two airlines are expected to announce a merger within the coming days. However, despite this optimism, as shown by the chart below, shares of LCC have not responded.

LCC Chart
(Click to enlarge)

LCC data by YCharts

Deal Already Priced In?

Some have argued that LCC shares have already priced in the likely merger with AMR. This line of reasoning makes some sense given the fact that LCC shares have soared since AMR entered bankruptcy and merger discussions began. However, it must be noted that the valuation for the combined carrier has continued to increase over time. As recently as December 7, 2012, the value of the proposed merger was $8.5 billion. Currently, reports are citing $11 billion as the merger value. Some sources have even cited numbers as high as $13 billion. Certainly, there is a big difference between these two figures. Despite this increase in valuation, as shown by the chart below, LCC shares have only moved modestly higher since December 7.

LCC Chart
(Click to enlarge)

LCC data by YCharts

Sector Move

Another reason why I do not believe LCC shares fully reflect the value of the proposed merger with AMR is the fact that the entire airline sector has been moving higher over the past few months, not just LCC. In fact, as shown by the chart below, LCC shares have underperformed rivals United Continental (NYSE:UAL), Delta (NYSE:DAL), and Southwest (NYSE:LUV) over the past three months.

LCC Chart
(Click to enlarge)

LCC data by YCharts

Merger Details

It looks like the breakdown in ownership of the new merger airline will be AMR creditors owning 72% and LCC shareholders owning the remaining 28%. Using the $11 billion valuation, this would mean that LCC shareholders stake in the new company would be $3.08 billion. Currently, LCC has a market cap of just $2.3 billion. These numbers indicate that LCC shares have significant upside if a deal is indeed announced.

Short Interest

Right now, short interest in LCC stands at 23.69 million shares or 17% of the float. If a deal is announced, I look for a short squeeze to develop as shorts are forced to cover due to massive losses.

Risks

Of course, a merger is no guarantee. The boards of both AMR and LCC need to approve the deal and regulars also need to sign off. For those who believe strongly in the efficient market hypothesis, it should be noted that the recent performance of LCC shares suggest that, behind the scenes, something might be going wrong with the merger talks. Reports have given no indication of any such problems but that does not mean they do not exist.

Conclusion

I have decided to take a long position in LCC calls as a way to play the potential merger in an effort to limit my risk if the deal falls through while maximizing my reward if a merger is announced.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. I am long LCC calls