U.S. Airways And American Airlines Merger Has Eye On Emerging Markets

| About: American Airlines (AAL)

Shares of US Airways (LCC) and American Airlines (AAMRQ.PK) have seen substantial appreciation over the past few months due to merger rumors. Now that they've decided to tie the knot, how will the tie-up affect both profitability and the route structure to lucrative emerging markets?

Over the past decade, the United States commercial aviation industry has undergone a sea change. Since 9/11 the cost structure of legacy carriers hasn't allowed full-service airlines to compete head-to-head with no-frills, low-cost carriers in most person-to-person domestic markets. The advent of Southwest Airlines (NYSE:LUV) as a nationwide carrier saw legacy airlines largely retreat from point-to-point domestic service while further consolidating hub-and-spoke operations and catering to corporate clients.

This reality catalyzed two fundamental changes in the U.S. airline industry: increased focus on higher-yielding international routes, and further consolidation of legacy carriers. The US Airways/American Airlines merger is indicative of both trends.

After Delta (NYSE:DAL) merged with Northwest, and United (NYSE:UAL) with Continental, US Airways and American were the last two at the dance without a partner. Many market observers figured it was only a matter of time before these two entities got together as it became increasingly difficult for legacy carriers to operate profitably on a nationwide scale. Given American’s precarious financial situation, a merger, and a concomitant reset of onerous labor deals, seemed like the most logical solution.

While American’s overall profitability may have suffered as a result of an inflated cost structure, the company possesses a number of prized assets that could have made the company a valuable commodity to any airline. The company’s hubs in cities with major corporate ties – New York, Los Angeles, Chicago, Dallas, and Miami – make it well-positioned to win lucrative corporate contracts. With retail domestic travelers opting for either Southwest or bargain online fares, these corporate contracts are what allow operations to remain close to profitability.

Furthermore, and arguably most importantly, American Airlines is the United States’ largest operator to the fast-growing emerging markets of Latin America. Recently released DOT statistics show that American is easily the most profitable operator to Latin America with yields significantly outpacing those of its competitors. The company’s high brand recognition in Brazil and its service to six Brazilian destinations make it the leading U.S. carrier to South America’s largest economy. American’s sizable presence in markets like Colombia, Peru, Chile, and Mexico also means the company has exposure to many fast-growing markets to the south.

A merger with US Airways could allow American to optimize its South American network, with US Airways’ Charlotte hub possibly becoming a relief hub for Miami. For example, lower-yielding connecting traffic from Brazil to destinations like Boston, and Orlando, could be routed through Charlotte, while higher-yielding traffic can be kept on the nonstop routes to Miami. New aircraft types should also allow for the merged entity to more accurately allocate seats to various international destinations.

While the synergies envisaged by the higher-ups in Phoenix and Dallas will take time to implement, the reduction of redundant hubs and improved cost structure should see the new carrier see profitability in the future.

Given the vagaries of the airline industry however, now is likely not the time to invest in either American or US Airways. Both stocks have appreciated substantially over the past few months; as market observers know, mature domestic market carriers make for terrible long-term investments.

However at some point over the medium-term, concerns over some event, be it the health of the U.S. economy, rising gas prices, or an aircraft grounding, will send these stocks substantially lower. When that happens, this new carrier, with its improved cost structure, lucrative Latin American routes, and numerous corporate contracts could make for a very profitable trade.