By Vaughn Cordle, CFA And Jim Higgins, CFA
Better Economics and Competitive Fares Go Hand in Hand
The new American (AAMRQ.PK) will be the world's largest airline, with available seat-miles running neck-and-neck with Delta (DAL) and United (UAL) in the U.S., as the following exhibit illustrates. However, because it will have appreciably more flights and seats than they have, AA/US will also have more opportunities to optimize unit revenues via fleet rationalization.
A merged American Airlines and US Airways (LCC) will pull down uneconomic aircraft and capacity, especially in the overly fragmented regional segment that feeds the two airlines. Load factors are too low on many of the regional carrier and mainline city pairs, and this is where the merged airline can produce cost and revenue synergies by way of improving the fleet mix. Aircraft that are too old, not optimally sized, and fuel-inefficient will be replaced as the merged airlines' network is rationalized.
One key outcome we expect from a merger is that higher load factors and a more fuel-efficient fleet that is better mixed and matched with the ebb and flow of demand in various markets will generate higher unit revenue and improved earnings while keeping fares competitive.
As an example, the newly merged airline will not want to keep using old and fuel inefficient aircraft on the Chicago (ORD) to Phoenix (PHX) route where both currently compete. The merged airline is likely to keep US's A320/321 and AA's B737-800 aircraft and phase out AA's MD80/83 aircraft, which in recent quarters have represented 39% of the block hours on this route (see table).
The newer Boeings (BA) and Airbuses have 33% lower fuel consumption per seat, which implies that fuel costs per seat on this city pair will be about 16% lower once the older aircraft are removed. As fuel expense represents about 37% of AA's total operating costs, total expenses will drop by about 6% on this route by simply replacing the older aircraft with more fuel-efficient jets.
Of course there are other costs that must be considered. These costs, specifically labor, will be discussed in one of our next research notes that will be part of a series of notes on the merger and its impact on the airline industry.
The Regional Carrier Segment is Ripe for Restructuring
The reduction in the number of fuel inefficient and small 50-seat or less aircraft, replacing them with larger aircraft, would have been a critical driver of improved economics at a restructured, standalone, AA, and will take on an even more important role in a merged AA and US. This regional restructuring will result in fewer flight operations, lower fuel and maintenance costs per seat, and reduced delays in major hubs like DFW, Chicago and Miami. Fewer flights into and out of major hubs reduce air and ground delays, which in turn frees up capacity and reduces block hours for the airline and flight time for the consumer. Larger regional jets will enable the combined carriers to offer more two-class cabins and passenger comfort, thereby improving competitiveness and growing revenues.
For the combined airline, the eight carriers (see chart) that currently comprise the regional segment will represent 53% of system-wide flights, 11% of the ASMs and 36% of the block hours. Seventy-four percent of the combined airline's regional flights will be on aircraft with 50 seats or less.
The new airline will have 889 mainline aircraft and 622 regional aircraft, with regional flights spread across the eight feeder airlines as illustrated in the following chart. While contracts with individual regional carriers will need to play out, we believe it likely that the new American will ultimately reduce the number of regional carriers it employs to feed its network.
Better Merger Economics Allow Lower Fares
Fares will follow costs over time, and the airlines need to earn their weighted cost of capital over a full business cycle. Accordingly, the new American Airlines becomes more profitable and competitive because it can offer competitive fares while improving earnings once the fleet mix and network are rationalized. The merged airline will need to be fare-competitive in order to enhance scope economies (i.e., network synergies) via increased passenger volumes. The higher the volume, the better the operating economics as the company spreads expenses and fixed costs over more passengers. Moreover, tighter capacity management will reduce the number of lower-end "junk" fares and improve overall yields and profitability without raising prevailing fares in any particular market.
That last sentence is a key point: In our view, it would be a mistake to assume that fares will naturally rise anytime soon as a result of the merger. Passenger demand will be weaker this year than it would have been otherwise due to fiscal tightening, which in turn dampens GDP and job growth. Additionally, the merger isn't even expected to close until 2013's third quarter. For these reasons, we don't expect average fares to move much higher than inflation in the short and intermediate term.
Over the longer run, average fares will be a function of industry capacity growth, likely higher labor costs, fuel costs, and GDP and employment growth. Capacity levels in the U.S. will be more disciplined because of industry consolidation, and the result will be a more optimal management of supply and demand. Moreover, the key outcome of the recent years' string of mergers will be that rationalization of the overly fragmented industry will lead to sustainable returns that optimize benefits for all stakeholders--consumers, labor and investors.
Valuation Analysis: Attractive Upside
Valuation projections we have seen in various press reports target an $11.0 billion value for a merged American and US Airways. Indeed, taking US Airways' closing price on 13 February, and assuming the 72%/28% equity value split that is slated to take place with the merger, the indicated value is $10.7 billion. The company expects total synergies of over $1 billion by 2015 with $900 million from network revenue synergies and $550 million in cost synergies, partially offset by labor dis-synergies of approximately $400 million.
Of more interest to us is the potential value of the combined AA/US once the merger is seasoned and benefits at the company and industry level are realized. The best starting point is Delta Air Lines, whose 2008 merger with Northwest has produced the lion's share of merger benefits that are likely.
To be clear in explaining what our valuation projection means, we:
- Start with combined AMR plus US Airways 2012 revenues;
- Gross those revenues up by direct merger benefits we have calculated from Delta's experience and fleet optimization benefits for American, plus revenue benefits that we estimate will accrue from increased industry concentration (18% in HHI terms) the merger brings about; all in, it is worth noting that we believe somewhat more revenue benefits are likely than AA and US project;
- Apply DAL EBITDAR (earnings before interest, taxes, depreciation & amortization) and operating margins; and
- Apply DAL's current stock valuation on three metrics based on its trailing 12-month results.
The bottom line is that our analysis projects a combined value for a merged and mature American and US Airways of $12.5 to $14.0 billion, with an average across the three metrics of approximately of $13 billion. To place that in context, if US Airways holders could realize the midpoint of that valuation projection today, it would place the stock at about $18 per share, or 23% above LCC's February 13 closing price. This mature valuation is not expected to be realized initially, is subject to any aggregate changes in valuation of the industry as investors pay more for a more economically viable set of companies, and we will update the estimates as the merged companies release additional information.
Better Economics, Competitive Fares and Valuation Upside
In summary, a combined American and US Airways will continue the airline industry's journey toward higher concentration and sustainable returns, while having significant opportunity to improve company-specific earnings via rationalization and upgrading of an inefficient fleet, among other drivers. There will be labor cost dis-synergies as US Airways' underpaid (by industry standards) employees are brought to parity, but the overall impact of the merger will be, in our opinion, favorable for both American/US Airways stakeholders and the airline industry as a whole, leading to considerable valuation upside as those merger benefits mature in coming years.