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After the merger announcement of US Airways (LCC) and American Airlines (AAMRQ.PK), the first company didn't see much of a rally whereas the second company saw a huge increase in its share price. More specifically, American Airlines saw its shares appreciate by 160% whereas the share price of US Airways is up by merely 6% since the merger announcement. Does this even make sense? Actually it doesn't even come close to making sense if we look at the details of the merger.

According to the merger agreement, 28% of the new company will be owned by US Airways shareholders whereas nearly 70% of the company will be owned by the creditors of American Airlines. The current shareholders of American Airlines will only get 3.5% of the newly formed company. Basically, according to the agreement, the current value of US Airways will be eight times as large as the current value of American Airlines. In other words, if US Airways and American Airlines had the same number of outstanding shares, each US Airways share would have been as valuable as eight American Airlines shares. Currently, American Airlines has 335 million outstanding shares and US Airways has 162 million outstanding shares, so in order for the comparison to be apples to apples, I will compare the market value of the two companies.

US Airways is currently worth $2.46 billion whereas American Airlines is $1.09 billion. This looks like either American Airlines is grossly overvalued or US Airways is grossly undervalued. We know that 3.5% of the new company will be owned by American Airlines shareholders and 28% of it will be owned by US Airways shareholders; therefore, we can easily calculate the value of the new company according to the current value of these two companies. According to the current value of US Airways, the merged company will be worth $8.78 billion; whereas, according to the current value of American Airlines, the merged company will be worth $31.14 billion. According to the management of the two companies, the combination will be worth $11 billion, which means the current valuation of US Airways is grossly undervalued and the current valuation of American Airlines is grossly overvalued. When the merger goes through, if the market values the new company same way it currently values US Airways, the market cap of the new company will be $8.78 billion, which values American Airlines at $307 million. Basically, when all is said and done, each share of American Airlines will be worth between $1.00 and $1.35. Currently American Airlines trades for $3.25 per share, which means whoever bought American Airlines and decided to hold it till the merger will lose half or more of his or her money once the merger is finalized.

Many people who buy American Airlines shares probably don't intend to keep their shares till the merger. Many people realize that this is a pump and dump scheme and they are probably hoping to get out before the whole thing blows up. This reminds me of a story:

Once upon a time, one rich man and his assistant show up in a village and announce to the people that he will pay $10 for every monkey they catch. The villagers see this as easy money and they catch a lot of monkeys for this man. Next day, he comes back and promises $20 for each monkey that villagers can catch and the villagers catch even more monkeys. On the third day, the reward is increased to $30 and on the fourth day, it is increased to $40. At the end of the fourth day, the village runs out of monkeys to catch. The next day, the man comes to the village and promises the villagers $100 per monkey. Now the villagers are worried that they will leave a lot of money on the table because they already caught all the monkeys around the town. Once the guy leaves, his assistant comes to the village with the monkeys that were caught in the past few days in cages and offers to sell each monkey to the villagers for $50. Of course, people agree to pay this amount without any complaints because they believe that they will earn $100 per monkey when the man arrives again on the next day. Of course, the man never arrives again. This is one of the classic examples of pump and dump.

As a principle, I am a long-only investor and I never short any shares (with the exception of writing covered calls on my current shares, which some people consider shorting), so I will not suggest anyone short American Airlines shares. On the other hand, unless the combination of US Airways and American Airlines reaches a market cap of $30 billion, the current shares of American Airlines are grossly overvalued. Even the most optimistic scenarios would make this company overvalued by at least 50-60%. I would definitely stay away from buying any shares of this company.

Those who want to get exposure to the "new American Airlines" should buy stocks of US Airways instead because these shares will turn into the new company's shares and they will reflect nearly one third of the new company. I have been long US Airways for the last year and it's been very rewarding and there is still plenty of upside potential left.

Source: American Airlines Is Ridiculously Expensive