More Details Emerge About The New American Airlines

Apr.18.13 | About: American Airlines (AAL)

I've been covering the merger of US Airways (LCC) and American Airlines (AAMRQ.PK) for a long time. As the merger date comes closer, more details are emerging about the new company, which will go with the "American Airlines" name.

Brief History

The latest documents show that the two companies discussed a possible merger as early as 7 months prior to American Airlines filing for bankruptcy. The two companies already knew that a merger was inevitable for them to become a major player in the airline industry where mergers between companies are pretty common. Once American Airlines filed for bankruptcy, the CEO of US Airways, Doug Parker, insisted that the two companies should merge together before American airlines emerges out of bankruptcy and the CEO of American Airlines, Tom Horton, was strongly leaning towards waiting until his company emerges from bankruptcy before merging with US Airways because this would allow American Airlines to hold a better position in the merger negotiations. Eventually the time ran out and Doug Parker's side outweighed Tom Horton's side. We are set to have a new airline around the 3rd or 4th quarter of this year. The new company will keep the CEO of US Airways while keeping the name, logo and headquarters of American Airlines.

Future Guideline Looks Pretty

The "new American Airlines" expects to be highly profitable for the foreseeable future. For its first year, the company expects to earn $2.6 billion, which would put the company's fair value anywhere between $25 and $35 billion. This is much better than the initial estimates which put the company's value between $11-14 billion. By 2015, the company expects to earn $4.4 billion excluding one-time items but the number is expected to fall back to $2.6 billion by 2017. Still, the company expects to be highly profitable for at least another 5 years and this is not something many airlines can promise to their shareholders.

While the company expects to generate between $40-48 billion in annual revenues for the next 5 years, it expects to spend between $12-15 billion on fuel annually during the same period. The fuel and employees will make up the two largest costs for the company. Thanks to the restructuring efforts at American Airlines, the labor costs will be anywhere between $7-10 billion annually through 2017.

What Will The Current Investors Get?

It is still too early to determine what the shareholders of US Airways and American Airlines will get from the merger. Obviously they will get stock of the new company, but it is difficult to tell how much the new company will be worth. When a company gets offered to the public for the first time either through IPO or spin off, the first few days tend to be highly volatile. Many times a company's stock will appreciate or depreciate by 20-30% within the first day of trading. We don't know if investors will value the next company based on its future earnings or on emotions. Until recently, US Airways was trading with a P/E ratio below 4. Because airline companies tend to go bankrupt periodically, investors have always been skeptical of this sector and we have no option but to wait and see.

The agreement signed by the bankruptcy judge a couple weeks ago gives the majority of the new company to the bondholders of American Airlines. The creditors are expected to get back every penny they invested in American Airlines, which is a rare case for companies that emerge from bankruptcy where haircuts are a common practice. The current shareholders of American Airlines will be given 3.5% of the new company which is subject to an increase if the company's market value reaches a level where creditors get all their money back and there is still value left. The current investors of US Airways will receive 28% of the new company. If the new company is valued at $11 billion, US Airways is worth $3.08 billion which is significantly above the current market value of US Airways which stands at $2.65 billion. If we take less conservative valuations of the new company, the current fair value of US Airways may go as high as $5-6 billion. From the most conservative case to the most liberal case, US Airways investors will be very happy with the outcome. The stockholders of American Airlines may or may not be happy with the outcome, and their outcome will highly depend on the value of the new company.

Conclusion

The days ahead will be mostly volatile for the investors of US Airways and American Airlines but things don't look too bad in the long run. I'm more confident for the investors of US Airways than the shareholders of American Airlines though. I bought shares of US Airways at $11.00 and some more at $13.00. I kept selling covered calls which resulted in pretty nice premiums due to the high volatility of the stock, and I was able to bring my breakeven price to $9.30. I am planning to hold my shares and continue to write monthly calls at least until the merger finalizes and possibly beyond that.

Disclosure: I am long LCC. 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.