What a difference 6 months makes! Not long ago, AMR Corporation (AAMRQ.PK), parent company of American Airlines, was a penny stock on the pink sheets headed for a slow and seemingly inevitable death. The dreaded "Q" that was added to its ticker kept most serious investors away.
On November 16th 2012, you could buy AMR at $0.36 a share. But then came speculation of a merger (now confirmed and in the process of being approved). Last week, AMR reached an intra-day high of $7.15 (before fading a bit this week); still that's almost 20 times its all-time low, an unprecedented turnaround! Its market cap is even within sight of its soon-to-be partner, US Airways (LCC), which isn't in Chapter 11.
AMR shares may be worth as much as $15
Believe it or not, the meteoritic rise of AMR's share price actually makes rational sense! At first I didn't get it (I even tried to short AMR a few months ago after reading this article), but now that I have crunched the numbers, I'm convinced that AMR stock holds significant value. Yes, even though the company is technically bankrupt and its current shares will soon be cancelled! According to my math, at US Airways' current valuation, AMR stock could be worth up to $15, leaving enough room for the share price to double yet again.
First things first, the value of AMR stock is essentially pegged to the price of US Airways. That's because US Airways shareholders get 28% of the new combined airline, while American Airlines shareholders and creditors split up the remaining 72%. So the price of AMR stock tracks that of US Airways in absolute terms, acting like an option on US Airways stock. Indeed, the recent jump in US Airways shares, from $12 to around $18, has chased AMR from its low. At that price level, it's a different game for once-unlucky AMR shareholders. If US Airways continues to push higher, you can expect AMR to do the same.
So what changed in the last few months?
When AMR filed for bankruptcy, its margins were under pressure, it had high legacy labor costs, it was paying sky-high interest rates and nobody on Wall Street was willing to buy a secondary offering of its shares. Its options were limited. Now, the situation is completely different. Airline stocks are in high demand due to improving economic conditions, higher capacity utilization, more reasonable oil prices, and most importantly, the prospect of airline consolidation.
Merger agreement & bankruptcy plan
As most investors know, when a company declares bankruptcy, creditors and shareholders line up in strict order to receive what's left. But in this case, nobody needs to take a haircut. The way I understand this merger agreement, AMR owes its creditors a fixed sum and anything on top of that is gravy for AMR shareholders. Of course, in the 290-page agreement, there's more than its fair share of stipulations. Including a clause where even if nobody else gets paid, the executives get to carve out 40,000,000 shares of the new company for an "Incentive Award Plan".
Yet, under what's called the "Initial Old Equity Allocation", AMR shareholders are entitled to 3.5% of the combined value of both airlines, a rare event for owners of bankrupt equities. But that 3.5% represents less than a dollar a share of AMR's stock price. The real money is in the "Market-Based Old Equity Allocation". Management has so far been coy about the exact mechanics of that windfall for AMR shareholders. Thomas Horton, CEO of AMR, was reported as saying: "Once the unsecured creditors are fully satisfied, any incremental value that gets created goes to the equity holders, over and above that 3.5%" (source). But no additional details were provided.
How do I arrive at $15?
I'll try to keep the math as simple as possible:
- Let's start with the 500M or so new common shares AMR gets to distribute to its existing creditors and shareholders (as calculated by taking the number "US Airways Fully Diluted Shares", or 208M multiplied by 72%/28%, which is the new ownership ratio).
- At nearly $20 a share, that's $10B worth of equity to divide amongst the AMR group.
- Creditors have rights to roughly $3.5B according to Schedule A of the agreement, while Labor gets to collect an extra 31% of whatever the creditors receive (31% comes from 23.6% / 76.4%, where 23.6% is the portion earmarked for labor unions).
- That leaves well over $5B to be distributed among current AMR shareholders. That would also mean current AMR shareholders would own about 36% of the new company, above and beyond the 28% promised to LCC investors.
- With close to 335M AMR shares outstanding, that comes to a gross estimate of $15.00 a share for AMR, which is currently trading in the $5.50 range.
- While that may seem like a bargain, remember though that my estimate is contingent on a number of unproven assumptions that make the final figure considerably less reliable. The inherent risks in interpreting a legal contract does increase the margin of error significantly.
To summarize the agreement, I had to make a number of assumptions:
- Unsecured claims are calculated based on a projected closing date of August 31st, 2013.
- The amount of "US Airways Fully Diluted Shares" (208M) is taken as of February 11, 2013.
- The approximate number of AMR shares (335M) is taken from Google Finance as of May 17th 2013. It is assumed that no significant dilution will occur to AMR stock until the company exits from bankruptcy.
- While US Airways currently trades at about $18 or $19, I round up to $20 to estimate the "volume weighted average price" of the common shares in the combined company.
- I ignored the "preferred conversion price cap" because it is unlikely common stock will appreciate by more than $19 during the 4-months it will take for all the preferred shares to be converted. This allows us to ignore the "Mandatory Shares in Excess of Cap" section.
- I ignored the previously-mentioned "Initial Old Equity Allocation" which represents 3.5% of total common shares. This amount is material only when the price of US Airways gets in the low-teens.
- I assume the price of US Airways will stay above the estimated "Value Hurdle Price" of about $10.18. It gets severely more complicated when there's not enough cash to go around.
- While there are 4 "Mandatory Conversion Dates" and a whole bunch of stipulations surrounding the distribution of common shares, I assume the entire conversion (optional or not) takes place on the effective date of the merger. In theory, the price of a stock always has an equal chance of going up or down, so things should even out in the end.
- Preferred stock holders will be entitled to a dividend yield of 6.25%. I ignored it for the sake of simplicity, especially since AMR's debt is currently accruing at much higher interest rates.
- The "Single-Dip Non-Preferred Allocation" is supposed to grow at 12% per year once the effective date kicks in. Since this allocation is small to begin with, I ignored this premium.
- Most importantly, I'm assuming the merger will be allowed to go through and no major challenges will be made to the Debtor's Chapter 11 plan. The more likely the merger is to be executed in its current form, the more we would expect AMR shares to trade close to its fair market value. Unfortunately, there's no way to quantify those odds at the present time.
Possible insider ownership
My guess is the deal was purposely opaque in order to allow creditors and insiders, who presumably understand the intricacies of this "market-based old equity allocation" plan, to purchase AMR on the cheap. According to Yahoo Finance, Mr. Horton owns close to one million shares, while Gerard Arpey (the previous CEO) owns close to 2.5 million of them. The list of insiders goes on: Daniel Garton owns over 800,000 shares, so does Robert Reding, Gary Kennedy has over 450,000 shares and Isabella Goren about 429,000.
Of course, I am only speculating here on their intent. But there's also the possibility, according to CRT Capital Group analyst Kevin Starke, that bondholder groups have "substantial holdings in the common stock" (source). Furthermore, the short interest is surprisingly low, it now stands at just half of one percent (source). Clearly, the smart money is on the long side.
Watch out for the US Airways price floor
Specifically, if the price of US Airways plunges below $10, all bets are off. The "Market-Based Old Equity Allocation" becomes negative and the bonus distribution gets cancelled, leaving current shareholders with a measly 3.5% of the new company. And if US Airways trades below $7.80, current AMR shareholders don't even get a single penny on the dollar. You don't want to be left holding AMR stock when that happens.
How much will the new airline be worth?
Evaluating the combined market capitalization of the merged company is beyond the scope of this article. Right now, Wall Street seems to be signaling $14B, but this bull market may prove too optimistic. This article provides a good in-depth analysis.
Airlines are notoriously bad investments
However, the airline industry remains a fickle business. While the prospects look bright, the combination of low barriers to entry, high fixed costs and a capital-intensive industry are all reasons the price of US Airways (and thus AMR) may not be sustainable in the long-run. Given the difficulties merged airlines have had integrating their computer systems and labor structure, I wouldn't count on the promised operational efficiencies to materialize any time soon.
While AAMRQ is bound to remain very volatile, keeping a close eye on LCC might help explain some of the turbulence.