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It's been a couple days since the Department of Justice filed a lawsuit to block the merger between American Airlines (AAMRQ.PK) and US Airways (LCC). Since then, American Airlines shareholders saw the value of their shares decline by 55%, whereas the shareholders of US Airways took a hit of 16%. The Department of Justice seems to believe that a merger between these two companies would hurt the customers by reducing the number of large airline companies and giving too much pricing power to the top 4 airline companies in the world by eliminating some of the competition. The Department of Justice argued that American Airlines and US Airways have about 1,000 routes in common, and there would be no competition for these routes in the event of a merger as the companies would work towards eliminating their redundancies.

This argument makes very little, if any, sense to me. First of all, we are not talking about merger of two regular companies. One of the companies involved in this merger is working towards emerging from a bankruptcy. Without this merger, American Airlines wouldn't be able to survive. The company currently has so much debt that the only way for it to pay its debt is to merge with US Airways, and let the debt holders to claim some of the shares of the new company. Keep in mind that some of the biggest bondholders of American Airlines include employees of the very company.

American Airlines has to emerge from its bankruptcy in a way that will satisfy its bondholders. Otherwise, it will take a lifetime for the company to get approval to emerge from the bankruptcy and come back to life. There is no way that the bondholders of American Airlines would accept a solution where they are going to lose all of their holdings. It simply won't happen. The bond holders aren't the only ones whose investment is in stake either. If American Airlines were to emerge from the bankruptcy alone, it would wipe out the company's shareholders completely. The shares trading under AAMRQ would be worth literally nothing (remember GM in 2009?) in that case.

Now, for the sake of argument, let's say American Airlines has to emerge from the bankruptcy alone. Now the company will have 2 options: 1) it can continue the practices that drove it to bankruptcy in the first place and go bankrupt again, 2) it can cut costs across the board, sell a lot of assets, get smaller and cancel a bunch of routes that are not profitable. Now, let's discuss the results of both options to see why DOJ's decision to block the merger doesn't make any sense.

In the first option, American Airlines emerges from bankruptcy alone, and business goes as usual. Sooner or later, the company would have to declare bankruptcy again, because the current model is not exactly profitable or sustainable in the long run. There is too much competition and too much dependence on oil prices for the airline companies. If there are 1,000 routes where American Airlines competes with US Airways, this number would be reduced significantly after American Airlines emerges from bankruptcy because both companies would be urged to cancel the routes that are not profitable to them. In this scenario, the consumers would suffer greatly because some routes would be eliminated completely and other routes would see strong price increases due to lack of profitability.

In the second option, American Airlines emerges from the bankruptcy as a much smaller company as it sells many assets including some routes. This would have the same effect on the consumers as a merger would and defeat the purpose of blocking the merger in the first place. After all, if American Airlines put some of its valuable assets to sale, most of these assets would be picked up by the companies that happen to be the top 5 airline companies in the world. If a bunch of American Airlines routes and assets are bought by US Airways (as well as Delta Airlines and a few others) how is that helping the consumers? The same big airlines would just get bigger and they would just gain more pricing control.

Currently, the top 5 airline companies in the US are (in this order): Delta Airlines, United Airlines, Southwest Airlines, American Airlines and US Airways. The sixth largest airline company is Jet Blue, but it's far behind the top 5 in terms of volume. If American Airlines and US Airways can successfully merge, the new top 5 list will be as follows: New American Airlines, Delta Airlines, United Airlines, Southwest Airlines and Jet Blue.

Since Jet Blue is much smaller than the other airlines, the top 5 would become top 4, which would give them a lot of pricing power. On the other hand, if American Airlines were to put its assets on sale or if it failed to emerge from bankruptcy successfully, this would be the picture we are looking at anyway. So basically, by blocking the merger, DOJ is not helping consumers that much. Airline companies have to merge for a good reason, and they can't just go out of business every few years. After all, airline companies are just like other companies; they are in business to make a profit.

Sadly, the announcements from the executives of these two companies didn't help the situation either. During the merger talks, the management of both companies attempted to show their shareholders that they are in good position, so they kept insisting that they are highly profitable regardless of the merger situation. Of course, DOJ used this against these companies, basically saying that "if you guys are as profitable as you brag about, then you don't really need a merger." Just because these companies are profitable at the moment doesn't necessarily mean they are guaranteed to be profitable in the future. The business model of American Airlines is hardly sustainable in the long run.

At the moment, the investors would be better off by buying shares of US Airways rather than American Airlines. In the event that merger doesn't work out, US Airways still has a nice valuation, as it trades for 5 times its earnings and its market cap is less than its cash holdings. If the merger doesn't work out, the shareholders of American Airlines will get pretty much nothing. I expect a long legal fight with multiple sides (the federal government, the local governments, the two companies, consumers, unions, employees, bondholders, stockholders) with multiple appeal processes no matter what decision is made. Obviously US Airways is a much safer bet at this point.

I will write more about this matter as the story develops further.

Source: AMR-US Merger: Why DOJ's Action Makes No Sense