Did American Airlines And US Airways Get A Green Light To Merge?

Nov. 5.13 | About: American Airlines (AAL)

On Monday, both US Airways (LCC) and American Airlines (AAMRQ) saw their shares rally sharply after talk that the government might actually be open for a settlement and it might give the two companies a conditional "green light" if they agree to make some concessions. This is the first time since the announcement of the DOJ lawsuit that the government is willing to negotiate as the court case is scheduled to start in a couple weeks.

When the Department of Justice first announced the lawsuit it was going to pursue against the two airline companies, some analysts downplayed it by saying that the government would end up sitting down with these companies and settling on terms. Back then, the government officials said that they had absolutely no interest in settling with the two companies and they wanted the merger to fall apart regardless of what concessions the airline companies could come up with.

On Monday, the U.S. attorney general Eric Holder said that the government would be fine with settling with the airline companies if they agree to give up on some take-off and landing spots in several airports including Reagan National at the nation's capital. This is the first time ever the government openly said it would be ok with the idea of a merger and the government's tone is a lot different than how it was a few months ago. As the government shutdown slowed the hand of the government, it probably found itself in a position that is difficult to defend in court.

The government will still look for solutions that are likely to alleviate its concerns, such as decreased competition, too much pricing power and too many spots to be held by the merged company in certain airports. For the next two weeks, negotiations will be going on to determine the best course of action and the best case scenario calls for a settlement before the court date.

It is very surprising to hear Mr. Holder talk about the case before the court date. A lot of people predicted that the government would be negotiating with the airline companies for a solution before the court date, but no one really expected the government to be vocal about it.

A lot of investors are taking this development as a green light from the government for the merger. The shares of American Airlines rallied by about 25% and US Airways appreciated by another 5% in the earlier hours of trading but ended the day up by only 1%. While I agree that this is a huge development, there is still a lot of work to do in the next 2 weeks before a settlement can be reached.

I have been covering this merger for nearly a year and US Airways has been one of my best performing stocks this year. In the last 52 weeks, the shares of US Airways rallied by 82% and since early 2011, investors saw the value of their shares appreciate by 410%. While some of the rally was fueled by the merger speculation, much of the rally could be attributable to the success of US Airways CEO Doug Parker. Under Mr. Parker's management, US Airways was able to grow its earnings by more than 300% in the last couple years. Even after multiplying in the last couple years, US Airways is still cheap with a trailing P/E of 8 and forward P/E of 7. This is why I kept insisting that the company was cheap regardless of whether the merger happened or not.

After the merger, each share of US Airways will become a share of the new American Airlines (the company's name will be American Airlines) and these shares will make up 28% of the new company. If the merger happens, the combined company is expected to generate $40 billion in revenues and $2-3 billion in net earnings. Even if we take a conservative P/E ratio of 8 to value this company, we would be looking at a new American Airlines that's worth $20 billion. If US Airways makes up 28% of the new company, this values US Airways at $5.6 billion, which is far above the company's current value of $4.4 billion. After the merger, the shares of US Airways should be worth $28-30. If the merger doesn't happen, US Airways should still be worth around $25, given its low valuation. The company's current market value is $4.4 whereas its cash and short term investments alone total $3.5 billion. I currently have some shares of US Airways in addition to some calls. I used to sell covered calls every month in order to increase my overall return (which brought my breakeven price to far below $10). However, I haven't done that recently. Regardless of the merger, US Airways continues to offer strong value to investors. The next couple weeks will be very busy and exciting for the management and shareholders of US Airways as the merger story will end one way or another.

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.