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Potential Gain in the New American Airlines

The new American Airlines (AAL), formed by the merger between US Airways and the old American Airlines, started trading on 12/9/2013, opened at $23.95 and closed at $24.6. Considering the favorable macro environments of the airline industry, the positive features of the new company, and the attractive valuation of its stocks, AAL looks like a profitable investment in the next few years.

Favorable Industrial Trends

After the consolidation activities in recent years, the airline industry is now dominated by a few major airlines. For example, the four largest airlines, American Airlines, Delta Air Lines (DAL), United Airlines (UAL) and Southwest Airlines (LUV), will control more than 80% of the US domestic market. This supports ticket price stability and allows the industry to respond to fluctuations in fuel price quickly and in a sensible manner. Thus, barring extreme events such as a huge spike in oil price, a terrorist attack or a global health pandemic, the airline industry can be expected to operate in a stable environment in which positive momentum is the main trend.

This positive business momentum will be helped by the recovery of the global economy. The airline industry is known to be well correlated to the general health of the global economy, which is undergoing a recovery in many major regions, including the US, Europe and China. As economic activities accelerate, more traveling can be expected and the airlines will directly benefit from it.

The airline industry has a much improved business model, based on the concept of charging by the provided services, which includes checked luggage fees, flight change fees, etc. This, in the history of the airline industry, offers the real possibility of a profitable business. For example, it is estimated that the fees from the extra services amounts to about $27 billion a year. Compared with the old business model in which everything is free except for the ticket, these extra revenues will mostly go directly to the bottom line, significantly improving the earnings power of the industry. Though these extra charges have not been popular with the travelers, they have become an integral part of the industry's practice and are here to stay.

This new business model is part of the lessons that the airline industry learned from its turbulent history, characterized by constant money loss and frequent bankruptcies. Also from the lessons learned, the airlines have been doing a much better job managing their capacity, including aircraft deployment and route adjustment to match supply and demand. This will cut expenses and directly help the industry's bottom line.

Positive Company Features

The newly formed AAL has the nice combination of the vast domestic flight network of US Airways and the extensive international routes of the old American Airlines. It will have 6700 daily flights to 330 destinations in 50 countries. The company can use the domestic flights as feeder traffic for the international flights, which is especially appealing to business travelers, and thus enable AAL to capture the most profitable segment of the industry. This is a goal of the new company, as stated explicitly by the CEO.

The merger of the two airlines can present significant cost savings. The company's target is $1 billion in merger-related savings. This can prove to be conservative. As a reference point, when UAL and DAL went through their respective merger, each announced merger-related savings of $2 billion. AAL already has some experience in combining airlines and it can also learn from UAL and DAL. Thus, it can be expected that the merger process of AAL will be smoother and the actual savings will be above its target, which in turn can trigger a positive response in its share price.

For example, significant savings can be expected from the redeployment of full size aircraft from regional routes to more profitable markets, made possible by the company's decision to fly more above-50-seat regional jets in regional routes, both cutting the operation cost and freeing up full size aircraft.

The new company will have more than 100 million frequent flyers. This can be a huge revenue base since travelers these days pay a lot of attention to airline awards and tend to stay with their favorite airlines in order to quickly accumulate award miles. This is especially so for business travelers who are usually less sensitive to the ticket price.

Attractive Valuation

AAL has the lowest valuation among the major airlines, measured by the forward price-to-earnings ratio, as shown in the following table (source: Yahoo Finance, finance.yahoo.com). The comparison in the table includes the major airlines, as well as JetBlue (JBLU) where the earnings for both 2013 and 2014 are analyst estimates.

Price on 12/9/2013

2013 Earnings

2014 Earnings

Current P/E

Forward P/E

Earnings Growth

AAL

$24.60

$2.49

$3.02

9.88

8.15

21.29%

DAL

$28.88

$3.11

$3.04

9.29

9.50

-2.25%

UAL

$37.55

$2.12

$4.06

17.71

9.25

91.51%

LUV

$18.50

$1.05

$1.25

17.62

14.80

19.05%

JBLU

$8.36

$0.49

$0.66

17.06

12.67

34.69%

The valuation of AAL may turn out to be even more attractive than those shown in the above table, because the earnings potential from the merged new company may have not been fully appreciated by the analysts.

From the valuation shown in the above table, an estimate can be made for the target share price of AAL, which is summarized in the following table. Two estimates are given in the table, based on the average PE of two groups of airlines. The first consists of UAL and DAL and the second includes all airlines in the above valuation table, except for AAL. Essentially, this says that if AAL only catches up with the rest of the major airlines in PE, its share price can have noticeable appreciation from its current level.

Base

Average PE

Target Price for AAL

Potential Gain

DAL and UAL

9.37

$28

14%

DAL, UAL, LUV and JBLU

11.55

$35

42%

Hunter Keay, Wolfe Research Inc

$39

59%

Jamie Baker, JPMorgan Chase &Co

$37

50%

In this table, two additional target price estimates are also given, from two analysts. As is clear, both expect significant price appreciation for AAL.

Potential Risks

Potential risks of investing in AAL at this time mostly involve the execution of the merger. Integrating two companies is notoriously difficult and in most cases can be expected to encounter hiccups. Though the airline industry has been through many mergers and has learned many lessons, it should be pointed out that the potential risks are there. Thus, investors should keep a close eye on the merger integration process. Should anything unexpected happen, corresponding modifications should be made.

Source: Potential Gain In The New American Airlines