Does A US Airways-American Airlines Merger Make Sense?

| About: American Airlines (AAL)

Ever since AMR (AAMRQ.PK) filed for bankruptcy in November, there has been rampant speculation about whether it will merge with or be acquired by one of its competitors. Speculation further escalated last week, with US Airways (LCC) publicly confirming that it is looking into an acquisition of AMR. Moreover, the company finally completed a labor agreement with its flight attendants, suggesting that it is in a hurry to square away its own house. Delta (NYSE:DAL) and TPG Capital are also apparently considering making offers for American, and Delta is even weighing a potential bid for US Airways, according to recent reports.

Delta, being the second largest carrier in the world (and only slightly behind United Continental (NYSE:UAL)), would have a hard time convincing regulators to sign off on either deal. Delta and US Airways compete heavily throughout the East Coast, and dominate the Southeast in particular. Delta and American compete at JFK and LAX, the two most important international gateways in the U.S. Given the amount of route overlap and the size of a combined entity, any merger attempt would risk being bogged down in antitrust review for years.

US Airways therefore seems like the logical partner, if there is to be one. (TPG would take AA private and run it as a standalone carrier.) The major benefit to both carriers would be an expansion of their route networks (though some cuts on overlapping routes would be likely). American would gain access to the US Airways hubs in Charlotte and Philadelphia, which are much better able to serve domestic traffic than American's hubs at New York's JFK and Miami. Furthermore, whereas Delta's JFK operation and United's Newark hub are both signigicantly larger than American's transatlantic gateway at JFK, US Airways dominates the Philadelphia market.

Some might argue that the JFK and Philadelphia hubs are incompatible, but this is not necessarily true. Due to slot constraints, American has basically limited its JFK flying to international markets and major domestic routes. US Airways, by contrast, serves a vast number of small-medium size East Coast and Midwest markets from Philadelphia. A combined carrier could route passengers from small markets through Philadelphia, while focusing on more lucrative large market origin-destination passengers at JFK. Alternatively, a combined carrier could downsize at JFK and sell off some of its very valuable slots there.

US Airways would particularly benefit from a combination by gaining American's global reach. American has a much stronger position in the transatlantic market, and is the market leader to Latin America. While American is relatively weak on transpacific routes, US Airways currently has zero exposure there, so it would still stand to gain. A combined carrier could reorganize the route structure to focus on the markets it would dominate (Philadelphia, Charlotte, Miami, Dallas/Fort Worth, and Phoenix), while cutting back somewhat in the ultra-competitive New York, Chicago, and LA markets.

The biggest downside of a potential merger is that the two companies could have trouble executing as they attempt to combine the two carriers and the various work groups. This is a recurrent worry with major airline mergers. Perhaps for this reason, US Airways management has stated that the company can survive as a standalone entity and does not necessarily need a merger.

Another potential issue is coordination with American's OneWorld partners. American's biggest problems are that it competes from the #2 or #3 slot in the major markets of New York, Chicago, and Los Angeles. However, its partners, such as BA, Iberia, and JAL want to serve those major international gateways for obvious reasons. In terms of providing connections to international Oneworld carriers, US Airways is at a disadvantage due to its focus on primarily second-tier cities.

On balance, I think a merger would probably be good for both carriers, and it would also be a positive for the industry as consolidation generally leads to lower capacity and higher fares. Both AMR and US Airways suffer from lower RASM than Delta and United. Combining to increase passenger options and cut down on management overhead would improve matters dramatically. But it is still an open question whether such a move is worth the risks inherent in a major merger. The biggest beneficiaries of an AMR-US Airways merger might actually be their competitors.

Disclosure: I am long UAL.