US Airways Stronger Than Ever

Jul. 9.12 | About: American Airlines (AAL)

I had never been a big fan of buying airline stocks as they have the tendency to go bankrupt to clean their balance sheet every decade or so. There is usually too much volatility in airline stocks, as their profits are directly related to oil prices and the short-term status of the global economy. A couple of months ago, I bought US Airways Group, Inc. (LCC) for $11.01 and sold covered calls expiring exactly a month later with a strike price of $11.00. At the end of the month, my stocks got called and my profit was around 7% and I missed out on another possible 5% or so profit.

Then I bought the same shares again and wrote in-the-money calls again; it looks like I will be making another 7% profit by the third Friday of July and I will continue to miss out on additional profits as the company's stock price seems to go up relentlessly. As a conservative investor who rarely buys stocks without writing covered calls on them, I am happy with having smaller profits at the time of stock rallies in exchange for reduced risk at the time of plunges.

One reason for US Airways to see a major rally while the market has been flat at best is the story of a merger with AMR Corporation (AAMRQ.PK), which is in the process of cleaning up its balance sheet through bankruptcy. Recently, American Airlines has asked the judge for more time in order to put together details of its bankruptcy plan as the company plans to emerge and continue its operations seamlessly after taking the exit.

The process is expected to continue for another quarter and the merger is expected to finalize around Christmas time. Initially, American Airlines was given until September to come up with a reorganization plan; however, this deadline is extended until December. If the company isn't able to come up with a sufficient plan by the deadline, the court will pick a third party to come up with a plan that AMR Corporation would be forced to accept. In this case, the "third party" will likely to be US Airways and the plan will be a merger between the two companies.

It is very common in the airline industry for companies to have mergers. In fact, this is as common a practice as companies going bankrupt in the industry. In the past, Delta Airlines and United Airlines have been parts of similar scenarios. Last Wednesday, US Airways CEO Doug Parker reiterated his company's interest in merging with AMR Corporation, while stressing that the company was "fine with the delay" as "there is certainly no urgency for us to merge." The merger is supported by unions within AMR Corporation and it will increase US Airways' market share significantly.

Currently, AMR Corporation and US Airways have alternating plans and US Airways believes that the delay will allow them a chance to get their plan picked. One complication regarding the bankruptcy of AMR Corporation stems from the rewriting of employee contracts. Most jobs in AMR Corporation are unionized and the company has to agree with all unions before moving forward with emergence from bankruptcy. At the moment, AMR Corporation plans to cut $1.2 billion from employee costs; this will be very difficult to achieve, given the strong presence of unions in the company.

Last year, US Airways earned $1.16 per share, and this year, the company's income is expected to triple to $4.39 due to cheaper oil, improved margins and higher demand. US Airways got rid of the practice of hedging oil prices, which helped the company's margins significantly; it will continue to do so for the foreseeable future. Passenger revenue per available mile was up 6% in June, compared with last year. At the moment, all indicators are bullish for US Airways, with 12-month price targets going as high as $28, indicating an upside potential of more than 100%. A more conservative Deutsche Bank expects the company to earn $3.5 this year and it set a 12-month target price of $20. This is still a 50% upside potential for the company. In the last year, the stock price rallied from $3.96 to nearly $14, and it has the potential to offer investors another year of great returns.

Disclosure: I am long LCC.