Why Is US Airways Plunging?

| About: American Airlines (AAL)

After seeing a massive rally since the beginning of the year, US Airways (LCC) is up nearly 150% year to date. Everything seems to be going well with the company and it is expected to post impressive growth in the next few years. On the other hand, the company's share price has been plunging for the last 3 trading days. Many will wonder why the company's share price down 20% in the last 3 trading days. Could this be the end of the rally for US Airways, or is this simply profit taking?

First, I will look at the events surrounding US Airways in the last couple days in order to figure out why this stock's price is plunging at the moment. On Thursday, the CEOs of US Airways and American Airways (AAMRQ.PK) came together to discuss a possible merger. From the looks of it, the meeting was not as productive as the investors of US Airways would have wanted it to be. Very little to no progress was made when Tom Horton of American Airlines told Doug Parker of US Airways not to pressure American Airlines into rushing in a quick deal. In response, Doug Parker reportedly said that he would not just sit there and wait forever for American Airlines to resolve its bankruptcy issues.

Reportedly, American Airlines is weighing its options and the company's executives are convinced that merging with US Airways is not the only option they have available. If the deal with US Airways doesn't work out, the company might be able to merge with another airline or even form a partnership of multiple airlines. American Airlines may emerge from the bankruptcy alone if the court and the other stakeholders accept the company's business plan, however this may not be a very strong possibility. Any plan for emergence of American Airlines from bankruptcy is subject to approval of not only the court, but also the bondholders, unions and other stakeholders of the company.

Interestingly enough, the CEO of American Airlines told USA Today that if possible, American Airlines would attempt to acquire another airline rather than being acquired by someone else. I think this is a very bold statement and I don't believe that the stakeholders would allow a bankrupt company to acquire another company; however this statement puts a possible American-US Airways merger in a difficult spot. The CEO of American Airlines believes that US Airways needs this merger more than American Airlines as US Airways is a much smaller company and in need of a merger of this size to become one of the major players in the airline industry.

American Airlines and US Airways run a lot of routes together, many times connecting each other's flights. Furthermore, the two companies have similar corporate culture, which should make a merger rather seamless. The other companies interested in merging with American Airlines do not offer these advantages for American Airlines. In the last few months, unions and some bondholders of American Airlines expressed their strong interest in a possible merger with US Airways.

At the end of the day, the merger between the two companies will not be as smooth as US Airways hoped it would be. US Airways expected little to no resistance from the management of American Airlines, but the resistance keeps mounting. Many investors of US Airways also saw the merger as an almost certainty, pushing the stock price up more than 150% from the beginning of the year to mid July. The plunge we are seeing in the stock price of US Airways in the last 3 trading days reflect the fear of US Airways investors that the merger between the two companies will not take place.

American Airlines has until December 28 to announce its final plan. If the company fails to announce an acceptable plan by then, the court will request alternative plans from third parties including US Airways. If the court finds the plan of the third party to be feasible, American Airlines will have to accept such plan. The CEO of American Airlines is convinced that his company can present an acceptable plan to the court by then, and the management of US Airways is convinced of the opposite. Earlier, the deadline was September and American Airlines had asked for an extension. On an interesting note, US Airways bought a large number of bonds of American Airlines in order to join the ranks of the creditors of the company. This was a smart move by the company as this makes US Airways one of the major stakeholders in the story.

A lot of US Airways investors still believe that the merger is possible and those that don't believe it to be possible are selling their shares. Many of the company's investors believe that the company's recent rally was mostly due to the possibility of this merger and if the merger doesn't materialize, the stock price will go back to last year's mid-one-digit levels. While I agree that the speculations of the merger played a role in the rally of the company's stock price, I don't think it was the sole reason. There have been other compelling reasons to buy US Airways other than its possible merger with American Airlines. US Airways stopped hedging oil prices a few months ago, saving the company a lot of money. In the next several quarters, the company is expected to post much stronger results than it ever did. For example, analysts expect the company to post an earnings growth rate of more than 100% in the next year. Analyst target prices for US Airways still ranges between $15 and $20 per share based on the company's earnings projections.

On July 25th, US Airways will report its quarterly earnings. The company is expected to earn $1.55 per share for the quarter and $3.29 per share for the year. Given the company's current share price under $12, these numbers are very impressive. US Airways is having one of the most profitable periods of its history and the company will be in great shape as long as it can maintain this. Of course, much of this success depends on oil prices, and currently the low prices favor the company greatly. On July 18th, American Airlines posted a profit of $95 million with the exception of costs related to bankruptcy and reorganization.

Given the strong earnings and balance sheet of US Airways, I am bullish for the company in short and medium term. In the long term, all I can say is that the airline companies are too complex to tell.

Disclosure: I am long LCC and have sold covered calls on my position.

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