DOJ Blocks US Airways-American Airlines Merger, Now What?

| About: American Airlines (AAL)

On Tuesday morning, the investors of US Airways (LCC) and American Airlines (AAMRQ.PK) woke up with a shocking development. After gaining approval of the European Union, the merger was blocked by the Department of Justice. As a reaction, the share price of US Airways plunged by 10% and American Airlines lost about 60% of its market value. What's going to happen now?

First, let me remind you one thing. A block by the U.S. Justice Department is not the same as a court decision even though it can delay things greatly by lengthening the process considerably. The U.S. Justice Department believes that the merger will violate U.S. antitrust law, lead to less competition, and allow for the merged company to have higher pricing power, hurting customers in the long run. At this point, the DOJ is not a decision maker, but it is a plaintiff in the lawsuit (even though it will be a decision maker later on because the merger can't happen without DOJ's approval).

Even though a number of states and local governments spoke out against the merger, no one was expecting the federal government to be involved in this, especially with a lawsuit. Looks like all the analysts, investors and the management of both companies were caught off guard.

The federal government's involvement doesn't guarantee any kind of results though. The courts may or may not side with the plaintiff in this case, so all is not lost yet. The largest 5 airlines currently account for 86% of the air traffic in the US where number 4 happens to be the American Airlines and number 5 happens to be the US Airways. Combining together, the two airlines would form the country's (and possibly the world's) largest airline by volume. In process, this would reduce the number of airline companies that control 86% of the traffic from 5 to 4 companies. This would give the big four tremendous power in setting ticket prices, which is the biggest worry for the Justice Department. This is also one of the strongest cases that can be used against the merger at the court.

It is said that American Airlines and US Airways compete in about 1,000 routes across the country and a possible merger would kill all this competition. As a result, this would hurt consumers who would have to face much higher ticket prices. At least the company wouldn't have to offer as many promotions as it does today due to lack of major competition in many of the routes after the merger. Furthermore, the merged company would control 69% of the take-offs and landings in Reagan National Airport located in the nation's capital. Apparently, this is another thing that bothers the federal government.

Actually, the block didn't come out of the blue. Last month, there were reports mentioning a possible lawsuit against the merger where six states would join the DOJ. I'm actually surprised that investors didn't pay attention to these reports last month and they are freaking out right now as if the sky is falling.

So what could happen in court? The court could completely block the merger, which is probably a slim possibility. The court could also ask the companies to give some concessions before the merger, which would result in a delay in the merger but it would still happen. US Airways and American Airlines could make a comeback by asking the DOJ to demonstrate that their merger is different from the mergers that were already approved, such as the merger of Delta Air Lines (NYSE:DAL) and Northwest awhile back. After all, why approve one merger while blocking another if they are the not all that different?

Regardless of whether the merger happens or not, the investors of US Airways should not be too worried. In fact, I believe that they over panicked. Last year, I wrote several pieces of US Airways and I was invested in the company. I kept saying that the company was a great investment regardless of the merger, and many people didn't agree with me. The company's share price jumped from the $3s to $10s, then to the $13s and then to the $18s. There are very few companies that can remain to be undervalued after such a strong rally; however, US Airways is one of these companies. The company trades for only 5 times of last year's earnings. US Airways has about $21 per share in cash, whereas, the company's stock price is as low as $17. No matter how you cut it, US Airways is pretty cheap.

In fact, one could even argue that the company would be worth more without the merger. The merger was expected to be valued at $13 billion and the investors of US Airways were scheduled to get 28% of the new company, valuing the company at $3.65 billion which is only 6 times last year's earnings even though that would be above today's share price.

If the merger doesn't happen, investors of American Airlines will be in a more complicated situation than the investors of US Airways. We don't really know what the value of American Airlines would be after emerging from bankruptcy alone, especially with the current management. I think the merger will happen after limited concessions though. As I mentioned above, there has already been mergers similar to this one and they were approved.

Today, I bought some calls of US Airways with a strike price of $17.00 expiring in January 2015. I've been long in this company on and off since last year.

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.

Additional disclosure: I'm long @17.00 calls expiring in Jan2015.

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