The investors of US Airways (LCC) and American Airlines (AAMRQ) woke up to good news Tuesday, as the two airline companies finally reached an agreement with the Department of Justice about merging. While the airliners will have to give up on certain assets for the settlement to happen, this is a very important development for the entire airline industry in the US.
Details of the deal
Reaching the settlement was far from easy. It took months of tough negotiations to get there. US Airways agreed to sell 104 take-off and landing slots at Reagan National Airport at the nation's capital, 34 clots in New York and a lot of assets in several big cities including Chicago, Los Angeles and Boston in order to ease some of government's worries about lessened competition as a result of the merger. As I've been covering this merger for more than a year with several articles, I was expecting the merger to eventually happen as a result of asset sales, but I didn't expect asset sales to be this big. As it turns out, US Airways will have to let go of a lot of assets to make this merger happen.
Earlier this year, American Airlines gained approval from the bankruptcy court to emerge from bankruptcy on a plan which was based on this merger. Now American Airlines can take this settlement to the bankruptcy court and finalize its reorganization.
Attorney General Eric Holder was happy with the settlement as he said: "By guaranteeing a bigger foothold for low-cost carriers at key U.S. airports, this settlement ensures airline passengers will see more competition on nonstop and connecting routes throughout the country."
This is a lot of improvement from the government's initial reaction. When the lawsuit to block the merger was first announced, the government officials were saying that they didn't care about settlement and that they just wanted to kill the merger at all costs. Over time, helped by the government shut down, the Department of Justice softened its stance and got closer to settlement. Of course, the government also saw that it didn't have much to gain from blocking the settlement after all.
What does that mean for the investors?
The new airline's share price will be based off of the share price of US Airways at the time of the merger. Once the merger gets finalized, US Airways shareholders will get 28% of the new company and the rest of the company will be divided up between shareholders and debt holders of American Airlines.
Currently US Airways trades for $23 with a market value of $4.6 billion. If the merger happened today, the new airline would be worth $12.88 billion. This means that there will be $8.28 billion worth of equity to be divided between shareholders and debt holders of American Airlines. I've seen many different calculations valuing American Airlines based on the current value of US Airways and they range widely from $10 per share to $20 per share. For the time being, we know one thing for sure; the downside of American Airlines is far more limited than it was a week ago. If the merger was canceled, the shares of American Airlines could be worth as little as $0, and now they are worth a lot more than that, which should be a relief to the shareholders of the company.
Then again, this is a conservative estimate because the current share price of US Airways actually makes the combined airline undervalued. The new airline is expected to generate $40 billion in revenues. If we apply the current profit margins of US Airways to this value, we get a gross profit of $22.44 billion, an operating profit of $4.44 billion and a net income of $2.5 billion. This excludes the $1 billion of annual net synergies the new airline expects to have because of its massive size. If the new airline generates about $3 billion in net earnings and we assign it the P/E ratio of Delta Airlines (about 12), it would be valued at $36 billion, which is triple the value it would be today based off of the current value of US Airways. According to the current value of US Airways, the new airline will have a forward P/E of 3, which is ridiculously low.
Since the debt holders of American Airlines will be shareholders of the new company, the debt of the new company will be fairly limited. The new company should be cash rich since American Airlines has about $6 billion and US Airways has close to $4 billion of cash and short term holdings. This will allow these companies to buy new planes and upgrade their fleets to meet the needs of the next decade. Having newer planes should also help the airline companies with fuel costs since the newer planes tend to have better fuel economies. The companies could also use their cash in other ways, such as rewarding the patient investors with a buyback or dividends (especially if the new company gets valued as cheaply as US Airways is today).
As more details emerge about the merger, we will be able to calculate value of the new company more efficiently. At the moment, the settlement is an exciting development for the shareholders of both US Airways and American Airlines.
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.