American-US Air Merger Would Bolster The Industry

Includes: AAL
by: Vaughn Cordle, CFA

Apparently, my short note on the potential for bankruptcy at American Airlines (NASDAQ:AMR) struck a nerve, given the volume of emails and calls received. As a follow-up and to encourage debate, it may be useful to throw out a few thoughts about a post-bankruptcy scenario.

AMR management appears to be using the bankruptcy scare as a means of influencing labor contract negotiations. Analysts are discussing the potential for bankruptcy because of liquidity concerns.

If the company ultimately files for bankruptcy protection and emerges successfully, its creditworthiness and ability to secure new aircraft improve. However, the airline will likely continue to be one of the weakest competitors with too much debt, unhappy employees, and a route network with revenue-generating potential that has been surpassed by larger competitors.

A merger with another airline, after or during bankruptcy, would produce valuable cost and revenue synergies, and further increase industry market concentration. This is an important consideration, as the Obama administration wants to dump $36 billion in higher security and user fees upon the industry, and it appears that neither political party can be counted on to understand the impact those higher costs will have on the industry's size and structure.

Our recent market concentration work shows that industry concentration has increased 40% from its historic nadir, since the rash of recent mergers, which includes Southwest and AirTran. However, it's still too low in my estimation to allow the industry to earn its cost of capital over a full business cycle. Stated differently, more consolidation and mergers are needed.

A cross-border merger between American Airlines and one of its alliance partners makes the most sense, but current laws of foreign ownership are a major barrier. This restriction is a rule that doesn't make sense in a global economy, especially for the overleveraged U.S. network airlines that are not cost- (or service-quality) competitive.

Of the six non-merged U.S. airlines we have examined, a combination of US Airways and American Airlines produces the most value post-bankruptcy and -merger. Labor benefits in this scenario because the synergies produced can be shared with all stakeholders, including the airlines' passengers. An important benefit is that with the merger there is an increased industry market concentration that increases pricing power for all airlines.

The industry has underinvested for the last decade, and it's hard to justify next-gen investment when paying down debt and higher government-imposed costs are the greater priority. Both the merger and higher industry concentration from the merger allow the restructured airlines to pay higher wages than would be the case otherwise. And just as important, this is something capital providers will support, because share prices and market values will soar. Hence my suggestion that AMR pilots, as well as other employees, negotiate an equity stake in the new airline before it emerges from bankruptcy.

Of course, this assumes that American eventually files. Without a filing, the company can continue to muddle through with a business that is not fit for longer-term investment. In fact, the company has been in a slow liquidation for over a decade. This is reflected on the balance sheet with the large negative net worth and 15-year-old, on average, aircraft fleet.

The real problem for AMR is the $13 billion in defined benefit pension plan obligations and $3 billion in health care benefit obligations. Pension plan assets are $7.7 billion, and the funding status, the difference between plan assets and obligations, is a negative $5.5 billion. Unfortunately, and given a more current discount rate and using actual returns on plan assets, the funding status is understated by approximately $1.5 billion.

With the updated pension plan accounting, the company will be required to increase plan cash contributions, which will result in lower earnings and a more negative net worth in 2012. The final numbers will not be known until the end of the year. AMR’s pension plan assets and obligations would be taken over by the PBGC if the company files bankruptcy.

In terms of magnitude, it’s the pension and health care liabilities and costs that get to the heart of AMR’s inability to earn its capital cost, invest in competitive resources, restore lost wages and grow the airline.

Key Points

Post-bankruptcy, AMR's new, less leveraged capital structure could better handle higher capex and new aircraft. Throw in a merger with U.S. Airways, and it's a win/win/win scenario -- for the two airlines, labor, as well as the industry and its capital providers.

Of course, what looks good on paper may be impossible to implement because of various pockets of resistance, especially from labor. The devil is in the details, and I'm simply making the case that from a strategic fit perspective, the merger scenario makes the most sense. It meets the various tests of consistency for all stakeholders. Moreover, it improves the industry’s ability to absorb the massive new costs that are likely imposed upon it by a government that must reduce an unsustainable federal deficit.

AMR management will obviously want to remain in control in any merger scenario. This may not be the best outcome. Many, at least on Wall Street, believe that the best candidate to run the combined company would be US Airways’ Doug Parker. He is a realist who has nothing invested in maintaining American's self-image that it is the leading airline in the industry. This was once correct, but is no longer so, with the industry's competitive evolution. In my view, Parker would manage American for an optimal outcome for all stakeholders, not attempt to achieve a standing that is no longer achievable.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.