Has AMR's Deal Been Priced-In

Masam is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The news of a potential merger between the US Airways (NYSE: LCC) and AMR (NASDAQOTH: AAMRQ) has been in the air for quite some time. Time and again, US Air’s stock witnesses volatility, whenever news regarding the potential merger hits the market. In two days, three bits of news have made it to the headlines:

December 19: American Airlines parent AMR and US Airways appear to be close to a merger agreement, with a possible decision coming next month. AMR's board will meet January 9 to discuss any merger plans and may make an announcement shortly thereafter. The chief hurdle to any deal looks to be how to divide the equity in the new company - especially with AMR emerging from bankruptcy - and who would run the new airline.

December 20: AMR keeps inching closer to merging with US Airways as execs with both companies start to get down to the nitty-gritty in talks. On January 9, the AMR board will meet to decide if a public announcement should be made

December 20: AMR Corp.'s American Airlines and US Airways are near a tentative deal on how their pilots would be handled in a potential merger. The talks, which include airline executives, representatives of AMR's creditors committee and both airlines' pilots unions, are a crucial step toward determining whether the two airlines will combine when AMR emerges from bankruptcy proceedings next year.

Now the main question to be asked by the investors is: How much of this potential merger has been priced in US Air’s stock?

Well, it is for sure that US Air’s stock reflects some premium because of the potential merger. The stock valuations reflect a premium versus its legacy peers due to the company’s aggressiveness in pursuing M&A activity.

However, does that mean that the stock will pull back significantly if we see news that reduces the probability of merger between US Air and AMR?

No is the answer. As has been the case for some time, US Air’s stock is expected to continue to ebb and flow with the M&A news to some degree. The M&A debate has been prevalent in the airline industry for some time and continues to be centered on US Air in one form or another. Even if US Air's recent efforts with AMR don't amount to a near-term deal, investors will likely assume that the company can either pursue a more hostile attempt at a transaction or a different M&A opportunity altogether. Therefore, we should understand that if the merger between US Air and AAMRQ does not go through, the short-term dip in US Air’s price will give its investors an ideal entry point in the stock.

Thus, the resiliency of the M&A debate surrounding US Air's shares is the reason that my calculations for US Air assume that the market will continue to price the stock with a high probability of M&A. Along these lines, if shorter-term M&A developments were to cause a pullback in shares, I will view it as a tactical buying opportunity to acquire a cheap longer-term 'M&A option value' in US Air. Of course, in this scenario, I am considering the macro environment for the airline industry as constant.

What scenarios might cause the M&A premium to dwindle?

There are 2 scenarios:

(1) If a deal were to be announced I expect it to be a 'sell the news' event as investors are forced to acknowledge the difficulty of integration – one reason why no US airline in recent history has maintained its premium multiple in its post-deal form. We have the episode of Republic Airways and United airlines acquiring Frontier Airlines and Continental Airlines, respectively. In the former case, the acquisition of Frontier Airlines has not boded well for the profits and margins of Republic Airlines. United Continental Airlines (after the merger) has also been experiencing declining margins. Delta Airlines has also decided to spin-off Comair, its commuter carrier.

(2) Should the industry fundamentals begin to deteriorate rapidly, I believe that the investors’ willingness to speculate on the M&A news will quickly wane in the face of the necessary premium that must be placed on integration risk in such an environment compounded by the typical volatility in the airline shares.

Pros and Cons of the Merger and Conclusion

It is interesting to note that a merger at this time will not only benefit the short-term investors but also benefit the long-term investors. The acquisition of AMR’s American Airlines will give US Air an access to key Latin American routes that will surely give it an edge over the other airlines and simultaneously boost its earnings. Combining the airlines is expected to lead to an increase in the sales by creating a larger network of routes. Not only this, both the airlines are expecting to achieve cost savings through synergies. Money can be saved through the elimination of redundant executives, airplanes, headquarters and other facilities. US Air believes that a cost benefit of $1.2 billion can be achieved after the merger.

However, there are some costs attached to the merger as well. The experts call this transition costs. The expenditures on repainting planes, closing facilities, aligning computer systems and databases and negotiating new labor contracts for all unionized employees are some of the examples that are likely to push up the transition costs.  

Investors are bullish on the merger between the US Air and AAMRQ.  Given that the merger has not been fully priced-in the stock, the US Air’s stock price is expected to go up once the merger deal is finalized. After the deal is done, the sell-side is expected to favorably revise the valuations of US Air which will benefit the long-term investors.


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