Will American Airlines be all that for US Airways?
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US Airways (NYSE: LCC) has taken another step closer towards a deal with American Airlines with the signing of a non-disclosure agreement that will facilitate more intensive due diligence before any transaction can be initiated. Doug Parker, Chief Executive Officer of US Airways, has been very open about his desire to combine the two airlines. US Airways even went so far as to negotiate with the unions of American Airlines and also buy its debt so that it could participate in creditor events.
The investor community obviously approves of the pursuit of American Airlines by US Airways. Since American Airlines entered bankruptcy back in November 2011, the share price of US Airways more than doubled, though it has fallen after the initial bullish surge.
While US Airways' pursuit of American Airlines has certainly rewarded its shareholders in the near term, the long term impact of the merger is dubious. Airline mergers have a very poor track record. Since deregulation in the industry in 1978, more than 200 air carriers have filed for bankruptcy. US Airways has done it twice. American Airlines was the last legacy airline to file for bankruptcy with its Chapter 11 petition.
Overll, mergers and acquisitions sound much better when pitched by investment bankers in the corporate suites than what actually results in the real world. Anand Chokkavelu of Motley Fool wrote in "The 100 Things I've Learned in Investing," about these corporate deals: "Mergers and acquisitions are overrated. Somewhere between 50% and 85% of mergers fail to boost value. The frequency of achieving promised "synergies" should be filed somewhere between unicorns and no-hitters."
A major factor for this is the debt entailed.
US Airways is already larded up with a debt-to-equity ratio of 8.77. That staggering figure will only increase if it purchases American Airlines. Writing in The Wall Street Journal, financier Mike Milken warned about too much debt for airlines and other companies in his article "Why Capital Structure Matters." In the April 21, 2009 piece, he noted that, "even a dollar of debt may be too much for some companies. Over the past four decades, many companies have struggled with the wrong capital structures. During cycles of credit expansion, companies have often failed to build enough liquidity to survive the inevitable contractions. Especially vulnerable are enterprises with unpredictable revenue streams that end up with too much debt during business slowdowns. It happened 40 years ago, it happened 20 years ago, and it's happening again. Over-leveraging in many industries -- especially airlines, aerospace and technology -- started in the late 1960s."
The recent track record of airlines mergers and acquisitions has certainly not been auspicious.
Republic Airways (NASDAQ: RJET) acquired Frontier Airlines for $1.1 billion in late 2009. It has been trying to get rid of Frontier Airlines for almost a year, with no buyers. That deal has had tremendous adverse effects on the price, profit margin and debt-to-equity ratio of Republic Airways, which is why it is looking to spin off Frontier Airlines since no one wants to buy it.
Creating the world's largest airline through a merger has certainly not benefited the shareholders of United-Continental (NYSE: UAL). Since the merger in May 2010, both the share price and the profit margin have fallen for United-Continental. The debt-to-equity ratio is also a very unhealthy 7.540.
Charlie Munger, partner of Warren Buffett, once observed that "The net amount of money that's been made by the shareholders of airlines since Kitty Hawk is now a negative figure." That could account for the lack of buyers for air carriers now. American Airlines attempted to sell American Eagle, its regional airline, but there were no takers. Republic Airways has been trying to sell Frontier Airlines for almost a year without any success. Delta Air Lines (NYSE: DAL) recently announced that it would ground Comair, its commuter carrier, that it acquired at a cost of $2.3 billion in 2000.
The most profitable air carrier now is Spirit Airlines (NASDAQ: SAVE). An ultra discount carrier, it charges for everything. That is not why US Airways is looking to combine forces with American Airlines, however. The most attractive features of American Airlines are supposed to be its Latin American routes and New York-to-London flights.
Also making the success of airlines even more doubtful is that a period of high oil prices of around $100 a barrel appears to be ensuing. In an interview with the Financial Times earlier this year, Ali al-Naimi, the oil minister for Saudi Arabia, stated that $100 barrel oil was needed in order to finance the domestic programs instituted to prevent an "Arab Spring" rebellion in The Desert Kingdom.
As fuel costs are about 40% of the fixed costs of an airline, the share price moves in an inverse relationship to the price of a barrel of oil as the chart below shows. Higher fuel costs coupled with the associated debt from an acquisition of American Airlines would be crippling for a barely profitable US Airways.
In July, American Airlines identified five carriers that it wished to consider as a merger partner. Other than Delta Air Lines hiring the financial firm of Blackstone as an advisor and British Airways recently reportedly signing a non-disclosure agreement, there has been little interest displayed other than that from US Airways. Having to file for bankruptcy certainly proved that no party wanted to buy American Airlines as its share price was falling, too. That obviously raises questions about the value of American Airlines; and what it would add to any other group. About this, Laura Glading, president of the Association of Professional Flight Attendants, stated that, "American needs to merge. We think American is going to be in jeopardy if it manages to emerge (from bankruptcy) as a standalone."
While a US Airways-American merger will certainly consolidate the industry, it is difficult to see how two companies that cannot survive on their own and have three bankruptcies between them will endure and evolve to be a profitable entity. More than 200 previous bankruptcies and over 50 mergers certainly resulted in consolidation in the industry but obviously did not help US Airways or American Airlines: why now? Yes, ticket prices have risen. In response, airline passenger traffic has also fallen...welcome to the invisible hand of Mr. Market. As Benjamin Graham stated, "The market is there to serve you, not guide you!"
In 1989, then-USAir merged with Piedmont Airlines. At that time, it was the largest airline merger in history. Needless to say, it was touted as being a positive move, much like the proposed American Airlines transaction is today. Since that time, US Airways has filed for bankruptcy twice. According to its CEO, it cannot hope to survive without merging with American Airlines. With passenger traffic falling and oil prices rising, it is difficult to see how a transaction that would result in a high debt airline will be beneficial in the long term for anyone other than the investment bankers and lawyers being paid outrageous fees for working on the deal.
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