Airline Merger: Don't Get (too) Carried Away

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

Airlines around the globe are reporting record load factors. Some airliners are even reporting record earnings. This is mainly due to recovering major economies coupled with rising disposable incomes, which have bolstered both business and leisure travel. This will certainly allow airliners to drop unprofitable routes and increase the frequency on high margin, busy routes. Or maybe even expand!

Transforming into a Giant!

US Airways (NYSE: LCC) recently announced that it would be merging with American Airlines (NASDAQOTH: AAMRQ) under an $11 billion deal. American Airlines currently operates around 3,400 daily flights in over 250 countries. Once the merger is through, the world’s second largest airliner will be operating around 6,700 daily flights to 336 destinations. The beauty of the merger is that only 12 out of 900 routes overlap. Moreover, with one more competitor down, airliners can hike their fares more conveniently.

But several reports have shown that merger is being carried out at a premium. According to the deal, shareholders of US Airways will own 28% of the joint entity while AMR creditors will own 72%. Many articles claim that on a $11 billion valuation, the equity of US Airways should appreciate to over $3 billion, which leaves room for a nearly 20% appreciation. But isn’t the $11 billion valuation a self-proclaimed value?

A simple thing that needs to be understood!

Let’s assume that a commodity “X” is priced at $100 in the market. But “A” decides to buy the commodity from “B” at $120. That’s a gain for “B,” but on the books, the assets of “A” are still worth the $100 fair market value, and not $120. I fail to understand why retail investors think that buying above market value would add sustainable value to the airline merger. It is the joint operations that would add value to the joint entity.

American Airlines fleet operates with 617 Boeing jets and 281 American Eagle jets, while United Airlines (NYSE: UAL) fleet operates with 692 Boeing and Airbus jets along with 566 smaller jets. Going by the 72% ownership of AMR creditors, American Airlines is valued at around $8 billion, which is comparable to the market cap of United Continental. Now I know that this is not a perfect comparison, but it gives an idea of what we’re looking at. I believe that since American Airlines is still cash strapped, it does not deserve such lofty valuations.

What If?

Moreover, the merger of fleets takes time. Southwest Airlines (NYSE: LUV) had acquired AirTran Airways back in 2011, but it was only last month that their fleets actually merged. Over the last 5 years, the EPS growth of Southwest Airlines shrank by nearly 8%, but it is now that analysts estimate a 30% plus annual EPS growth for the next 5 years. Moreover, if the restructuring of American Airlines takes longer than estimated, US Airways might be required to raise more capital. Its debt/equity ratio is already over 600% and analysts are not expecting a blockbuster FY13 either.

Foolish Conclusion

As a matter of fact, JPMorgan recently downgraded the shares of US Airways. But no damage has been done yet. Both the boards are still in advanced talks and I’m confident some crucial issues will be addressed before the merger. I believe that investors should not jump to conclusions and should wait for further announcements as its better to enter late than to catch falling knives. Since US Airways is already highly leveraged, its merger with American Airlines has not only amplified its rewards but also its risks. But investing in American Airlines would be a great idea, as it would have relatively easy access to funding without bureaucratic loops. Moreover, the deal in itself would unlock shareholder value.


PiyushArora has no position in any stocks mentioned. The Motley Fool recommends Southwest Airlines. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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