Is It Fair to Block This Airline Merger?

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The U.S. Department of Justice's lawsuit to block the AMR (NASDAQOTH: AAMRQ.PK) US Airways (NYSE: LCC) merger comes after a string of airline combinations over the last several years. The DoJ contends that the merger is anti-competitive, seemingly regretting its allowance of past airline mergers to proceed. Now, AMR and US Airways are paying the price for being late to the party.

Unable to compete

AMR is currently in bankruptcy protection as a result of its inability to compete against Delta and United. Scale and hub dominance are the keys to competing effectively in the airline industry, and Delta and United secured both with mergers.

United and Continental merged in 2010 to compete with Delta, which merged with Northwest Airlines in 2008. Southwest Airlines (NYSE: LUV) is now three years into its merger with AirTran, which lifted it into second-place in U.S. market share.

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Delta, United, and Southwest have all benefited tremendously from being the three largest airlines in the U.S., while AMR and US Airways continue to struggle as decidedly smaller oligopolists. Therefore, it makes sense from both companies' points of view to combine and leapfrog their competitors to become the largest company in the industry.

DoJ says no more mergers

Unfortunately, the Department of Justice says it has had enough with airline mergers. The department is concerned that the merger will reduce competition, leading to price increases for consumers. Indeed, competition at certain hubs will certainly be reduced; the combined company will have a virtual monopoly in Charlotte, Dallas/Fort Worth, Texas, Reagan National, and Miami. Those markets would undoubtedly suffer from higher prices due to reduced competition.

However, there is a reason that AMR is currently in bankruptcy proceedings -- and that most airlines can expect to go through a restructuring once every couple of decades:  competition is fierce and returns on capital are consistently low. Airlines are always undercutting each other on price, even as it seems they cannot add enough fees to the tab.

Even if the merger goes through, it is unlikely that the combined company will be able to sustain returns on capital above its cost of capital for a prolonged period. Competition from budget carriers like Southwest and JetBlue would keep the bigger airline in check.

Southwest rapidly expanded to new airports during the credit crisis, and its merger with AirTran gave it access to dozens of new markets in which it had not previously operated. This created additional price pressure for airlines that use Southwest's hubs.

In addition, Southwest operates with one of the lowest cost structures in the industry due to its point-to-point strategy and single-model fleet. This rather than using the hub strategy that is the core model of United, Delta, AMR, and US Air. Southwest averages an 8% operating margin and is profitable year in and year out, while the largest hub-model carriers cannot consistently earn a profit -- much less an 8% operating margin.

JetBlue's experience is similar to that of Southwest, with consistent profitability at a 7% to 8% operating margin. Therefore, budget carriers will continue to provide an anchor for larger airlines' fares.

Bottom line

Even the biggest airlines that dominate major hubs are having trouble earning a consistent profit. AMR and US Airways cannot survive with half the market shares of their rivals, much less earn an economic profit for shareholders. Although prices at some major hubs will undoubtedly increase, it is unfair and unwise to disallow the merger due to the poor economics of each company on a standalone basis. Southwest Airlines, JetBlue, and other point-to-point carriers will keep air fares from getting out of hand, while low barriers to entry will provide additional competition when it is economic to do so.

The airline industry has been a major destroyer of shareholder wealth since inception, and it will continue to do so as long as companies are not able to perform the actions necessary to compete economically.

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Ted Cooper 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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