DOJ Surprise Part 1: Effects on Large Carriers

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

The biggest news in the airline industry right now is the Department of Justice’s move to block the proposed merger deal between US Airways and American Airlines parent company AMR. While most of the discussion has surrounded what the effects on US Airways and American will be, this article focuses on the effects on the other large industry players. After the news broke, shares of all carriers were down sharply. But is the news really as bad as it seems?

The industry plan

The airline industry used to be one of high competition, frequent price wars, and a pattern of bankruptcy filings. But the industry trend began to change when Delta Air Lines (NYSE: DAL) merged with Northwest Airlines to create the world’s largest airline. This was followed by the creation of an even larger airline, United Continental Holdings (NYSE: UAL), from the merger of United Airlines and Continental Airlines. In another merger the following year, Southwest Airlines (NYSE: LUV) acquired AirTran in a merger that combined two of the largest discount carriers.

Each merger further reduced competition as six legacy carriers shrank to four and two major discount carriers combined. And with the bankruptcy of American Airlines, the opportunity arrived to combine the last two unmerged legacy carriers. With a merger plan agreed to, the approval of company stakeholders on both sides, the approval of the merger by the European Union, and a history of airline mergers allowed by the DOJ, it looked like the US Airways AMR merger would close in the coming months.

I was caught off guard as much as anybody by the DOJ’s challenge to the merger. The move shocked industry analysts while the markets drove shares of U.S. based airlines sharply lower.

Industry effects

As of now, United Continental and Delta are the two largest airlines, respectively, while Southwest occupies a dominant position among low fare carriers. United and Delta were quite likely looking forward to raising prices with less competition around but those plans are now on hold while the lawsuit plays out. In the meantime, American Airlines is still in bankruptcy and may begin preparing alternatives in the event US Airways/AMR lose the lawsuit. Some analysts have argued American may need to shrink operations, giving United and Delta opportunities to grab what American gives up. In effect, American would be a standalone carrier but United and Delta could grow stronger by acquiring some former assets, possibly increasing their own pricing power.

Under the worst case scenario, American Airlines would liquidate, however I believe this is not likely. The airline has managed to begin posting profits again and even without further consolidation the airline industry is expected to benefit from increased economic activity and actions stemming from previous mergers. But in the unlikely event of a liquidation, there would be a fire sale of airline assets. The most likely bidders would ironically be the carrier the DOJ didn’t want to get its hands on American, and United and Delta, the two even larger airlines.

If American can emerge from bankruptcy without shedding any assets, it would be a stronger airline than the one the filed for bankruptcy in 2011. It would have an improved cost structure and be more competitive with rivals. If American plays it well, the airline will maintain a disciplined approach to capacity and competition whereby an industry with four big players could still have oligopolistic elements. However, if the restructured American decides the best way to profit is to grow capacity and launch price-based market share grabs, the airline industry could be in for additional price wars.

Southwest is in a different category than United and Delta as it offers flights to non-major airports and generally lower fares. The discounter would have benefited from US Airways integrating with American since US Airways is a quasi-low-cost carrier. The integration of US Airways with American would likely have resulted in the elimination of the lowest US Airways fares, giving Southwest an even more dominant position in the low cost market. But Southwest also has an advantage in that it provides a different service from the legacy carriers. Southwest has always branded itself as being different while lower fares bring a group of passengers that otherwise wouldn’t fly into Southwest’s market. So while US Airways will be sticking around with somewhat lower fares, competition from having four legacy carriers instead of three threatens the legacy airline business model more than the discount one.

The remaining carriers

Investors in all airlines were hoping the US Airways/AMR merger would close so each carrier could gain additional pricing power. When the surprise from the DOJ came out, the markets pounded airline shares. But the effects on United, Delta, and Southwest remain uncertain and will shape out as the lawsuit progresses and American reacts. However, on a forward earnings basis, major airline shares are quite cheap after the sell-off. While the chances of creating stronger airline pricing power have decreased, shares still look cheap and I am holding mine and considering adding to positions in the future.

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Alexander MacLennan owns shares of Delta Air Lines. He is also long the following options: $22 JAN 2015 Delta calls, $25 JAN 2015 Delta calls, $30 JAN 2015 Delta calls. 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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