Don’t Expect to Profit From an AMR-US Airways Group, Inc. (LCC) Merger

The United Continental merger is a case in point. As I recently wrote, the company promised revenue synergies totaling $800 million-$900 million due to the combination of the United and Continental networks. However, integration snafus led to technology meltdowns, massive flight delays, and particularly poor customer service (even for an airline!). As a result, United saw revenue dis-synergies in 2012; the company lost ground to each of its major competitors. There is no guarantee that the same problems would affect American and US Airways. However, given the complexity of large airline mergers, it would not be prudent to assume that their merger will produce “smooth sailing.”

Valuation
If one wanted to invest in the American-US Airways merger, the natural way to do so would be to buy US Airways stock. Shares have recently been trading near $15. At that price, based on a diluted share count of around 200 million (which may be too low – the diluted share count was 205 million last quarter), US Airways is worth $3 billion. Based on its 28% ownership in the merged carrier, the “new American” would need to be valued at $10.7 billion for current US Airways shareholders to break even. By contrast, Delta is the most valuable U.S. airline, with a market cap of $12.3 billion, whereas United is only worth $8.4 billion.

Certainly, $10.7 billion would be a “stretched” valuation for a merged American-US Airways. The “new American’s” situation would be much closer to that of United than that of Delta. Delta has already completed its merger with Northwest, and has been showing industry-leading unit revenue growth over the past two years. By contrast, United Continental’s lower valuation accurately reflects the costs and risks of merger integration.

US Airways could choose to repurchase its convertible notes with cash (this would require $500 million-$600 million) in order to reduce the diluted share count. This would permit shareholders to break even at a lower market cap (perhaps as low as $9 billion for the combined entity). However, that would create its own set of risks. Due to the costs of merger integration, it is prudent to enter the process with a very strong cash position; United Continental had over $9 billion of cash and investments when it closed its merger on Oct. 1, 2010.

Effect on competitors
The merger does not promise a clear effect on competitors, either. The further “rationalization” of the airline industry into four major competitors (American/US Airways, United, Delta, and Southwest Airlines Co. (NYSE:LUV)) could help all of the carriers by improving pricing power. Competitors could particularly benefit if merger integration leads to poor operational performance, as was the case for United Continental. However, there is no way to know in advance if American and US Airways will be doomed to repeat United Continental’s mistakes.