Airline Stocks Dip As The Justice Department Blocks US Airways-American Merger

The U.S. Department of Justice filed a lawsuit yesterday in the District Court of Washington seeking to block the merger between US Airways (NYSE:LCC) and American Airlines that would create the largest airline in the world. The Justice Department contends that the proposed merger hurts consumer interest, as post merger over 80% of the domestic air travel market would be controlled by only four players – United (NYSE:UAL), Delta (NYSE:DAL), Southwest (NYSE:LUV) and American-US Airways. The Department believes the merger will initiate another set of capacity reductions from the combined US Airways-American entity in pursuit of higher profits, like the ones that were seen following the previous airline mergers. The reduced industry’s flying capacity will in turn lower competition, allowing airlines to raise airfares more freely, thus hurting customer interests.

To the investor community and both American and US Airways, this move from the Justice Department comes as a surprise, as the department gave its approval to many airline mergers and acquisitions in the past decade, including the four big combinations of US Airways and America West, Delta and Northwest, United and Continental, and Southwest and AirTran.

In response to the Justice Department’s claims, US Airways and American Airlines contend that their networks are highly complementary and that blocking their merger will deny customers the benefits that come with a larger network. The two airlines argue that their merger will provide customers with a competitive alternative to Delta and United with strong connectivity to international destinations. As their next plan of action, US Airways and American Airlines will defend their case in court and said in a press release on Tuesday: “We [US Airways and American Airlines] will mount a vigorous defense and pursue all legal options in order to achieve this merger and deliver the benefits of the new American to our customers and communities as soon as possible.” ^[1]

Here we try to understand the repercussions on American Airlines, US Airways and the airline industry if the Justice Department were to succeed in its move. We currently have a stock price estimate of $18.50 for US Airways, around 15% ahead of its current market price.

See our complete analysis of US Airways here

A trial between the Justice Department and American-US Airways will mean that the merger which was set to close in the current quarter will now take longer. In the Justice Department’s decision stands, the impact on many stakeholders especially employees and debt holders of American will be severe.

Repercussions For American Airlines

A bankruptcy-exit through a merger with US Airways is one of the most preferable outcomes for American Airlines, as it provides a secure future for its employees and faster recoveries to its debt holders. American’s stakeholders and employee unions overwhelmingly support the merger. Even American’s shareholders are getting a stake, albeit a minor one, in the current reorganization plan. However, if this were not to happen in the court outcome, American will have to spend a lot more time in bankruptcy court proceedings, most likely through 2014, as it will have to come up with another reorganization plan. The carrier will have to renegotiate with its debt holders, make new growth estimates, get its unions on board the new plan and present all of this to the bankruptcy court. This will take time.

Meanwhile, Delta and United will further strengthen their positions in domestic as well as international markets. Additionally, an independent American will find it more difficult to compete with larger and more financially stable Delta and United. (See US Airways-American Will Give United And Delta Tough Competition)

Repercussions For US Airways

For US Airways, a scuttled merger will mean it will have to continue to compete with much larger network carriers like United, Delta and American on international routes and with low-cost carriers like Southwest and JetBlue (NASDAQ:JBLU) on many domestic routes. The merger with American is a unique opportunity for US Airways to jump ahead of competition to the top of the league. Ever since American filed for Chapter 11 protection in late 2011, US Airways expressed its interest for a merger. American on the other hand did not initially evince interest, but agreed to a merger after many of its unions supported the same.

Repercussions For The US Airline Industry

Additionally, if the merger does not go through, we believe the entire US airline industry will be impacted and not just American and US Airways. The slower rate of capacity additions over the past 3-4 years played a key role in returning airlines to profitability after nearly a decade of huge losses.

Growth in the domestic flying capacity was kept in check in recent years by capacity rationalization that followed big airline mergers, namely that of Delta-Northwest and United-Continental. The slower capacity addition helped airlines fly fuller planes as well as charge higher fares, thus boosting profits. If the US Airways-American merger does not take place, the industry may not only lose gains from their expected capacity rationalization, but may also have to cope with capacity expansion from an independent American, which will try to add capacity to compete with Delta and United. In this way, profits across the US airline industry could be impacted. This is why yesterday, in addition to a 13% decline in US Airways’ stock, the stocks of all major airlines were in the red.

Our current airline stock price estimates assume that the merger between US Airways and American will go through; however, if this does not happen, our price estimate will likely get revised lower. We are awaiting a final verdict from the court on the matter or some negotiated settlement between American-US Airways and the Justice Department involving concessions.

In the last major airline merger/acquisition review involving United and Continental, the Justice Department gave its approval after the carriers agreed to concede some landing slots at the Newark airport. We thus believe the deal between American and US Airways could also materialize if adequate concessions are provided by the carriers. Last week, US Airways and American received approval from the European Commission for their merger after agreeing to part with a couple of slots at London’s Heathrow airport.

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1. American Airlines and US Airways to fight Justice Department action, August 13 2013, www.usairways.com [↩]