Three Big Ways to Play the Airline Merger Battle
With the proposed merger between US Airways and American Airlines parent company AMR heading to court, investors bullish on the merger's prospects have many ways to get some skin in the game. The most direct investments involve the merging airlines themselves, while more insulated investments can be made in other airlines. Here I will take a look at how airline shares in general could be affected by a successful merger, why US Airways shares are not a do-or-die based on the merger, and how AMR shares offer the potential both a near-term double or a complete wipeout of your investment.
The other airlines
When the Department of Justice challenged the US Airways-AMR tie up, airline shares fell across the board. Delta Air Lines dropped back below the $20 level and United Continental Holdings lost grip on the $30 level. Two psychological levels of resistance for the carriers were quickly shattered by the news further demonstrating the market's disappointment in the merger lawsuit.
A clear takeaway from this is that the market wanted the merger to happen. The merger would mean further consolidation in an industry where competition has historically been harmful to industry players. Since the market has clearly indicated its view of the merger, investors should expect airline shares to recover much, if not all, of the losses taken on the day of the lawsuit announcement.
Investors wanting to stay clear of the merger partners themselves may want to consider an investment in Delta or United Continental. Shares would stand to gain in the event of a successful merger while neither airline will have its planned corporate structure changed by a negative merger decision.
US Airways shares
Under the current merger agreement, US Airways is the acquiring company and its shareholders will together own 28% of the new American Airlines Group, or AAG. US Airways is financially solvent for now and the foreseeable future so it does not need the merger to survive. Furthermore, US Airways shares look attractively priced based on cash per share (nearly $20), a lower price to book ratio than any other major carrier, and both a current and forward price to earnings ratio in the mid-single digits.
However, the market was so bullish on the merger's prospects for US Airways that US Airways shares were the hardest hit among major carriers (with the exception of AMR; I'll discuss why later). If US Airways shares were to return to their pre-lawsuit levels, investors would gain around 10% on their investment.
Adding to that, I see downside as limited here since US Airways already trades at a bargain basement valuation when compared to peers and the market as a whole. If the merger is ultimately approved, upside could very well be more than 10% since the merger would have cleared almost all hurdles and be ready for completion.
AMR shares represent a riskier bet than shares of any other major carrier due to the way common stock is treated in bankruptcy. When bankruptcy was initially filed, shares of AMR fell into the $0.30 range. The market treated the shares as virtually worthless since common stock is almost always wiped out in bankruptcy. US Airways had voiced its intention to acquire the bankrupt airline but the widely held view was that AMR common stockholders would see none of the buyout funds since it would all go to pay creditors higher up the ladder.
But then a few things happened. Airline shares rallied with shares of major carriers doubling in value. This in turn both increased the value of the reorganized American Airlines and increased the value of the US Airways stock US Airways would be buying AMR with. US Airways and AMR went through negotiations and eventually came up with the merger and bankruptcy plan that exists today. Not only were creditors to be paid in full, but there was some left over for AMR common stockholders.
The current plan gives AMR common stockholders 3.5% of the new American Airlines Group but the market-based old equity allocation gives AMR common stockholders a large percentage of the new AAG as the price of US Airways shares moves above $14.99. The following table shows how this amount increases.
LCC Share Price
AMR Common Shareholders Interest in AAG
Source: U.S. Bankruptcy Court documents
The value of AMR common shares increases faster than linear growth, and if the merger is approved, US Airways shares should increase in value, potentially doubling the current value of AMR common shares.
But AMR shares come with significant downside as well. If the merger fails, AMR creditors could no longer be paid in US Airways-AAG stock and the restructured AAG would likely need more capital to be stable enough on its own. Under this situation, AMR common stockholders are likely to receive little if anything in the bankruptcy plan.
Take your pick
The airline industry offers something for investors of varying risk levels. Airlines not active in the merger stand to benefit from industry consolidation in general while the merging partners themselves offer additional upside and risks due to their involvement in the merger. I am personally bullish on the industry and have holdings across many airlines, whether part of this merger or not. Investors interested in making an investment in the industry should examine their risk tolerance and decide which investments to pursue.
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The article Three Big Ways to Play the Airline Merger Battle originally appeared on Fool.com.
Alexander MacLennan owns shares of American Airlines, Delta Air Lines. He is also long the following options: $22 January 2015 Delta calls, $25 January 2015 Delta calls, $30 January 2015 Delta calls, $17 January 2015 US Airways calls. The Motley Fool has no position in any of the stocks mentioned. 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.
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