What The Airlines' Merger Defense Means for You: Part 1
Last week, US Airways and American Airlines parent company AMR filed their response to the Department of Justice's complaint involving the proposed merger between the two carriers. Its 50 pages offer many insights into the airlines' thinking and their legal battle strategy. This merger is critical to US Airways shareholders, and virtually the only way that AMR shareholders will see any return on their shares, so let's take a look at some of the response's key points.
Clearly, the airlines and the DOJ are on opposite sides of this debate, so it should not be too surprising that they disagree about the effects of deregulation. In the DOJ's complaint, the Department views the setup of the airline industry from 1978 until the recent wave of airline mergers as generally beneficial to consumers, since the business has relied upon healthy competition "to promote affordability, innovation, and service and quality improvements." The Department sees the latest mergers as catalysts for airlines to raise prices and reduce services.
US Airways and AMR have a very different view, however. In contrast to the DOJ's picture of 1978-2005, in which consumers benefited from healthy competition, the airlines paint a very different industry picture: "The post-deregulation history of legacy carriers is one of staggering financial loss, dozens of bankruptcies, hundreds of thousands of lost jobs, dramatic reductions in employee pay and benefits, and painful restructuring."
Unlike the DOJ, which considers the period between 1978 and 2005 to be among the best in the industry, the airlines see it as one of the worst.
Consumers vs. airlines
Remember that airlines are businesses first and service providers second. Like all corporations, airlines have a duty to their shareholders to make as much money as possible. From this view, US Airways and AMR are only doing the responsible thing.
The time between 1978 and 2005 was painful for airlines and their employees. All of the legacy carriers visited bankruptcy court at some point, and an assortment of other airlines were liquidated. The only legacy carrier to not go bankrupt during the 1978-2005 period was American Airlines. But the most commonly cited reason for its 2011 bankruptcy was that its cost structure could not compete with those of carriers that had previously restructured in bankruptcy.
To make money, airlines need to not only put people in seats, but also do so at the right price. When there were many competitors, airlines would grab market share by undercutting fares; sometimes, they would even operate at a loss. The recent industry consolidation has substantially cut down on this strategy, boosting both profits and stability.
Contrasting this view, the DOJ sees this proposed merger from the perspective of the consumer, who has seen fares rise and services shrink in recent years. These fare increases and fee additions follow the airlines' profit-making goals.
Again, airlines are businesses, and they'll make as much money as they can. In an environment with fewer competitors, airlines have more room to raise prices.
There are now two merged megaairlines, letting investors begin to see the profit potential from consolidation. Delta Air Lines and Northwest Airlines merged in 2008, in one of the smoothest airline mergers on record. United Airlines and Continental Airlines merged two years later to form United Continental Holdings, currently the world's largest airline. Given United Continental's continual merger troubles, however, Delta provides the best look at a fully merged airline.
Since its merger, Delta has used profits to slash debt, increase its credit rating, and begin returning capital to shareholders through a stock buyback and dividend program. All of this has earned the airline a spot on the S&P 500 and pushed its shares to record highs.
On top of that, analysts expect Delta's earnings to continue growing, with consensus estimates of $2.79 per share for 2013 and $2.99 per share for 2014. Despite its recent run, Delta shares still trade at a forward price-to-earnings ratio in the single digits which gives the stock more room to run.
Wrapping up the first segment of this flight
Airlines have traditionally operated in an industry that destroys shareholder value, as intense competition holds down airline earnings and carriers get hammered during tough economic times. Since 2005, however, airlines have been consolidating and reducing this competition, while raising fares and fees.
Ultimately, this has led to the strong levels of profitability seen in the completed Delta-Northwest merger, and earnings growth both in the past and forecast during the next few years. A key point of the US Airways/AMR merger trial will be whether the airlines can justify increases in fares and fees, coupled with reductions in services, as essential to making the industry solvent in the long-term.
In the next part of this series, we'll examine how the DOJ and the airlines have substantially different views on the major carriers' power to control the market. We'll also look at how both sides have numbers to back their views up -- and why both sets of statistics are technically correct.
If you're curious...
Much of the information used in this article comes from the legal documents themselves. For those who want to examine the DOJ's complaint and the airlines' response further, here are links to the documents.
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The article What The Airlines' Merger Defense Means for You: Part 1 originally appeared on Fool.com.Alexander MacLennan owns shares of Air Canada, AMR, Delta Air Lines, and Gol Linhas. 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. This article is not an endorsement to buy or sell any security and does not constitute professional investment advice. Always do your own due diligence before buying or selling any security. 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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