The Risk/Reward Potential Is Looking Better for American Airlines

Until recently, shares of American Airlines parent company AMR have really fit the category of an all-or-nothing bet on the airline's merger with US Airways . But a recent report from JPMorgan Chase combined with another rally in airline shares has fueled the possibility that AMR shareholders may have less downside than previously thought.

An investment bank's opinion
While analysts shouldn't be relied upon for all opinions, their input is worth examining as part of typical investment research. A recent rally in AMR shares was fueled by such remarks from JPMorgan as the investment bank gave a bullish report on shares of the bankrupt airline.

For one, JPMorgan raised its opinion on the chances of the merger's completion from 50% previously to 60% today. But what is of especially interesting to note is that JPMorgan sees a recovery value of around $3.50 per share for AMR common shareholders even if the merger fails.

A better bet
Statistically speaking, a double-or-nothing bet makes sense if the odds that the event will occur are 50%. However, based upon the optimistic value in the event of a merger given by JPMorgan of $13 per AMR common share, AMR common shares have an upside potential of around 120%, rather than the typical 100% that would exist in a double-or-nothing play.

Adding in the view that downside is not $0 but is instead around $3.50 sets this up as an investment with 120% upside and 41% downside. As a bonus, the view of a 60% chance of a merger rather than a 50% chance seen in a double-or-nothing further sweetens the pot.

But why would AMR shares be worth more on their own than they would have been before?

Profits from a bankrupt airline
We normally don't see bankrupt companies as profitable, especially bankrupt airlines. But AMR is turning that narrative on its head by reporting a $289 million profit for the third quarter. Even more exciting is that if it weren't for various restructuring charges, the profit would have come in at $530 million, making it the most profitable quarter in the airline's history.

AMR is showing off its earnings power, which should help to increase the value of a standalone reorganized AMR. And when there is more valuable stock to distribute, common shareholders are much more likely to see a return on their investment.

Industry rally
One of the reasons AMR common shares were left for dead in 2012, trading well below $1 each, was that it was assumed that even if a merger took place, nothing would be left over for AMR common shareholders.

But from late 2012 to today, airline shares have posed one of the biggest rallies in their history, as major airlines solidly outperformed major indexes. Shares of US Airways and Delta Air Lines are both making post-recession highs on strong momentum that has seen shares of both airlines up more than 100% since their 2012 lows.

Airlines have ridden the waves of improving earnings, coupled with more bullish investor sentiment, driving the value of the entire industry higher as airline investments become tolerable to hold in one's portfolio.

For common shares of a standalone AMR, this is particularly important. For the old shares of AMR to see value, the new, reorganized American Airlines must be valuable enough for its newly issued shares to pay off creditors with value left over for AMR common stockholders. But as investors have been assigning higher multiples to airline stocks, the value of a reorganized American Airlines rises as well. This, in turn, should create more value of stock to divide up among AMR stakeholders, thereby increasing payouts to AMR common shareholders.

Still risky, but not as much
A combination of strong profits from AMR and a continuing rally in airline shares has led to a situation where the downside for AMR common shares is now probably above $0. Because of these factors, I mostly agree with JPMorgan's position on AMR common shares.

However, I can see the potential for a rise above $13 per AMR share if US Airways shares rally after a merger is approved. Looking at the bankruptcy documents, AMR common shares should be worth a little over $14 if US Airways shares are at $22 at the time of the the merger. With US Airways shares at $21.14 as of Oct. 18, US Airways shares would only need to rise 4% to hit the $22 level -- a reasonable level of gain in the event of a successful merger.

Of course, investors still face the risk the merger won't go forward, in which case the severe downside still applies. In addition, if the market sours on airline shares, AMR common shares could become worthless, as the reorganized American Airlines would have less total value.

Overall, this is still not an investment for the faint of heart. But for those with money they can afford to lose, the odds look at little better at AMR.

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Alexander MacLennan owns shares of AMR and Delta Air Lines and also has options on Delta Air Lines and US Airways Group. 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 don't 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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