AMR-US Airways: Merger now certain, but can it deliver promised benefits? November 2013

After a four-month delay caused by the DoJ’s antitrust lawsuit, American and US Airways expect to close their merger on December 9th, enabling AMR to emerge from Chapter 11 and creating the world’s largest carrier. The new company, to be known as American Airlines Group, will trade on the Nasdaq under the symbol “AAL”.

The final legal hurdles were cleared on November 27th, when the bankruptcy court handling AMR’s Chapter 11 case approved the November 12th agreement between AMR, US Airways and the DoJ to settle the DoJ’s August lawsuit that had sought to block the merger. The court also ruled that the merger may be consummated despite a pending private antitrust lawsuit from a group of consumers.

The DoJ settlement came about after considerable pressure from many quarters (labour, business leaders, etc), the Texas Attorney General dropping out of the DoJ lawsuit on October 1 and with the trial date approaching (November 25). By all counts, it was a reasonable settlement, and all parties seemingly walked away happy.

The DoJ secured what can only be described as unprecedented slot divestitures. American and US Airways agreed to divest 52 daily slot pairs at Washington Reagan National (DCA) and 17 slot pairs at New York LaGuardia (LGA), as well as two gates and related facilities at each of Boston Logan, Chicago O’Hare, Dallas Love Field, Los Angeles and Miami (slots only exist at four US Northeast airports). The divestitures will be made available to LCCs after the merger closes through a DoJ-approved bidding and sale process.

The slot divestitures will mean a 15.2% reduction in the two airlines’ combined daily round trips at DCA (from 290 to 246, excluding eight slot pairs currently leased to JetBlue) and a 7% reduction at LGA (from 175 to 163, excluding five slot pairs already leased to Southwest).

By comparison, United and Continental got away with having to give up only 18 slot pairs at Newark, where the DoJ had similar concerns about competition. United was left holding 75% of the slots at Newark, whereas after the divestitures the new American will account for 57% of the slots at DCA — only marginally more than the 55% share currently held by US Airways.

Therefore the DoJ felt that it achieved its key objective of securing LCCs significantly improved access to capacity-constrained airports — something that has to be good for competition and consumers in the long run.

When the DoJ filed its lawsuit in August, many were puzzled by that decision because it seemed like the rules were being changed in the middle of the game. But the reason is becoming clear. According to antitrust lawyers, before the lawsuit AMR and US Airways were prepared to give up nothing. So, the DoJ has succeeded in “extracting changes from an industry that had come to expect that its mergers would never be challenged” (as a Reuters article put it).

But American and US Airways now feel that, in the great scheme of things, the divestitures are a relatively small price to pay. Their business plan was based on 6,700 daily departures in 50-plus countries and did not rise or fall on a divestiture of 112 daily departures or a 15% reduction in service at one airport. Besides, the new American is retaining its dominant position at DCA.

The airlines have agreed separately with the DOT to continue to use all of their current DCA commuter slots for service to small and medium-sized communities. Analysts do not consider that an onerous commitment because most of those operations are believed to be profitable.

The other so-called concessions made by American and US Airways were mostly political gestures (to the states that had joined the DoJ lawsuit) that have little impact on the bottom line. The airlines have agreed to maintain their primary hubs “consistent with historical operations” for three years (something they wanted to do anyway) and maintain daily service in a number of markets for five years.

All in all, the settlement is expected to have no material impact on pro forma earnings or the merger synergies. The new American is still expected to generate the originally estimated $1bn-plus in annual net synergies beginning in 2015.

Industry implications

There is a strong and broad consensus that the DoJ settlement and the AMR-US Airways merger generally will be beneficial for the US airline industry, the US economy and many local communities.

However, long-term consumer benefits in the US domestic market are uncertain, and obviously not every LCC will benefit — the reasons why the consumer lobby and carriers such as Virgin America are not celebrating.

The main benefit of the AMR-US Airways merger is that it will lead to the US having three powerful global carriers of roughly equal size. American’s pilot union APA put it very aptly: “The merger will remedy American’s longstanding network shortfalls and put American on equal footing with Delta and United.”

While Delta and United will face a stronger competitor, that will be more than outweighed by the benefits of having fewer domestic players and hence more rational industry capacity and pricing.

Largely because of the earlier mergers and Chapter 11 restructurings, the past five years have seen very healthy trends in the US airline industry: tight capacity, rational pricing, higher yields, vastly improved profitability and ROIC goals being increasingly achieved. Even though the AMR-US Airways merger is not expected to lead to a significant reduction in domestic capacity (because of the complementary networks), it should help maintain capacity discipline. The financial community sees AMR-US Airways as the final major component in achieving what Fitch has described as a “more sustainable industry structure”.

US LCCs will benefit from both a more rational domestic capacity environment and the growth opportunities resulting from the divestitures and the new American’s likely exit from some smaller markets as the network rationalisation gets under way.

The biggest beneficiaries of the divestitures are likely to be the two largest LCCs, JetBlue and Southwest. JetBlue, which has been building service at both DCA and LGA, issued a press release saying that it applauded the DoJ settlement and was “eager” to increase service especially at those two airports. Southwest has a history of bidding aggressively for slots, and CEO Gary Kelly said recently that the carrier was “absolutely” interested in more slots at DCA and LGA.

Spirit Airlines can also be expected to bid for slots, especially at LGA. Allegiant has said that it would consider any opportunities, but there are no obvious ones here for a carrier with a niche business model that focuses on smaller cities. And sadly, there may not be anything much there for Virgin America, which has in the past found it tough to secure access to busy airports such as JFK, O’Hare and Newark.

Virgin America actually went public with its opposition to the AMR-US Airways merger just one day before the DoJ settlement was announced. The carrier had just won permission to present its case to the November 25 court hearing. It had planned to argue that the merger would solidify already considerable impediments to new entrants and that any settlement focusing on DCA and LGA slot divestitures would be inadequate. Virgin America is unlikely to be interested in LGA because of the perimeter rules prohibiting flights to Los Angeles and San Francisco. It remains to be seen if it is interested in any of the gates that will become available at Logan, O’Hare, Love Field, LAX and Miami.

Uncertain consumer benefits

US consumer organisations have never liked this merger because they (correctly) note that a reduction in the number of airlines tends to lead to higher fares. A May 2013 study by the Boyd Group found that the average true price of a one-way ticket in the US has increased by 30% since 2008.

From the consumer viewpoint, one problem in the US has been that the two largest LCCs, Southwest and JetBlue, have begun to behave too rationally. They have stopped or dramatically slowed growth, stopped aggressive discounting and begun courting higher-yield traffic, with the aim of maintaining healthy profitability and maximising shareholder returns.

Then again, having a healthy and profitable airline industry, including a sizable and diverse LCC sector, is also good for the consumer in the longer run. There are plenty of airlines left in the US to ensure robust competition.

But the slot and gate divestitures, while impressive compared to previous mergers, are unlikely to “dramatically enhance the ability of low-cost carriers to compete systemwide”, as the DoJ’s Antitrust division suggested.

Impact on competition and fares will depend on the market. Analysts have made the point that since LCCs tend to focus on large leisure-oriented markets, the DCA and LGA slot divestitures may end up benefiting travellers on routes such as Orlando but ultimately reduce the level of service to smaller cities and even larger ones such as Raleigh/Durham and Minneapolis.

Delta has cleverly put itself forward as a remedy for such service shifts, arguing that it should be allowed to bid for slots especially at DCA, because it could ensure continuation of nonstop flights to small and mid-sized cities. The argument has some merit, but the DoJ is expected to rule that only LCCs are eligible to bid.

AMR’s financial turnaround

After incurring adjusted net losses totalling $11.2bn in 2001-2012, including a $1.1bn loss in 2011 and a $130m loss in 2012, and having been in Chapter 11 since November 2011, AMR has at last staged a financial turnaround this year.

The latest quarterly results suggest that AMR is now in great shape. Its 3Q13 net profit was $289m, contrasting with a $238m net loss in 3Q12. The $530m adjusted net profit was a new quarterly record. Operating margin was an excellent 10.4% — not in Delta’s league (15.9%) and lower than US Airways’ (12.1%), but easily beating UAL’s 7%.

The turnaround has been driven by the restructuring efforts. Labour costs fell by 13.3% year-on-year. Mainline ex-fuel CASM was down by 5.4% — the fifth consecutive quarter of unit cost reduction. AMR also enjoyed “solid revenue momentum”. Its transatlantic RASM rose by 11.4%, which the airline attributed to the success of its joint business with BA, Iberia and Finnair.

In the past two quarters AMR raised almost $2bn in new term loans and $1.4bn through a private EETC offering (the latter to refinance debt) — all at very low interest rates. As a result, its cash reserves rose to $7.7bn (31% of last year’s revenues) and its interest expenses will be reduced.

AMR anticipates further profit margin improvements from renegotiated vendor and supplier contracts and through a better matching of aircraft size to demand with the deployment of A319s and two-class RJs, beginning in 3Q.

AMR’s Chapter 11 has seen continued active fleet renewal. The mainline operation is taking A319s, 737-800s and 777-300ERs and retiring 757-200s and MD-80s. This year will see 59 new aircraft added to the year-end 2012 mainline fleet of 608, but because of retirements the fleet will grow by only nine units (to 617).

AMR will now be reporting healthy profits for 2013. BofA Merrill Lynch’s mid-October prediction was operating and ex-item net profits of $1.5bn and $919m and an operating margin of 6%. Significantly, AMR will be making an employee profit-sharing payment for 2013 — its first in 13 years.

But it remains to be seen if and how quickly the new American will be able to close the margin gap with Delta and deliver the promised “significant value” to shareholders.

On the positive side, having secured unusually strong support from labour bodes well for labour integration. JP Morgan analysts also suggested recently that the decision to migrate IT “upwards” to AMR’s more robust systems (contrasting with UAL-Continental’s strategy) could “alleviate some of the technology hurdles”. Labour and IT integration have been the toughest nuts to crack in recent mergers.

On the negative side, S&P suggested on November 12 that the main risk associated with the AMR-US Airways merger is that the increase in labour costs under new contracts will come in higher than the management currently foresees. US Airways has below-market labour costs and continues to experience labour strife.

There may also be a problem that the combined AMR-US Airways network, although very large, “will not be quite as strong as those created by the United-Continental and Delta-Northwest mergers” (as S&P put it). Others have noted that Delta and UAL are by now far ahead in terms of having captured corporate market share, making catching up a more daunting task for the new American.