James M. Higgins, CFA / Vaughn Cordle, CFA
The recent petition of AMR and the Unsecured Creditors’ Committee to the bankruptcy court for an extension of management’s exclusivity period to file a Chapter 11 reorganization plan will likely be granted. Acceptance of that petition would leave the filing deadline at March 11, 2013 with the subsequent deadline for soliciting approvals of the plan moved to May 10, 2013. The urgency to merge AMR and US Airways, at least from the AMR side, is now reduced.
An AMR and US Airways merger would clearly benefit from revenue and cost synergies, and in the process, would strengthen the airline industry as increased concentration diminished the intensity of rivalry. We believe a combination of the two carriers would measurably increase the post-Chapter 11 value of AMR for all stakeholders, relative to a freestanding AMR. The offset to those benefits would be higher labor costs, with the pilots' compensation increase especially material. We expect US Airways’ labor costs to significantly rise and to match AMR’s, whose latest contract offer to its pilots was just approved by a 74% majority. Those costs, in turn will approach or match Delta’s and United’s new higher rates once UAL's new labor contract is reset.
AMR management clearly wants to be the surviving team, but this outcome may not be possible, given labor’s preference for US Airways’ CEO Doug Parker and his core management team. Without labor’s support, and with the likelihood that AMR pilots will end up as the largest shareholder in a merged company, it will be a challenge for AMR CEO Tom Horton and his key executives to maintain control of the combined airline.
Industry fundamentals would improve if the carriers merge, owing to an increase in market concentration as fewer airlines vie for passengers and as competition softens on city-pairs where AMR and US Airways currently overlap. This change in industry structure enhances the revenue synergies from the proposed merger. The new competitive climate, in turn, would improve the industry’s risk profile and result in higher earnings and expanded valuation multiples for most, if not all, of the airlines. Yet, while further industry consolidation would benefit labor and shareholders, the industry’s customers would not necessarily face higher fares as airlines would pass through some of their economic benefits of consolidation and fight to grow and improve their competitive product offerings.
Industry profits have been too low for too long, resulting in network airline balance sheets that are overleveraged and inherently unsustainable. The need to pay down debt and build up equity, and managements that are focused on profitability rather than market share, provide some capacity discipline. A lack of such discipline had been evident since deregulation in 1978 and was especially damaging after 2000, the peak of the last major business cycle. However, more rational behavior has prevailed since 2007 as the fuel price spike in 2008 gave way to a slumping global economy. Moreover, all of the forces that are shaping the mainline airline industry are also encouraging further consolidation in the regional carrier segment, as airlines scale up aircraft seat size and replace uneconomic capacity with new fuel and revenue/cost efficient aircraft.
A more concentrated industry is essential to the U.S. airlines’ ability to properly invest in competitive resources and move toward a sustainable capital structure and acceptable returns on that capital. This evolution is necessary to compete with stronger and lower cost foreign competitors and to position the industry for potentially slower economic growth in coming years that may result from the need for the US and other countries to deleverage stressed balance sheets caused by the Great Recession of 2009 and years of deficit spending. These economic and airline industry-wide headwinds will be significantly stronger if Washington is unable to resolve the upcoming fiscal cliff problem by the end of this year or soon thereafter.
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