Stuck in a Box: Why American Won’t Merge Anytime Soon (Guest Post)

It’s been quite some time since the Cardinal graced us with his presence, but today he’s back to fight the “American will merge” rumors. I agree with what he says here completely.

A lot of silly things are being said in the wake of the announced takeover of AirTran by Southwest. For AA in a Boxinstance, there’s renewed speculation about what American needs to do. Here’s a Reuter’s article as an example.

The article mentions potential merger partners for American: Alaska, JetBlue and US Airways.

This speculation is almost certainly useless. So long as American’s management remains remotely sane and rational, American won’t be merging with anyone anytime soon.

The reasons are simple: (1) American’s stock is too beaten down and (2), American’s costs are too high.

Market Caps
Let’s look at some market capitalizations. A company’s market cap is the value of its outstanding equity (the price of its stock times the number of shares outstanding). It’s the theoretical amount you would need to pay to buy 100% of the company. It’s theoretical because, in fact, to actually acquire the company generally requires paying a takeover premium (otherwise the company’s management is likely to make it hard for its company to be taken over).

The following amounts are in $ billions.

2.1 American (AMR)
1.8 Alaska (ALK)
1.9 JetBlue (JBLU)
1.5 US Airways (LCC)

It’s readily apparent that factoring in a takeover premium on any of Alaska, JetBlue or US Airways would mean that AMR would have to fork over around 50% (or maybe even more) of its equity to any acquire any of these airlines.

American, of course, is vastly larger than any of these three potential partners. So why is American’s market cap only marginally larger?

Good Guys Finish Last
The issue is that American is not making much, if any money. It’s a huge enterprise, but it’s basically breakeven at best at the moment. Ironically, this is because American and Continental were the only two legacy major airlines not to completely screw over their shareholders after 9/11 by going bankrupt. Delta, Northwest, United and US Airways (twice!) went through the bankruptcy carwash after 9/11, which enabled them to crush costs, including labor and aircraft finance costs, at the cost of destroying all shareholder value. American did the right thing by its shareholders and, by the skin of its teeth, avoided bankruptcy. This preserved value for shareholders, but it meant American has had a much tougher time reducing costs. While Continental did not go bankrupt post 9/11, it was the beneficiary of two prior bankruptcies in the 1980s and 1990s. American stands alone as the only legacy major to never screw its shareholders in this fashion, but it has left it in a very poor cost position. Ironically, because the other legacy majors did destroy all shareholder value in the past, they are now in a much better position today. In this regard, at least, good guys finish last.

In fact, American’s cost position handicaps its merger prospects twice over. First, its market cap is beaten down, so its stock is a weak currency with which to purchase another company. But secondly, because American is so big relative to any of its potential targets, were American to take over another airline, American’s costs would be more-or-less instantly imposed on the operations of the other airline. So, for instance, if American were to take over US Airways (which has significantly lower costs) American’s labor scales would essentially immediately apply to US Airways employees (this is actually more or less a direct consequence of US government labor law, so essentially just a fact of life). Blam! US Airways’ routes would instantly become less profitable.

In other words, the minute that American took over one of these carriers, its higher costs would instantly destroy a lot of the value for which American just paid. That 50% that American just paid would be buying much less that you might initially think.

(This discussion has implicitly assumed American uses stock to purchase a target. If it used cash, that would be even worse, because American would pay hard dollars for value that would then be destroyed — if it used stock, at least it wouldn’t have increased its net debt uselessly, “only” destroyed shareholder value).

For this reason, unless AMR management completely loses its senses, AMR will not do a merger for the foreseeable future. As far as Mergers and Acquisitions are concerned, American is in a box. It can’t do a merger without throwing away a lot of shareholder value.

This is why you see American doing things like entering into partnership agreements with JetBlue. It’s not necessarily American’s usual mode, but it’s one of the few things they can do these days. They need to make nice because they have few reasonable alternatives.

Stuck In A Box, For Now
So can American get out of this box? In some ways, it’s not up to them. Except in times of distress, airline costs tend to increase, especially at the legacy majors. So, if American can hold the line on costs, the other legacy major airline costs are likely to get relatively worse than those of American. It’s not a real great place to be in, waiting for your competitors to suck more so that you relatively suck less. And there’s a serious snag: American’s employees are furious about their lack of wage increases and desperately want to force American into paying them more. Pilots, flight attendants and mechanics all want a pound of flesh (and then some) from American. They’re each willing to strike American to get what they want — and like other legacy major airlines, American can’t long tolerate a strike without going into bankruptcy.

That’s the other way American could get out of its box — declare bankruptcy. But that would almost certainly completely destroy shareholder value, and since the airline is, at least ostensibly, run in the interests of the shareholders, American can’t do that while reasonable alternatives remain. So American can’t exactly choose bankruptcy either.

So, for now, it’s highly unlikely that American can do anything to get itself out of it’s mergers and acquisitions box, and any speculation about that is, at best, ill-informed.

But Not Dead
Don’t misunderstand — American’s situation is hardly desperate, it’s just not good. It’s not in danger of bankruptcy any time soon (unless its unions do something stupid, and that cannot be ruled out, unfortunately). It’s still a powerful competitor, the third largest airline in the US. It still “owns” Dallas and Miami and has a big chunk of Chicago and New York. It’s finally got approval for anti-trust immunity with British Airways, which will help on the margin. American’s just stuck for now on the M&A front. Moreover, so long as its profits remain largely ephemeral, there’s no good case for organic growth either.

So, for now, unless something big changes in the environment (or American’s management loses its sanity), expect American to be largely stuck for the foreseeable future. For now, all they can do is try to improve their cost position relative to the industry. Tough sledding, but no one said this was an easy business.


The Cardinal is a long-time industry observer, who is currently [redacted]. He was previously a [redacted] at [redacted]. Prior to this he worked at [redacted], [redacted] and [redacted]. To his sorrow, he lives in [redacted] and in his spare time enjoys [redacted with extreme prejudice].


27 Responses to Stuck in a Box: Why American Won’t Merge Anytime Soon (Guest Post)

  1. Richard says:

    You mentioned about the anti-trust immunity with British Airways. I had considered that as an “opening salvo” in the merger/acquisition of BA and AA. After all you only have to look at the (now somewhat old) paint on the Virgin Atlantic jets “No BA/AA”.

  2. robert says:

    How does AA’s relationship with BA affect all this? Isn’t that likely to get stronger (possibly going further, in the style of Air France/KLM or even BA/Iberia)?

  3. Scott Moyer says:

    So, AA will not initiate any mergers/acquisitions but what about AA as a target for US, JB, or Alaskan? Doug Parker isn’t afraid to try to slay Goliath –i.e. attempted Delta acquisition.

    • I’d tend to think USAirways would stay away from merging with/buying American as the lead partner for the same labor cost reasons. Plus that’d probably have to be a hostile takeover. I can see the AMR folks being as cranky if not moreso than the Delta folks were.

    • CF says:

      I’m with Nicholas. Remember, Delta was in bankruptcy so that means that there are opportunities to make significant changes in a takeover. So, if AA goes into bankruptcy, I bet we’d see US Airways all over it. But outside, I don’t think it makes much sense because the cost levels at AA are too high for US Airways (and US Airways costs would have to go up to AA levels).

  4. I don’t know who the ‘Cardinal’ is, and by the ending of the blog it looks like I won’t find out so can’t really judge what was said by some unknown person. But you never know what an airline might do as has been proven in the past.

  5. brian says:

    US laws prevents ownership of US airlines by foreign carriers. I believe the current limit is 25% which is why LH has such a limited share of B6 and why there was all the initial uproar about Virgin America (who actually owns and controls the airline someone in US or R. Branson?). The AA/IB/BA deal is not necessarily a prelude to a merger as NW/KL and UA/LH have been in similar agreements since the 1990s. It’s called sales without preference, for UA/LH revenue sharing agreements mean neither carrier is concerned about if the overwater segments are on their metal or the others. It’s meant to make the partner carriers more competitive, offer better service, and coordinate prices and schedules. My experience is that it helps the airlines and customers (albeit fares may not decrease but convenience will).

  6. A says:

    Nice guys do finish last. AA gets much of my support because they haven’t robbed their creditors and shareholders in the very turbulent past 10 years. I find them one of the more honorable airlines out there because of this. My opinion still to this day is that one, if not all, UA, DL, NW, etc. should have passed Chapter 11 bankruptcy and gone straight to Chapter 7 – liquidation. Bankruptcy is a clear sign of a failed business, and only in the USA do we allow companies to “reorganize” and instantally get a competitive advantage in the marketplace because of this. We don’t necessarily have a US flag carrier, but we support failed businesses much in the same vein as Alitalia with our very lax corporate bankruptcy laws.

    • desertkid says:

      AA may be a hit with the creditors, but not with the employees. As a former employee at AA for 16 years (non-management and management), they rob their employees. While the VPs and Senior VPs, fly confirmed First Class and accumulate AAdvantage miles, us ‘working folks’ flew stand by. Any while they defended bonuses and executive pay, because that’s what the ‘market’ is paying. But when it came to middle/lower management/non-management, they used ‘your pay is comprable to other airlines.’ How come we didn’t get ‘market’ pay?

      AA will get what it is due! Besides, you don’t want AA to buy another airline…Air Cal, RenoAir, TWA…need I say more. What’s left of those mergers? Until (upper) management gets a dose of reality, they are doomed to fail!

      • Never made sense to me why you buy another airline just to wipe out what they did. AirCal and RenoAir flew up and down the west coast and AA didn’t so it made sense to buy them but not to eliminate their up and down the coast routes.

        Maybe it was a cheaper way to get aircraft by buying three airlines and they serving the markets they flew.

  7. Evan says:

    Great post, and I agree. AA has a singular problem, and it’s not their competitors, fleet, M&A prospects, or anything like that. It’s their labor. Their costs are too high and can’t come down because of their poor labor relations.

    No merger or acquisition is going to solve that, it has to be done on the home front, piece by piece. And it’s a toxic characteristic for anyone interested in merging or buying them.

    Otherwise (and admittedly it’s a big “otherwise”), AA’s position is just fine as #3 with great share in some of the highest yielding and loyal markets in the country.

    Look for more partnerships (perhaps US in One World, maybe even Alaska eventually) in the mean time.

    • CF says:

      And this is why I think AA’s management has failed. The most important thing AA can do right now is work with employees to keep costs as low as possible. Instead, relations are awful and employee groups are even rejecting tentative agreements with marginal increases. What AA needs is to stay flat until others catch up (which could be a long time), but that requires have good, open relationships with labor. That doesn’t exist at AA.

  8. Don says:

    I think AA would buy JetBlue in the next year. Wall Street would finance it.

  9. Alex Hill says:

    All this aside (though I find it very interesting and appreciate the perspective), who would AA merge with, now or three years ago? There’s no other carrier whose network fits, at least not nearly as well as DL/NW or UA/CO did. AA shares at least one hub city with all four except NW, whose DTW and MSP hubs would be very redundant with ORD anyway, whereas neither of those merger pairs had any overlapping hubs before the merger. Thus, any AA merger probably would have (rightly) had to give up considerably more to appease regulators. US wouldn’t add much to AA’s network either — PHL is so close to NYC, AA already tried and failed with a hub in North Carolina (RDU), and PHX doesn’t add much to LAX.

    AS would make sense except that their profitability out of the state of Alaska and Seattle is largely due to their low costs and ability to gather feed from both oneworld and SkyTeam partners; I’d think they’d lose the broad feed if they merged with AA.

  10. Ed Kelty says:

    What about a merger of US and Alaska?

    • Andrew says:

      I’ve thought about this too. It seems like Alaska’s network would be a great way for US to beef up the West Coast, with very little overlap with their current network.

      • Yeah, if only US only had a codeshare partner with service out of LAX, SFO and SEA to enhance their network.

        Oh, wait, they do, it’s United.

        And hey, nothing like adding a new group of pilots to have lawsuits about. And a completely incompatible fleet. But other than that, it’s a great idea.

        • Marshall says:

          After the merger is finished and the new UA reoptimizes their network, would they really need US as a codeshare? They could pull ASMs out of CLE and stick them into IAD, right in between PHL and CLT. Or they could send them over to West Coast and focus on their Trans-Pacific feed.

    • b757capt says:

      I’ve always thought a Hawaiian/US Airways merger would be the best.

      • Ed says:

        I’m with you on that. And add Virgin America for a greater west coast presence. You could structure the Virgin America part of the deal with a stock swap involving US and Virgin Atlantic shares. The “new, new” US Airways could then join with Virgin Atlantic, Virgin Australia and the other “Virgins” to create a Virgin Alliance.

  11. Fred says:

    I think the best combination would be for AA to buy JetBlue to bulk up AA’s east coast operation, and then purchase Alaska to funnel all the west coast traffic into the oneworld Pacific operations. Looks good on paper, but probably won’t happen anytime soon. I agree with Cranky; AA’s in rough shape.

    • “Alaska to funnel all the west coast traffic into the oneworld Pacific operations”

      You mean AA’s whopping huge 1x LAX-NRT?

      Yeah, CX flies a decent amount of West Coast-Pacific, as does JAL, and QF handles Australia… except none of them fly to SEA (AS’s primary hub) or have ATI with AA. Oh, and guess what? CX and QF already codeshare with AS, so adding AS does very little.

      AA would do with AS what airlines based back East traditionally do with West Coast networks- fritter away the market share to WN or other airlines (in fact, a good chunk of AS’s network used to be WA’s network, previous to DL buying them. All DL kept was SLC).

  12. Rob Garren says:

    I always thought a good match-up would be if Southwest bought either AirTran or Jet Blue AND Alaska. I really thought Southwest might buy Jet Blue and Alaska and just be slightly bigger than United/Continental. Well, now they’ve bought AirTran. I don’t know if they could get away with buying Alaska as well, but that would really be a formidable force. I’m surprised how cheaply AA is valued. Pretty amazing to put them within such close range of the value of Alaska and Jet Blue. In fact, if Alaska and Jet Blue combined that would be an improvement for both of those airlines and they’d really be better off than combining with AA or US.

  13. Scott @ DTW says:

    One could easily assert that AA was actually the FIRST major to engage in this latest round of tie-ups when it acquired TWA back in 2001. All of the references I have seen to AA being the “long time biggest carrier” seem to forget that only nine years ago UA was substantially larger than AA by nearly every measure. When you consider that AA was really the first the leapfrog the heap, it’s not all that odd for AA to find itself the smallest of the “big three” nearly ten years later.

  14. Craig says:

    What a great article. Finally making some sense out of all the AA merger rumors.

  15. steve says:

    I sometimes wonder what is required in order to write an article on the airline industry. While the other legacy carriers were filing bankruptcy, AA was being praised by the media on how they were negotiating (out of bankruptcy) new contracts with everyone involved. Without the crippling effects of bankruptcy, Arpey and team, using the threat of bankruptcy, accomplished what the others did in bankruptcy. This included massive pay cuts by its employees.

    The writer also fails to mention the massive repayments of debt AA has accomplished in the last 10 years. (more than 10 billion) He also fails to discuss the dismal employee morale and massive costs that come with a merger. The one positive effect of mergers is the reduction in competition. (since airlines are never allowed to go out of business) This is a benefit that all the carriers enjoy.

    American gets the benefit of reduction in competition without incurring the costs of a merger.

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