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 instance, 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.
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.
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].