The Deal: DOJ Looks to Ground US Air-AMR Merger

NEW YORK ( The Deal) -- The Department of Justice stunned the market on Tuesday, by filing a lawsuit seeking to block the proposed $11 billion merger of US Airways ( LCC) and the parent of American Airlines, AMR ( AMR).

The DOJ was joined in its lawsuit by attorneys general from six states and the District of Columbia. The DOJ and the state AGs said the merger, which would form the world's largest airline, would substantially lessen competition for commercial air travel in local markets throughout the United States and result in passengers paying higher airfares and fees for ancillary services and receiving less service overall.

The DOJ said American and US Airways compete directly on more than a thousand routes where one or both offer connecting service, representing tens of billions of dollars in annual revenues. They engage in head-to-head competition with nonstop service on routes worth about $2 billion in annual routewide revenue. Eliminating this head-to-head competition would give the merged airline the incentive and ability to raise airfares, the department said.

A court injunction against the merger would upend plans for AMR to emerge from bankruptcy protection through the merger with US Airways.

The companies said they "intend to mount a vigorous and strong defense" to the DOJ's lawsuit.

"We believe that the DOJ is wrong in its assessment of our merger," the airlines said in a statement. "Integrating the complementary networks of American and US Airways to benefit passengers is the motivation for bringing these airlines together. Blocking this pro-competitive merger will deny customers access to a broader airline network that gives them more choices.

"Further, this merger provides the best outcome for AMR's restructuring. The widespread support from the employees and financial stakeholders of both airlines underscores the fact that this is the best path forward for both airlines and the customers and communities we serve."

The companies announced their plans to merge in May and predicted the deal would help consumers by creating a third truly national carrier to compete with Delta Air Lines Inc. and United Airlines parent UAL Corp.

Comments made to reporters by Assistant Attorney General for Antitrust Bill Baer and by others familiar with the situation suggest there is little chance the airlines and DOJ will reach a settlement that would head off litigation.

"We've looked for six months now at this deal and we think it's pretty messed up," Baer said. "It's pretty bad for consumers."

Nevertheless, the DOJ's action was a surprise given that the European Commission approved the deal last week after the carriers agreed to surrender one daily slot pair at London Heathrow and Philadelphia airports and to create incentives for a newcomer to enter the London-Philadelphia route.

Although the DOJ's complaint singled out Washington's Reagan National Airport as a location where competition will be particularly harmed, the U.S. antitrust regulators also cited predictions about the likely elimination of US Airways' "Advantage Fares" discounting strategy, and higher baggage fees among additional reasons for seeking to block the deal.

The DOJ said the vast majority of domestic airline routes are already highly concentrated and the merger would result in four airlines controlling more than 80% of the U.S. commercial air travel market. The merger would also entrench the merged airline as the dominant carrier at Washington Reagan National Airport, with control of 69% of the take-off and landing slots.

The merged airline would have a monopoly on 63% of the nonstop routes served out of Reagan National airport. As a result, Washington-area passengers would likely see higher prices and fewer choices if the merger is allowed, the department said.

The complaint also describes how, in recent years, the major airlines have succeeded in raising prices, imposing new fees and reducing service. The complaint quotes several public statements by senior US Airways executives, including president Scott Kirby, directly attributing this trend to a reduction in the number of competitors in the U.S. market.

The DOJ said that if they remain separate, US Airways and American will continue to be "important competitive constraints" on each other and on other airlines.

According to the DOJ, US Airways competes aggressively for budget-minded flyers under its Advantage Fares program by offering discounts of up to 40% for connecting flights on other airlines' nonstop routes. The other legacy airlines -- American, Delta ( DAL) and United (owned by United Continental Holdings ( UAL)) -- routinely match the nonstop fares where they offer connecting service in order to avoid inciting costly fare wars, the DOJ said.

The Advantage Fares strategy has been critical to US Airways because it funnels traffic to its hubs, which are typically in smaller markets than the other legacy carriers' hubs. With the addition of American's hubs, the combined airline's network will look similar to Delta's and United's networks, and as a result the Advantage Fares program will likely be eliminated, the DOJ predicted.

The DOJ said it based that prediction on an internal analysis conducted by American Airlines in October 2012 that concluded, "the Advantage Fares program would have to be eliminated in a merger with American, as American's large, nonstop markets would now be susceptible to reactionary pricing from Delta and United."

DOJ also cited comments that same month from an American executive, who said, "The industry will force alignment to a single approach--one that aligns with the large legacy carriers as it is revenue maximizing."

In predicting the merger would likely result in higher ancillary fees, such as fees charged for checked bags and flight changes, the DOJ noted that US Airway officials have praised consolidation as a way to increase carriers' leverage to raise baggage handling fees.

The DOJ noted that the fees have become huge profit centers for the airlines. In 2012, domestic airlines generated more than $6 billion in fees from checked bags and flight changes alone, according to the government's suit.

The legacy carriers often match each other when one introduces or increases a fee, and if others do not match the initiating carrier tends to withdraw the change.

By reducing the number of airlines, the merger will likely make it easier for the remaining carriers to coordinate fee increases.

The department also said that the merger will make coordination easier among the legacy carriers. Although low-cost carriers such as Southwest Airlines ( LUV) and JetBlue Airways ( JBLU) offer consumers many benefits, they fly to fewer locations and are unlikely to be able to constrain the coordinated behavior among those carriers.

The DOJ also dismissed the merger as the best route for AMR to emerge from bankruptcy, a restructuring that is already setting up the carrier to operate profitably with a competitive cost structure and plans for growth.

"American recently made the largest aircraft order in industry history, and its post-bankruptcy standalone plan called for increasing both the number of flights and the number of destinations served by those flights at each of its hubs," the DOJ said.

In fact, fear of having to compete against a reenergized American is one of US Airways' reasons for doing the deal, the DOJ said.

The department's complaint cited comments from US Airways executives' describing American's standalone growth plan as "industry destabilizing" because it would provoke other airlines to enhance their own growth plans, thus increasing competitive pressures throughout the industry. The merger would "allow US Airways' management to abandon these aggressive growth plans and continue the industry's current trend toward higher prices and less service."

A source familiar with the situation predicted the airlines will try to convince a judge that the DOJ's arguments against the merger contradict each other or have little to do with the merger itself.

For instance, in past airline mergers the DOJ has argued that head-to-head competition is measured by nonstop routes and that similar routes with connecting flights don't qualify as competition to those nonstops.

In this merger, however, the DOJ is breaking from established policy by viewing US Airways' Advantage Fare flights as competitors to other legacy carriers' nonstop routes to the same destinations.

The DOJ also paints US Airways in contradictory ways, the source said. For instance, the carrier is depicted at times as an upstart maverick because it offers the discounted Advantage Fares and at other times the government argues that US Airways is an entrenched industry giant determined to stamp out any destabilizing force that prevents it from imposing fare increases at will.

The source said the DOJ's determination to preserve airlines' willingness to trade slots at Reagan National by preventing the combined American and US Airway from gaining a stranglehold assumes that airlines are currently able to enter that market, but the DOJ goes on to say that entry at Reagan National is unlikely, the source said.

Finally, the source said many of the DOJ's concerns reflect its long-standing worries about airline consolidation generally and do not spell out how the merger of the 4th- and 5th-largest carriers will make the situation worse.

Although the two airlines had plenty of indication that the government's suit was coming -- the DOJ has been making its concerns about the merger clear to the parties and the carriers had asked for a decision by Aug. 15 -- the market was caught by surprise.

Airline stocks tumbled on the news. Shares in US Airways closed down 13.07%, to $16.36 on Tuesday. UAL closed down 7.47%, to $30.73; Delta closed down 7%, to $19.55.

JPMorgan & Chase Co. analysts Jamie Baker and Mark Streeter noted that labor unions, Pension Benefit Guaranty Corp., Internal Revenue Service and Treasury all had signed off or publicly expressed support for the deal and warned that the industry's longer-term earnings prospects will be jeopardized if a standalone AMR must grow its way to competitive network parity with Delta and United.

"We expected industry capacity to accelerate and longer-term earnings prospects to be diminished in the absence of a merger," they wrote.

-- Written by Bill McConnell in Washington

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