The Deal: Stormy Skies Ahead for American, US Airways

NEW YORK (The Deal) -- Hours after the Department of Justice's surprise announcement on Tuesday, Aug. 13, that it filed suit to block the planned $11 billion merger of US Airways Group (LCC) and AMR Corp. (AAMRQ), the airlines pledged to fight vigorously to win approval. Investors and creditors of the two companies had better hope they succeed.

The DOJ, in arguing against a merger that would create the world's largest air carrier, included numerous quotes from executives at the two companies from prior to the deal's announcement saying that both airlines would be fine without a deal. But analysts say that while it is true that neither airline would be in immediate jeopardy absent a merger, neither is well positioned to compete over the long term on their own.

The airlines are not moving on to plan B just yet.

US Airways CEO Doug Parker, who would run the combined airline, on Tuesday told executives focused on integrating the two companies to proceed with their work. Sources close to the two airlines continue to hope a settlement is possible, although comments from Assistant Attorney General for Antitrust William Baer suggest a trial is more likely.

Should the airlines lose in court, AMR, the bankrupt parent of American Airlines Inc., would face the more immediate risk but the smaller US Airways would also have issues to deal with.

AMR had hoped to use the deal as a path to exit Chapter 11 protection. The company in the months leading up to the Feb. 14 merger announcement had been formulating a standalone plan as an alternative, but sources say creditors overwhelmingly favored combining with US Airways because that option allowed a better payback, as well as creating a more powerful company.

American Airlines even without a deal is blessed with large operations in major markets including Chicago, Los Angeles, New York and Miami, and has a strong alliance with British Airways plc that gives it extensive access to London's coveted Heathrow Airport. But the company would lack the scale of archrivals United Continental Holdings ( UAL) and Delta Air Lines ( DAL) -- both of which were given approval to do mergers in recent years -- and, more importantly, would have to deal with disgruntled labor groups.

Labor relations at American Airlines had been spiraling downhill for nearly a decade, and were so bad by November 2011 when the company filed for bankruptcy that pilots and other labor groups took the unusual step of endorsing a deal with US Airways over going it alone with the airline's current management team.

AMR chief executive Tom Horton was scheduled to step aside in favor of US Airways' Parker post-deal, and AMR's board would have to move quickly if the deal was abandoned to decide whether to stay with Horton, who authored the airline's standalone plan, or seek a new leader who might reboot relations with workers.

"American pilots are very antagonistic towards American's management team and appear to be determined to remove them from the picture through the merger," Raymond James & Associates managing director James D. Parker said.

Beyond reaching deals with labor, American Airlines would likely have to invest aggressively to try to compete against United and Delta, with analysts estimating the company could look to grow by as much as 20% annually by 2017. Such growth could succeed in holding down prices as regulators hope, but could also put the financial stability of not only American Airlines but the entire industry at risk.

Indeed, while Delta and United might benefit in the near term from turbulence at American, over time the DOJ decision is likely to reverberate throughout the airline sector.

JP Morgan Chase analyst Jamie Baker said a scenario in which American and US Airways each remain independent "yet overshadowed by the superior networks" of Delta and United "poses longer-term risks for investors and passengers alike." The increased capacity could diminish margins and leave airlines less able to reinvest in their business.

"In our view, a network duopoly (Delta and United) where US Airways and American increasingly need to fight for share is less desirable than a fair and oligopolized industry" with three large airlines of roughly equal size, Baker said. "We believe three is better than two, though clearly our views are at odds with the DOJ."

Some have suggested that should the merger fail, American Airlines would be better off resisting the urge to grow, and instead focus on its brand and key business routes in hopes of becoming a specialty airline catering primarily to more lucrative corporate travel. Then again, Delta and United are also concentrating on those same travelers, so such a transformation would not be easy.

US Airways, meanwhile, has labor issues of its own, with its pilots still operating under two separate contracts stemming from a 2005 merger between US Air and America West Holdings Inc. The AMR deal was seen as a catalyst for resolving festering labor problems inside the airline.

The company has actually benefited financially from keeping workers on those outdated contracts, and can argue that its smaller size and weak network relative to United, Delta, American and even Southwest Airlines ( LUV) mandates lower pay rates. But labor sources said Wednesday they believe it is time for raises with or without a deal, calling into question how long the status quo could be maintained.

US Airways' well-regarded management will have to pivot carefully to avoid an identity crisis at the airline, which risks being squeezed in between larger international airlines that primarily court business travelers and discounters such as Southwest that haul a good portion of the nation's domestic tourists.

The airline without an American Airlines deal could seek to gain scale via a merger with a smaller carrier that the DOJ might find more palatable, or could be forced to further streamline its operations and focus on niches where it can be profitable.

"The team at US Airways has done an admirable job over the years keeping the airline relevant, but that can only go on for so long," an industry consultant said Wednesday. "Absent this obvious path for growth, they have some difficult decisions to make."

-- Written by Lou Whiteman in New York

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