American Airlines and US Airways Merger: Analysis

Background

In early 2013, the merger between US Airways and American Airlines became official, and by April 2015, the final regulatory hurdle — FAA approval — had been cleared (Maynard, 2013; Holmes, 2015). The merged airline had significant strategic implications, including US Airways leaving the Star Alliance (Maynard, 2013). The implementation timeline at the time the deal was announced was expected to take between 18 and 24 months, and that time frame remained valid — FAA approval was a precursor to the final operating merger between the two airlines.

The deal announced in early 2013 was yet another in an ongoing round of consolidations within the US airline industry. It was worth $11 billion and was structured shortly after American emerged from bankruptcy proceedings (Isidore, 2013). American was losing market share prior to the deal, and US Airways was vulnerable as one of the smaller domestic carriers, so there was clear strategic logic behind the transaction. The new airline would use the American Airlines name and would be majority-owned by American's creditors (BBC, 2013).

Both companies were among the old legacy carriers in the United States. American was founded in 1930 and US Airways in 1939. The merger came against the backdrop of industry consolidation that had reduced the number of competitors, along with a challenging operating environment that made turning consistent profits quite difficult. These consolidations were restructuring the airline industry, which had long suffered from overcapacity. The restructuring had the effect of reducing total industry capacity, which in turn was making airlines more profitable in the years leading up to the merger.

The two companies operated in the same business but were complementary in scope. Airlines typically operate routes through their own hubs, and between the two companies there were at least half a dozen hub airports. Routes are a key distribution channel and are subject to negotiation with airports; landing rights can be expensive at major facilities. Air travel is a perishable good, so an unsold seat represents a cost for which revenue will never be recovered. It is therefore important that airlines fill as many seats as possible — an industry metric known as load factor. Other key industry metrics include revenue per passenger mile flown, which evaluates how well an airline converts customers into actual revenue, and whether that revenue is sufficient to cover the industry's high fixed costs.

The point of the merger was to rationalize capacity. By doing so, the combined airline expected to achieve greater efficiency across its networks, resulting in higher load factors. Further, as the industry consolidated generally, much of the overcapacity that had plagued airlines would be eliminated, allowing carriers to charge higher ticket prices and remain consistently profitable. Rationalization also occurs in back-office functions such as marketing and ground operations, where the airline could improve its scale. The synergies expected from this deal centered on increasing load factors by funneling passengers from the US Airways route network onto American flights and eliminating duplicate routes that the two airlines had flown at roughly the same times. Further operating synergies were also anticipated over time, and the combined entity was expected to be more profitable than either predecessor as a result of these efficiencies.

The context of the two companies is also relevant. American Airlines was once the largest airline in the country, but its market share had been slipping consistently in recent years. In 1977, prior to deregulation, the industry was more heavily fragmented and American held a 12.6% market share, ranking second. By 1992, it had become the market leader with 20.4%, but began a downward slide from that point. By 2005 it was still the number-one airline, though with a reduced 17.5% share. Just seven years later, as it emerged from bankruptcy, its share had fallen to 12.9%, placing it fourth behind Delta, United, and Southwest (Rodrigue, 2015). The bankruptcy was brought about largely by adverse industry conditions and the legacy costs associated with pension plan obligations. American was essentially uncompetitive because it carried significant obligations it could not meet through operations while remaining price-competitive. Other legacy carriers had already used the bankruptcy process to restructure their costs, putting American at a competitive disadvantage — one of the key reasons its market share had been declining (Isidore & Ellis, 2011). The company entered bankruptcy proceedings but emerged as a smaller competitor with a mandate to reclaim its dominant market position while its brand remained strong. The merger would allow American to regain some of the scale it had lost since 2005.

US Airways was always one of the smaller major airlines. Its market share at the time of the merger is estimated at just over 8% by multiple sources, a figure consistent with confirmed data showing a 2014 share of 8.2%, compared with American's 12.4%. The combined company would therefore become the largest airline in the country, surpassing market leader Southwest, which held a 17% share (BTS.gov, 2015). US Airways ranked fifth in the market, and the two airlines behind it — JetBlue and Alaska — were gaining ground. US Airways was thus competitively and financially vulnerable. The merger had long been rumored, apparently delayed primarily by legal issues surrounding the American Airlines bankruptcy.

Industry Analysis

The modern era of US airlines began with deregulation in the late 1970s, a move that brought substantially more competition to the marketplace and dramatically increased industry capacity. The resulting environment was intensely competitive, with at least ten major carriers. The outcome was predictable: overcapacity and a persistent inability to turn a profit. Airlines have high fixed costs and must fill capacity as fully as possible in order to cover them, because planes cost money whether or not they carry passengers. The imperative for profitability is to align supply with demand, and for decades supply far exceeded it. In addition, older airlines typically carried defined-benefit retirement plans that were a persistent drag on fixed costs. Retirees were living longer, healthcare costs were rising sharply, and the new competitive environment meant airlines could not generate enough revenue to pay these benefits — many of which dated to union agreements from the pre-deregulation era when airlines were significantly more profitable. American reportedly shed upwards of $1 billion in pension obligations through its bankruptcy (Johnson, 2011).

The industry accordingly engaged in successive rounds of consolidation in order to reduce capacity and create larger, more efficient operations. This merger was just one of many in that process. The airline industry also saw several bankruptcies in the years leading up to American's: the 9/11 terror attacks, persistent high fuel prices, and the Great Recession all took their toll on airline profitability, prompting many carriers to seek bankruptcy protection in order to restructure their finances. American's bankruptcy was another instance of this trend. The merger was therefore well in line with industry norms and surprised virtually no one. The strategic fit was sound, and regulators had little reason for concern about a combination of the fourth- and fifth-largest carriers in a market that was not highly concentrated. The Herfindahl-Hirschman Index (HHI) rose from approximately 1,081 prior to the merger to 1,284 afterward — in both cases indicating a moderately concentrated marketplace (Investopedia, 2015), based on back-of-the-envelope calculations.

Conclusion

The merger between American Airlines and US Airways was predictable; the only real sticking point was timing, given the complications of the American Airlines bankruptcy. That company's owners — its creditors — needed to extract value from a declining airline. After it emerged from bankruptcy, the deal with US Airways proceeded. American paid a healthy premium, but strategically the combination made considerable sense. US Airways was operating a financially sustainable business but was not growing, and its position as the fifth-largest carrier in the country showed little prospect of improving. It was a natural takeover target.

The deal had two primary objectives. The first was to recoup value for the AMR creditors, and it achieved that goal. The combined entity, which carried a market value of $2.9 billion at the time of the deal — much of it speculative — subsequently reached a market capitalization of $47 billion. Even discounting some market exuberance, that figure represents an exceptional and rapid return for the creditors. On the operational side, American realized substantial synergies with US Airways even before the full integration was complete. The combined entity achieved a significant increase in revenue as the largest US airline, and American recorded a profit for the first time in years. The deal benefited from favorable tailwinds — the industry shedding excess capacity and a period of lower fuel price volatility — but overall the merger has clearly been both a strategic and financial success for all parties involved.