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American Airlines is better off flying solo

January 17, 2012: 12:00 PM ET

Airlines and private equity firms are exploring a deal with American Airlines, but its best option is to emerge from bankruptcy as an independent airline with a stronger balance sheet.

By Cyrus Sanati, contributor

american_airlines_757FORTUNE -- The sharks have started to circle American Airlines, but don't expect anything to come of it -- at least in the near term. A tie up involving American with either Delta Air Lines or US Airways makes little strategic sense at this point and would end up creating major headaches for all the parties involved. Meanwhile, a cash infusion from either TPG or another private equity firm isn't needed for the airline to work its way through bankruptcy.

It was just a matter of time before rumors would start about American Airlines being in play following its trip to the bankruptcy court in November. Delta has reportedly hired the Blackstone Group (BX) to look into a possible deal while US Airways (LCC) has hired Barclays (BCS) to do the same. Dallas-based private equity firm TPG is also apparently looking into the possibility of taking the airline private or splitting it up.

Tom Horton, AMR's new chief executive, warned employees in December that there would be "opportunists" who would threaten to destabilize the airline's attempt at reorganization. Such harsh language was meant to send a clear message to the markets: we are going to do this alone. Nothing has changed so far to alter Horton's thinking and it would probably take a lot to do so.

The rationale behind the deal talk is itself questionable. The biggest one touted in the media was that American somehow "missed out" on the airline merger mania over the last decade or so and that they need to be bigger if they ever want to be profitable. This, of course, is a total fallacy. American actually set off the consolidation craze by acquiring rival TWA in 2001. This merger created what was the largest airline in the world until Delta merged with Northwest Airlines in 2008 and United Airlines merged with Continental Airlines in 2010.

American chose to stay out of the other mergers because it was already big enough. In fact, it has spent much of the last decade paring down its capacity in order to boost its fledgling profit margins.

In fact, American has suffered because it was the first mover in the airline consolidation game. It did not attain the cost savings its rivals received when pairing up, especially when it came to labor and lease agreements. Unlike rivals Delta (DAL) and United (UAL), American acquired TWA before it was able to reorganize its cost structure in bankruptcy. That meant that American's expensive labor contracts remained intact and were then extended to all TWA employees. The airline wasn't able to renegotiate other high-priced contracts like its expensive airline leases. It was stuck paying off planes that were older and less fuel efficient.

Analysts and the media paint a picture of merger bliss if American would just pair up with larger rival Delta or smaller rival US Airways. But they seem to have it backwards. The bliss will come when American slashes its costs in bankruptcy, not if it merges. There is no evidence that airline mergers actually enhance revenue. In fact, airline travel is actually 20% less expensive than it was in 2001, after adjusting for inflation. That means that airlines have failed in their attempt to achieve any meaningful top-line growth by combining operations.

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Airlines have made money by controlling their costs and seeking additional revenue. Fees for bags, food, seat assignments and even for the cost of calling to book a ticket have helped keep many airlines in the black recently. Those fees have been instituted throughout the airline system and seem to have little to do with the consolidation craze.

To be fair, there are some initial benefits to combining operations. Merging headquarters and slashing management costs does help the surviving airline, although it can be limited. For example, United has had to hike the pay of Continental employees by 20% to 30% to entice them to move up to Chicago from Houston, a person close to the company told Fortune. The bizarre reason to remain headquartered in such an expensive city, even with tax breaks, shows that airline mergers aren't always rational.

An American combination with US Airways seems to be an especially irrational choice. Its attempts to grow its international business have been marginal at best as it operates from hubs like Pittsburgh, Charlotte, Philadelphia and Phoenix. American's network is far superior and its creditors know that. US Airways would therefore need to offer a lot of cash to sweeten any deal, something it doesn't have.

A pairing with Delta on the surface seems like a more rational choice, but there are a few major obstacles that sour the deal. First, the merger could create an antitrust issue as the two overlap in 65 nonstop domestic city-pairs. United Airlines and Continental only shared 14 domestic city-pairs when they proposed their merger, while Delta and Northwest shared even less at 12 city-pairs. That's important as antitrust regulators tend to look at city-pair concentration as opposed to overall market concentration.

On the international front, a Delta-American deal would upset the carefully balanced frequent flyer alliance system, since they are both the U.S. anchors for their respective alliances, Sky Team and One World. If one leaves to join the other it could be a big hit to passenger volume.

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And the connections that the two have with their respective European frequent flyer anchor airlines go beyond the typical partner arrangement as both have attained antitrust immunity over the Atlantic. American is effectively able to legally collude with British Airways on the lucrative New York to London route, while Delta is able to legally collude with Air France/KLM on the equally lucrative New York to Paris route. It's unclear if those contracts would continue after a merger.

In the end it will be American's creditors that will decide the company's fate. Of the nine members on the unsecured creditors committee, three belong to labor unions. The unions will likely move against management of they cut too much. But given that the cost structures at Delta and US Airways are lower, it seems unlikely that a merger would solve their money worries.

American's decision to go bankrupt with $4 billion in cash in the bank has given it enough time to weigh all its options. For now, management has 120 days to present a plan of reorganization to the court. A judge could extend that period out by an additional 18 months, so a deal, if any, is still a ways away. American will most likely emerge as an independent airline with a much stronger balance sheet. Once all cleaned up, it may be American calling the bankers to do a deal on their terms.

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