Southwest Airlines (LUV), the largest U.S. low-cost airline, has agreed to buy AirTran Holdings Inc. (AAI) for a combination of cash and Southwest shares. The agreement conforms with the consolidation trend in the airline industry.
 
This pending merger would be the third in the last two years following the oil price hike in 2008 and economic downturn in 2009. The trend was initiated with the first merger between Delta Air Lines (DAL) and Northwest in 2008. The second is the ongoing acquisition of Continental Airlines (CAL) by United Airlines, a wholly owned subsidiary of UAL Corp. (UAUA), scheduled for completion on October 1, 2010.
 
The acquisition of AirTran represents a unique opportunity for Southwest Airlines to expand its presence in key markets. Southwest will gain a valuable market presence in Atlanta, the busiest airport in the U.S. The deal would widen Southwest’s network by 25% and provide its first international destinations in the Caribbean and Mexico. Southwest will also expand its presence in key markets such as New York LaGuardia, Boston Logan and Baltimore/Washington through this merger.
 
Expansion of Southwest’ network, especially in the Northeast, may put pressure on major airlines that have well-entrenched and dominant hubs in the region. The Southwest-AirTran merger may increase fares, eliminate jobs and pose major challenges to carriers, especially American Airlines, a wholly owned subsidiary of AMR Corporation (AMR) and US Airways (LCC).
 
Although the merger has been approved by the boards of both companies, regulatory and shareholder approval is still pending. The deal, excluding debt and operating leases, is valued at $3.4 billion. Under the agreement, each AirTran common share will be exchanged for $3.75 in cash and 0.321 share of Southwest common stock.
 
The proposed transaction is expected to generate net synergies of approximately $400 million by 2013. This will also result in one-time charges in the range of $300 to $500 million. The combined company will have very few overlap routes.
 
We believe Southwest Airlines is well positioned for growth owing to its well managed costs, strong balance sheet, flexibility, network optimization, revenue initiatives and hedging activities. However, discounts on ticket prices, concerns on labor costs, fuel price volatility and investments in technology by the company keeps us on the sidelines.
 
Consequently, we are currently maintaining our long-term Neutral recommendation with the Zacks #3 (Hold) Rank for Southwest Airlines. We are also retaining the Zacks #3 (Hold) Rank for AirTran Holdings.
 
AIRTRAN HLDGS (AAI): Free Stock Analysis Report
 
AMR CORP (AMR): Free Stock Analysis Report
 
CONTL AIRLS-B (CAL): Free Stock Analysis Report
 
DELTA AIR LINES (DAL): Free Stock Analysis Report
 
US AIRWAYS GRP (LCC): Free Stock Analysis Report
 
SOUTHWEST AIR (LUV): Free Stock Analysis Report
 
UAL CORP (UAUA): Free Stock Analysis Report
 
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