Despite a strong turnaround in 2010, fortunes of air carriers in the US seem to be dwindling once again this year, owing to the prevailing market turmoil and surging fuel prices. In the current scenario, the industry is likely to see another round of consolidation in order to regain lost profits and operational efficiency.

Delta Air Lines Inc. (DAL) is expected to emerge as the strongest consolidator in the industry as it is on the look out for accretive acquisitions. On the other hand, American Airlines, a wholly owned subsidiary of AMR Corporation, has filed for bankruptcy protection in November last year and is looking for a suitable partner to merge with.

Thus, we see several combinations are on the way at present. Let us discuss each of them.

Delta and US Airways Combination

Delta Air Lines is seeking to buy US Airways Group Inc. (LCC). Delta is working with Goldman Sachs Group (GS) and The Blackstone Group (BX) as a financial advisor to assess and determine whether US Airways would be a strategic fit for the company.

The second largest U.S. airline has not placed any bid for US Airways until now and we expect the deal to be in the initial stages.

Delta and AMR Combination

A Delta-AMR combination would bring together the second and the third largest U.S. airlines, and will surpass United Continental Holdings Inc. (UAL) as the busiest airline serving the Hawaii market. Industry experts believe the combined entity will have limited hubs overlapping.

We believe the move will be a positive for Delta Air Lines. The company will unlock more opportunities for travelers in the West Coast as well as gain hubs in the key markets of Miami, Dallas and Chicago. Further, Delta will increase the number of flights in Latin America, where American Airlines has a strong presence. Moreover, Delta is progressing toward strengthening its footprint in New York, one of the major hubs of American Airlines. We believe that the merger with AMR would help in gaining further market share in the region.

Delta Air Lines has hired Blackstone as a financial advisor to assess its bid for American Airlines.

Merger of LCC and AMR

The merger between LCC and AMR is tipped to be the hottest pairing in the industry with respect to customer demand. Both the companies are struggling to remain competitive amid steeply rising fuel prices and a weak travel demand environment. US Airways, the fifth largest U.S. airline, has long-standing problems with its pilot union. American Airlines also remains challenged due to high labor costs and a debt-heavy balance sheet.

We believe the AMR-LCC merger deal could change the competitive dynamics of the airline industry. US Airways has been looking for a merger candidate following its bankruptcy protection filing in 2002. The company had earlier failed to acquire Delta, when the latter went bankrupt in 2006. As a result, US Airways might cash in on American Airlines’ bankruptcy and take over its larger rival.

According to sources and airline experts, any AMR bid will take several months or a year to materialize as the carrier is yet to complete its court restructuring process and will undergo an antitrust scrutiny. Effective early this year, the shares of American Airlines have been de-listed from the New York Stock Exchange.

Pairing TPG and AMR

The TPG review is in the early stages as the company is still to decide whether it will make an outright purchase or simply purchase a stake in AMR.

CONSOLIDATION – A SUCCESS STORY

Back in 2008, when air carriers were struggling with the oil price hike followed by the economic downturn in 2009, they underwent a consolidation to restore their profitability. The consolidation set in when Delta Air Lines’ successful acquired Northwest Airlines in 2008. The merger enabled Delta to become the second largest airline in the world, generating significant cost savings for both.

In 2010, United Airlines merged with Continental Airlines and formed a new company, United Continental Holdings. This merger created the world’s largest airline, overtaking Delta Air Lines. The third merger was between Southwest Airlines (LUV) and fellow discounter AirTran Holdings, which was completed in May 2011. Following Southwest gained valuable market traction in Atlanta, the busiest airport in the U.S. In addition, the combination provides unique opportunity for Southwest to expand its presence in key markets.

At present, Delta is considering acquisition bids for US Airways and AMR Corp. On the other hand, US Airways and a private equity firm TPG are mulling take over of American Airlines.

The three-mega mergers helped the industry to reduce competition and raise prices. We believe the upcoming consolidation will assist the industry to navigate through the current tough times and brings overall profitability.

We are currently maintaining our long-term Neutral recommendation on Delta Air Lines. For the short term (1-3 months), both Delta Air Lines and US Airways retain the Zacks # 3 (Hold) Rank.

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