AMR Corporation Is A Bargain

By Tom Sandlow Disclosure: I am long AAMRQ and fully hedged with short LCC shares and short LCC calls. (More...)

Synopsis: As a result of the terms of its bankruptcy and the proposed merger with U.S. Airways (LCC), an equity investment in AMR Corp (AAMRQ.PK) is equivalent to a series of derivatives on LCC. At current market values, AAMRQ is undervalued by approximately 40%. It is possible to create an arbitrage position that should capture this pricing differential over the next 6 months.

Background: LCC and AAMRQ have agreed to terms of a merger. The merger was approved by LCC shareholders on July 12. The merger is expected to be completed during the 3rd quarter. The primary remaining obstacle to the completion of the merger is the confirmation of the bankruptcy Plan of Reorganization (Plan). The confirmation hearing is scheduled for August 15. Under the terms of the Plan, the merged entity, American Airlines Group (AAG), will be owned by the existing LCC shareholders and the stakeholders of AMR. Specifically, existing LCC shareholders will exchange their LCC shares for a 28% ownership interest in AAG. AMR stakeholders will receive the remaining 72% ownership in AAG in exchange for their claims and equity interests in AMR Corp.

The AMR stakeholders ownership in AAG will be split amongst 4 groups: 1) Double-Dip Unsecured Creditors, 2) Single-Dip Unsecured Creditors, 3) Labor Claimants, and 4) AAMRQ holders. Double-Dip Unsecured Creditors are unsecured creditors of AMR Corp that are guaranteed by American Airlines and unsecured creditors of American Airlines that are guaranteed by AMR Corp. Single-Dip Unsecured Creditors are all other unsecured creditors of AMR Corp and its subsidiaries. The Labor Claimants represent the pensions and other employee benefits of AMR Corp and its subsidiaries.

Other creditors are not entitled to ownership interests in AAG, because their claims are being addressed through other means. For instance, secured creditors are either maintaining their contractual obligations and rights, being paid cash, or obtaining ownership of the secured assets. In any case, they are deemed to be unimpaired and will not share in the future ownership of AAG. Administrative expenses and Priority Claims will be paid in cash.

The procedure used to distribute the new AAG shares amongst the existing AMR stakeholders is set up in a manner to assure that the creditor groups are paid in full (including accrued and post petition interest) prior to the AAMRQ holders receiving more than a small portion of their expected holdings. Creditors will receive either 1) interests in a new convertible security that will convert to shares of common stock 30, 60, 90 and 120 days after the merger effective date, 2) shares in AAG, or 3) a combination of these instruments. The amount of shares received will be a function of the amount owed the creditor and the price of AAG shares at the time of the conversion/distribution of shares. AAMRQ shareholders will be entitled to the AAG shares being distributed to AMR stakeholders in excess of those required to pay the creditors in full. Due to the rapid improvement in the outlook for the airline industry since AMR's initial bankruptcy filing, the excess shares due AAMRQ holders is expected to be significant.

AAMRQ's Valuation: AAMRQ holders will receive AAG shares in 5 installments. At the effective date, AAMRQ shareholders will receive 3.5% of the new AAG. 30, 60, 90 and 120 days post the effective date, AAMRQ holders will receive an amount of shares equal to the estimated difference between the AAG ownership being distributed to the AMR stakeholders and the amount owed to the creditors. Other than the initial payment of shares to AAMRQ holders (3.5% of AAG ownership), the remaining receipt of shares by AAMRQ holders is a function of the shares required to pay the claims of the other AMR stakeholders receiving share in AAG. To the extent it requires less than 69.5% (72% - 3.5%) of AAG's ownership to meet the claims of the non-AAMRQ AMR stakeholders, AAMRQ holders will receive additional shares in AAG. In other words, AAMRQ holders will receive the excess of the AAG ownership being distributed to AMR stakeholders above that required to pay the claims of AMR's creditors.

These contractual amounts are effectively a series of options. The underlying is 72% ownership of AAG. The strike is the value of the creditor claims. Essentially, this is similar to any bankruptcy in which the equity holders maintain some ownership in the post-bankruptcy company. However, what makes this situation different is the opportunity to hedge the value of the post-bankruptcy entity. LCC equity holders will own 28% of AAG. We can use this fact to determine an expected market value of AAG. We can also use shares of LCC to hedge changes in AAG's expected market value.

Model Assumptions: Per the proposed Plan, each fully diluted share of LCC will be converted to a share of AAG. There are 209.9 million fully diluted shares of LCC outstanding. Based upon this share count being equivalent to 28% of AAG shares outstanding, AAG will have a total share count of 749.6 million shares. AMR Stakeholders will receive 539.7mm shares.

AAMRQ shareholders will receive 26.24mm shares (749.6 * 3.5%) upon the effective date. Since there are 335.3mm AAMRQ shares outstanding, this is equivalent to 0.08 shares of AAG per share of AAMRQ.

Per the proposed Plan of Reorganization the estimated claims of AMR stakeholders sharing in AAG's ownership are $7.7 billion. This value can be converted to a per share strike price by dividing $7.7 billion by the shares available to the non-AAMRQ AMR stakeholders. Non-AAMRQ AMR stakeholders are eligible to receive up to 513.5mm shares (539.7mm shares to AMR stakeholders less 26.2mm distributed to AAMRQ holders upon the effective date). Thus, the AAG strike price above which AAMRQ holders will receive additional shares is $14.995. This value is confirmed by the table in Exhibit B of June 5 filing (the table is as of May 30).

The model's valuation assumes the merger is effective August 22. This date assumes that all necessary approvals are in place by the Plan's Confirmation Hearing (August 15) and that the Plan is confirmed without any delays. However, because the holders of AAMRQ are effectively long a series of call options any delay in closing will result in an increase in the value of the options (due to their longer maturity). Of course if the delay is due to a factor that changes the expected payouts, the value of the options could be reduced.

The table below shows the value of each of the 4 options and the forward. The market values used are the closing values as of 7/26. The implied volatilities used are the implied volatilities from the $15 strike LCC call options maturing in September, October, November and December. All of these options are fairly liquid. The model indicates that as of 7/26, the value of the 4 options and shares of LCC that constitute AAMRQ are worth $8.05, but AAMRQ closed at $5.72. Ignoring the option value of these options and simply calculating their intrinsic value results in a value of $7.77 that is still significantly above the trading value of AAMRQ of $5.72.

		1st Option	2nd Option	3rd Option	4th Option	Forward	AAMRQ FV
Option Expiry		9/21/2013	10/21/2013	11/20/2013	12/20/2013	8/22/2013
Time to Expiration (in yrs)		0.1483	0.2305	0.3126	0.3948
Strike		14.99	14.99	14.99	14.99
Risk Free Rate		0.00%	0.00%	0.00%	0.00%
Implied Volatility		48.34%	39.65%	35.74%	35.44%
Delta N(d1)		0.9178	0.9137	0.9046	0.8841	1.00
Value		$4.24	$4.25	$4.28	$4.36	19.09
# of Calls/Share of AAMRQ		0.38	0.38	0.38	0.38	0.08
Value		1.62	1.63	1.64	1.67	1.49	$8.05
AAMRQ Price							$5.72
Spread							$2.33
Spread/AAMRQ							40.79%
Delta per AAMRQ		0.35	0.35	0.35	0.34	0.08	1.46
Intrinsic Value		1.57	1.57	1.57	1.57	1.49	7.77
Intrinsic Value - AAMRQ Price							2.05
							35.76%

AAMRQ can easily be hedged with a combination of short LCC stock and short LCC call options. I would anticipate such a hedge to work well over the life of the transaction. Unfortunately, the same conditions that lead to the large mispricing in AAMRQ result in significant daily P/L swings as the spread between AAMRQ's fair value and its market value fluctuate significantly.

Risks/Cautionary Notes:

• The most significant risk in the position is that the merger is not completed. This could occur for either of two primary reasons, the merger transaction does not obtain the necessary regulatory approvals (primarily US and EU airline/antitrust approvals) or the Reorganization Plan is not approved. I believe both of these are highly unlikely events. It's not clear that the investment would lose money if the transaction did not get clearance. Since the hedge of the AAMRQ holdings is to be short LCC shares, it may be the case that the decline in LCC share price would more than offset the decline in AAMRQ's price. In option lingo, a long AAMRQ position hedged with a short LCC position is long gamma. A long gamma position should make money if there is a large move in the price of the underlying. However, this assumes that a relationship still remains between LCC and AAMRQ and that is a significant assumption.
• There is a small negative rebate in borrowing LCC shares (3-4%). This cost has a minor impact on the expected returns (incorporated above). However, they also reflect the potential that borrowing LCC becomes more difficult. If borrowing shares become difficult and a hedger's borrow was called, it might result in a significant problem.