Back in February, AMR and US Airways announced their intention to merge to create the world's largest airline. The merger announcement had been preceded by a year-long courtship of bankrupt AMR by US Airways executives. Since then, leaders at the two companies have been busy drumming up support for the merger.

On Tuesday, they got a nasty surprise. While most industry observers expected a relatively smooth regulatory approval process, the Department of Justice filed a lawsuit on Tuesday (along with several state attorneys general) to block the merger entirely. Now American and US Airways will have to fight the DOJ in court. Alternatively, they may have to make significant concessions to give competitors better access to key airports like Washington's Reagan National Airport.

Merger enthusiasm
Many investors have been enthusiastic about consolidation in the airline industry, because they believe that it will make it easier for airlines to raise prices. As a result, rumors about an impending American-US Airways merger gave a boost to many airline stocks in late 2012 and early 2013. When the merger was officially announced in February, it ignited yet another big rally for airline stocks.


AAMRQ Chart

Airline Stocks One-Year Price Chart, data by YCharts

Shares of the bankrupt AMR rose more than tenfold between last August and the beginning of this week. US Airways stock nearly doubled over the same time period, after having more than doubled in the nine months before that. However, Tuesday's DOJ announcement led to a big sector-wide sell-off. AMR led the way with an ugly 45% loss.

AAMRQ Chart

Airline Stock Performance for 8/13/13, data by YCharts

Washington returns to the spotlight
The DOJ complaint highlighted two major factors. First, as I had noted in a previous article, a merger would give the combined carrier a dominant share of slots at Washington's Reagan National Airport. With 69% of the slots, the new American Airlines would be able to operate more than six times as many flights as any competitor.

The Reagan Airport slot issue could theoretically be resolved through a divestment. If the two carriers sold off 15-20 slot pairs, it would give low-cost carriers an opportunity to boost their presence there, increasing competition. It now seems likely that American and US Airways would have to give up at least this much in order to secure approval of the merger.

A bigger issue
However, American and US Airways face an even bigger issue. The biggest focus of the DOJ's complaint is the effect on nationwide airfares of removing US Airways as a competitor. Regulators point to a number of statements by US Airways executives indicating that consolidation would help the industry boost revenues.

Moreover, Assistant Attorney General Bill Baer showed that US Airways routinely offers the lowest fares in the industry for connecting itineraries: typically 40% lower than the comparable nonstop flights. US Airways fares even beat those of discount carriers in many cases.

There is relatively little overlap between the American and US Airways networks in terms of nonstop routes. However, when you include connecting itineraries, they compete on over 1,000 routes. Thus, the merger could affect a large number of consumers.

The US Airways hub structure probably explains its industry-leading fares on connecting routes. The carrier has hubs in smaller metropolitan areas than American, United Continental , or Delta Air Lines . This means that it has fewer origin and destination customers, and needs to attract more connecting passengers to fill its planes. Since American has hubs in the four largest U.S. metro areas, the combined carrier would be less likely to chase connecting traffic as vigorously as US Airways does today.

What now?
The American-US Airways merger is not dead yet. The two companies have pledged to fight the lawsuit in court. The combined carrier would only be slightly larger than United and Delta, which each had mega-mergers approved by DOJ within the last 10 years.

As a matter of fairness, it seems reasonable that American and US Airways would be allowed to merge in order to better compete. However, now that the airline industry is solidly profitable and there are fewer competitors of scale, DOJ clearly feels differently about consolidation.

Whatever happens, airline stocks are likely to experience significant turbulence as the details are sorted out in court over the next few months. From an investing point of view, though, this week's news might not be a bad thing. All of the major airlines are profitable (excluding special items), and they should be able to remain so regardless of whether or not American and US Airways ultimately merge. In the meantime, investors may get the opportunity to snap up some airline stocks on sale in the coming weeks and months.

If you're looking for the best investment opportunities in the airline industry, The Motley Fool has got you covered. Our new special free report highlights two airlines with particularly good prospects. These companies don't care whether or not American and US Airways merge. They've posted enviable profits by avoiding direct competition with other carriers. Click here to learn how these two airlines are leading a revolution in the industry, and discover whether they can keep delivering big gains for shareholders!

The article American and US Airways Get a Nasty Surprise originally appeared on Fool.com.

Adam Levine-Weinberg is short shares of United Continental Holdings and is long September 2013 $33 puts on United Continental Holdings. The Motley Fool recommends Southwest Airlines. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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