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Inside the world’s biggest airline merger

February 28, 2013, 2:10 PM UTC
AMR CEO Tom Horton in an American Airlines Boeing 777 at the Dallas/Fort Worth Airport
Photo: Nancy Newberry

Tom Horton had barely taken his first sip of tea around 8 a.m. on April 20 of last year when he received a surprise call from Doug Parker, chief of US Airways. “I’m trying to send you a letter by e-mail,” Parker told Horton, the lanky chief of American Airlines’ parent, AMR Corp., who was lounging in his Fort Worth office festooned with airline memorabilia and a framed photo of his childhood neighbor, astronaut John Glenn. “Doug was sending the e-mail from home, and he kept hitting send, but it wasn’t sending,” recalls Horton. “We had a funny e-mail exchange where I said, ‘Hey, Doug, we have good IT people who could help you out.’ ”

When he finally clicked on the attachment, Horton’s amusement dissolved into deep distress. Horton had long feared that the crafty Parker would raid American once it filed for bankruptcy, which it had done the previous November. But this merger proposal was more audacious than anything he’d envisioned. The three-page letter began: “I am now more than ever certain that, by virtue of the significant synergies created by a combination of AMR and US Airways, a combination transaction can in fact expedite rather than delay AMR’s emergence from Chapter 11 and preserve 6,200 jobs otherwise at risk.” As Horton read on, he found the terms of the proposed union astounding. US Airways, a scrappy carrier about half the size of American, would take a controlling 50.1% stake in the newly formed carrier — which strongly suggested that Parker was anointing himself, not Horton, to run what would become the world’s largest airline.

But most outrageous was the revelation that Parker had secretly negotiated deals with American’s three main unions, a gambit never before seen in an airline takeover. “We recently reached agreements with each of [the unions] that we could implement with the combination of the two airlines,” Parker stated. If the carriers merged, those “provisional contracts” would give American’s workers far better pay and work rules than the tough terms Horton was seeking in his own plan to revive the airline. It was clearly bait to get the unions on Parker’s side — and it was working. As Horton flipped through the news channels, the leaders of the pilots, flight attendants, and ground crews were lauding Parker as a savior and cheering for a merger, the faster the better. “I knew there had been some discussions, but who wouldn’t be surprised that another airline cut a deal with your company’s unions?” marvels Horton. “It was pretty exotic.”

The April letter was the opening thrust in a contentious, 10-month duel that ended on Feb. 14, when Parker and Horton finally sheathed their swords. The $11 billion union of American and US Airways will create the leading global airline, with combined revenues of $39 billion, edging United and Delta by a nose cone. Parker becomes CEO of the company, which will be called American Airlines Group, with Horton serving as chairman for no more than 12 months after the closing, slated for this fall. The deal has been portrayed as a victory for Parker, who succeeded in not only taking charge of the combined carriers but skirting a looming storm for US Airways, which faced cost increases that clouded its future as an independent airline. And his overture to labor was by any measure brilliant.

Far less appreciated, however, is the skill Horton displayed in deftly countering his rival’s attack. While Parker rallied the unions, behind the scenes Horton adroitly won the confidence of the creditors who ultimately determined the outcome; completed a sweeping restructuring plan that included new, hard-won labor deals; and scored a spectacular return for bond and stockholders, who along with employees will get 72% of the new carrier’s shares, a leap ahead of the deal originally proposed by Parker, even including the extra $1.5 billion in cash Parker had offered American’s investors. Horton’s heroics will almost certainly bring the bondholders a full 100¢ on every dollar, with hundreds of millions left over for the stockholders, who seldom get anything in a bankruptcy deal. “The recovery levels to American stakeholders is unprecedented in a major airline Chapter 11,” says Eric Siegert of Houlihan Lokey, investment banker for an influential group of creditors.

Despite kudos from Wall Street and the press, the merger isn’t as promising as advertised. The terms Parker needed to garner union support will weaken the concessions Horton pried from labor. To make the merger work, Parker will need to capture big revenue increases that are far from certain. And as virtually everyone interviewed for this story concedes, the last thing Parker wanted was Horton looking over his shoulder, monitoring his former rival’s progress in achieving those promised “synergies.”

Parker and Horton, both 51, boast similar résumés, but their personas are as opposite as Oscar and Felix in The Odd Couple, with Horton as the fastidious Felix. The future CEOs started their careers as new MBAs a couple of cubicles apart in the finance department at American in the mid-1980s. “I used to stop by Doug’s cubicle to play Nerf basketball,” says Horton. Son of a NASA executive, Horton has a slim physique and a closet full of well-tailored suits from Brooks Brothers. A devout Catholic, he huddled at a Starbucks with AMR director and fellow Catholic Phil Purcell, former CEO of Morgan Stanley, the day the merger was announced, with Ash Wednesday smudges on both their foreheads. As a manager, he’s unflappable, and a believer in careful, deliberate planning.

Parker, meanwhile, is flamboyant and charismatic, renowned for thriving on the gamesmanship of dealmaking. At age 39 he rose to head America West, then bought US Airways out of bankruptcy in 2005. His campaign to pluck Delta from Chapter 11 failed in 2007 when the unions opposed his deal and Delta chose Northwest instead. US Airways was also jilted for Continental in the second of Parker’s two attempts to merge with United. Parker took a key lesson from the Delta failure: To win a deal, the attacker must win labor’s backing.

By contrast, Horton saw bankruptcy as American’s salvation. By 2011 the iconic carrier had fallen far behind United and Delta. American’s CEO, Gerard Arpey, refused to consider bankruptcy because of the trauma it would inflict on management and employees. But in November 2011, the board voted for bankruptcy, Arpey resigned, and Horton, then president, was named CEO on the spot.

On Nov. 29, 2011, the day American entered bankruptcy, Horton phoned his old friend Parker. “I called Doug’s home by mistake and got his wife, Gwen,” recalls Horton. “My head was spinning, but I found myself exchanging chitchat about our families.” When they spoke that day, Horton explained that American was going bankrupt and that he needed to get the company’s “wings level” and was entirely focused on a restructuring within bankruptcy. Not much later, Parker called Horton back and said he’d been thinking that the airlines could do great things together. Horton reiterated his singular focus on rescuing the airline himself. Parker described Horton’s tone to Fortune as a “polite stiff-arm.”

A few months later Horton says he heard that Parker was touting a merger to Wall Street analysts. He called Parker to protest. “I was frosty,” says Horton. “I told Doug, ‘This is madness! I hear you’re already campaigning for a merger!’ ” According to Horton, Parker mainly remained silent, then said simply, “I’ll check with my people.” (“We’ve had more candid moments,” remarks Horton.) Parker tells Fortune that he was upfront with Horton and had told him in a separate January call that he was calling in advisers.

By March of last year Horton was continuing his strategy to drive deep reductions in labor costs — in particular, he was attempting to pressure the airline’s flight attendants, ground crews, and pilots to reach voluntary agreements more favorable than the terms filed with the bankruptcy courts. His proposed cuts were big: $1.25 billion in labor cost reductions, 13,000 layoffs, and an enhanced “scope clause,” which would give management more leeway for low-cost regional partners to fly shorter flights handled exclusively by American’s highly paid pilots.

Parker’s salvo on April 20 landed in the midst of these bitter negotiations. In contrast to American’s tough terms, US Airway’s secret agreements with the unions called for no pilot layoffs, about 4,000 fewer reductions in jobs for ground crews, and gentler scope clauses. The unions argued to the bankruptcy judge that American now had an alternative: a merger with US Airways, where giant revenue increases would support more generous pay and work rules, as Parker was arguing.

Horton feared Parker’s sweeteners would halt his negotiations and make a merger appear the only option to creditors. That was just Parker’s strategy, and American’s union leaders happily complied, calling for a quick deal and vilifying Horton. Decals on pilots’ flight bags protested FROM FIRST TO WORST, TIME FOR NEW MANAGEMENT.

American’s board members detested Parker’s letter and didn’t respond; they considered it more a publicity stunt than a serious proposal. Horton was angry and dismissive. “I don’t know what’s in the cactus water that the US Airways folks are drinking,” he groused (US Airways is based in Tempe, Ariz.), and said, “Parker will be about as successful with us as in his last three merger attempts.”

Horton firmly believed American could exit bankruptcy as a strong competitor, then buy another airline — possibly even US Airways. But since American’s creditors now effectively owned the airline, his first duty was to get them the best possible deal. And he saw that, right or wrong, the markets loved the idea of a merger: AMR bonds jumped from around 20¢ in December to about 55¢ after the merger proposal. Horton knew he was dealing with investors who wanted their money as fast as possible, especially now that they were sitting on big gains.

Horton’s view began to shift. To get the best deal from US Airways, and the best recovery for bondholders, American needed to show it had a strong independent plan. Specifically, Horton sought to demonstrate that American could exit bankruptcy as a robust standalone player with a big enough market cap to give the bondholders most or all of their money back on its own. To get there, it needed to work through the contentious labor agreements Parker had intended to disrupt.

Horton also needed to get AMR’s creditors on board with his plan. Two creditors’ groups were crucial: the court-appointed Unsecured Creditors Committee, an assemblage of representatives from the AMR unions, trade creditors, and trustees, and a second group made up chiefly of hedge funds that bought unsecured bonds for pennies on the dollar around the time of bankruptcy — Marathon Asset Management and J.P. Morgan Securities among them. Several of the funds formed what became known as the “ad hoc committee.” Unlike the UCC, the ad-hocs voted; nothing could pass without support from two-thirds of the bondholders, giving them the final say in any plan.

The ad-hocs didn’t officially endorse either option. But they were convinced that the standalone plan was the better way to swell the already big windfall on their bonds, so they offered to support Horton’s strategy. Importantly, Horton also persuaded them not to engage in talks with US Airways. (That didn’t stop Parker and US Airways president Scott Kirby from lobbying the ad-hocs tirelessly. According to the people they called, Parker and Kirby called the standalone plan “insane” and said that American would shrink drastically without the merger.)

Horton also agreed with his creditors to explore all possible merger options, not just that of US Airways. His choice was JetBlue, but its CEO and his close friend, Dave Barger, quickly told him his airline wanted to remain independent. That left only US Airways. “That was a big piece of information,” says Horton. “It allowed us to focus our minds on the US Airways deal and how it could be done in a way to create the most value.”

Horton and the ad-hocs pressed on with the labor negotiations. The ad-hocs warned the unions that they were willing to exit bankruptcy with no new contracts; they also told the unions that if they didn’t sign, the creditors would continue to support the bankruptcy court’s strict contract terms.

The pressure worked. In August two large ground workers’ unions and the flight attendants all approved new labor contracts. But the pilots initially voted down their deal. The pilots asked the ad hoc committee to write a letter pledging to remove the directors and management when American left bankruptcy. The committee wrote a letter promising to remove the board but declined to commit to replace management.

That letter helped attract the support needed to ratify the new contract, which the pilots approved on Dec. 7, 2012 — the final piece in Horton’s reorganization campaign. A month earlier US Airways made a new offer that raised American’s share to 70%. Both creditors’ groups backed a deal, but Horton insisted on improving the terms. “I went into war-paint mode,” says Horton.

Over the next three months he succeeded in pushing American’s share to 72% and — remarkably — guaranteeing the equity holders 3.5% of the combined market cap of the new airline, or close to $400 million. On Jan. 7, Horton spied Parker at a concert for the national championship football game in Miami. He came up behind Parker’s chair, grabbed his shoulders, and quipped, “Hey, Doug, don’t you have something you need to be working on?”

In late January, Horton attended a dinner at Patroon restaurant in Manhattan with a few of the ad hoc hedge fund managers. He offered to serve as either CEO or chairman, but it became clear he would not be CEO of the new airline. The managers wanted to pursue the easiest, fastest path to a merger and to their financial gain, and labor’s strong opposition to Horton probably doomed his chances.

In the end it was the market’s perceived enthusiasm for the deal, and the soaring bonds, that forced Horton’s hand. In a sense he was also a victim of his own success in orchestrating a sweeping restructuring. “All the value was created by the restructuring, especially those labor contracts,” says director Purcell. For his part, while Parker argues that most of the value is coming from the merger, he credits his old friend Horton with “doing a phenomenal job” with the restructuring and tells Fortune he was worried until the end that Horton would “run for the exits” and attempt to kill the deal.

But while the merger stoked confidence that the airline industry has finally reached a new era of stable, reliable profitability, that’s not at all a guarantee at the new company. The new labor contracts will substantially raise pay for union members: The merger projections contain a disturbing line labeled “labor harmonization” at a negative $400 million. Doug Parker is a master tactician and a talented manager who got his merger. But he now faces the challenge of turning it into real money — and landing this jumbo will require his deftest tactics yet.

This story is from the March 18, 2013 issue of Fortune.

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