AMR: Time to stem the losses Jul/Aug 2011

The $40bn of orders that American announced in July for 460 Airbus and Boeing narrowbody aircraft, aimed at “turbocharging” fleet renewal and “positioning the company for long–term success”, have not been well received in the investment community.

Many analysts have questioned how the airline can justify such spending while failing to earn returns on its existing capital base. JP Morgan analysts were quite scathing in their criticism in a July 20 research note: “When enterprises lose money by such a wide margin relative to peers, one would normally expect a material cost–reduction program and/or aggressive top–line strategy in response. We see neither in the case of AMR.” And UBS analysts were just as blunt: “This announcement represents a ton of new capital being put into a failing business model. We hope management is able to reassure the Street that profits are imminent to support this level of expenditure.”

AMR has had only two profitable years in the last decade (2006 and 2007). It incurred net losses totalling $12.2bn in 2001–2010 and is expected to lose more than $1bn in the next two years (according to Thomson/First Call consensus estimates).

AMR reported a disastrous $286m net loss for the quarter ended June 30, compared to a year–earlier loss of $11m, when all the other US major carriers remained profitable, albeit at reduced levels because of the sharply higher fuel prices. AMR also had an operating loss (1.3% of revenues) in what is typically one of the industry’s strongest quarters.

Analysts are particularly unhappy because American’s relative margin performance worsened in the second quarter – a reversal of a previous convergence trend. Bank of America Merrill Lynch estimated that AMR’s operating margin was seven points below the industry average margin.

AMR’s management have long been fond of making the point (in quarterly calls and presentations) that airlines must plan for the long term even while managing through near term challenges. The problem is that AMR seems to have focused exclusively on planning for the long term.

All of the management’s proposed remedies to the lagging financial performance bear fruit only in the distant future. The $500m in annual revenue benefits anticipated from the transatlantic and transpacific joint ventures and the “cornerstone” initiatives will not be realised until the end of 2012. The expected convergence of AMR’s and its competitors’ labour costs will take years. And now the fleet modernisation – a five–year process. Not surprising analysts could not muster enthusiasm for the orders.

So what is needed now is for the management to start managing for the near–term, with the aim of stemming the losses. That was basically the message many analysts were trying to convey to the management in AMR’s second–quarter call.

Another problem that American has had in recent times is that it does not want to cut capacity. It has been demoted from the largest US airline to number three as a result of the Delta–Northwest and United–Continental mergers. It is likely to have lost corporate market share as a result of the increased scale and strength of the merged entities. It is behind competitors in global alliance building efforts. And, because it cut capacity more aggressively than competitors a few years ago, American has been using that as the justification for needing to cut less now.

But the world does not work like that. It does not matter what happened in the past; if American is posting losses when other airlines are profitable, it probably should cut more deeply than other airlines. Prompted by the second–quarter losses and growing concerns about the global economy and potentially weakening air travel demand in the autumn, like its peers, American has announced new cost and capacity cuts. It is adjusting its autumn schedule, eliminating routes such as San Francisco- Honolulu and Los Angeles–San Salvador, temporarily suspending New York–Tokyo Haneda (through mid–2012) and closing its reservations office in Dublin. Together with its JV partners, it is in the process of evaluating the transatlantic winter schedule. These measures mean that mainline capacity will now increase by 1.9% in 2011, consisting of 5% international growth and flat domestic capacity.

In conjunction with the aircraft orders, AMR also announced its intent to move forward with the divestiture of AMR Eagle, which it first talked about a couple of years ago. More detail will be disclosed in August. The current thinking is that the regional unit will be spun off to AMR shareholders. AMR is the only one of the large network carriers that has kept most of its regional flying in–house. This has inevitably meant higher costs, so Eagle’s divestiture should lead to American securing more competitive rates and services for its regional feed.

The Airbus and Boeing orders

The deals announced on July 20 included firm orders for 460 aircraft, with deliveries beginning in 2013, and options and purchase rights for 465 additional aircraft through 2025. American has said that it considers them as two separate orders, rather than as an order split between the manufacturers.

As part of the Boeing deal, American will take 100 of the current 737NG family (starting in 2013), plus 100 of the future 737NG that will be powered by CFM International’s LEAPX engines (which Boeing is expected to formally launch this autumn). As part of the Airbus deal, American will take 130 of current- generation A320 family (also starting in 2013), plus 130 A320neos from 2017.

So American will be the first US network carrier to receive the A320neo and the first airline to commit to Boeing’s expected new 737 family offering.

These orders will enable American to rapidly renew its narrowbody fleet, to achieve the “youngest, most fuel–efficient fleet among US industry peers in about five years”. American operates some of the oldest aircraft in US fleets; its 224 MD–80s average 20+ years of age. The airline is looking to reduce its fleet age from 14.8 years at the end of 2010 (similar to Delta’s) to 9.5 years by the end of 2017.

Some commentators have argued that it did not make sense to order both 737s and A320s. But American will still be able to simplify its fleet. It will transition from four fleet types (MD–80, 737–800, 757 and 767–200) to two (the 737 and A320 families).

Significantly, American will benefit from around $13bn of committed financing provided by Airbus and Boeing through lease transactions.

This covers the first 230 deliveries. In other words, half of the aircraft will be taken on operating leases.

The details and terms of the financing are obviously strictly confidential, but the speculation is that this was simply too good a deal to miss. AMR CEO Gerard Arpey described it as “an incredible opportunity for our company that presented itself from two great manufacturers”.

Given the unique circumstances – Airbus’ strong desire to win American back, Boeing’s horror at potentially losing the exclusive relationship, etc – American was able to play the manufacturers off against each other like no other airline has before. It would have been a fool not to grab this opportunity.

American estimates that the transaction will create $1.5bn of net present value.

Of the US network carriers, American probably deserved this type of opportunity the most, because it has never been in Chapter 11 bankruptcy. When announcing the orders, Arpey reminded everyone that “we have a long track record of meeting our obligations to all of our stakeholders, including strategic partners, lenders, suppliers and investors”.

These orders will significantly increase American’s lease–adjusted debt burden in the future. AMR is already highly leveraged, with total lease–adjusted debt of $17.1bn at the end of June, and has significant debt repayments scheduled over the next few years.

However, AMR is not currently considered a Chapter 11 risk. Even JP Morgan analysts played down that possibility: “We simply don’t view an AMR Chapter 11 filing as likely or even close to likely given current industry dynamics.”

The deals give American the ability to acquire up to 925 aircraft over 12 years. With the long–term fleet plans in place, perhaps more management time will focus on sorting out the tough labour issues.