American: Amazing turnaround, tough integration hurdles to come June 2015

American Airlines Group (AAG), the world’s largest airline by traffic, has staged a surprisingly strong financial recovery since the closing of the AMR-US Airways merger and AMR’s exit from Chapter 11 in December 2013. The new American has not only closed the profit gap but is reporting operating margins that are vastly superior to Delta’s and United’s margins (albeit because of AAG’s lack of fuel hedges and profit sharing).

There is excitement about American’s prospects for a number of reasons. The group has a competitive cost structure. The stronger combined network is attracting more corporate contracts and higher volumes of business traffic. And the synergies from the merger are likely to build up rapidly from 2016. Analysts expect AAG to achieve the highest profit margin gains among the top three US carriers in the next several years.

The fact that American’s shares (AAL) were admitted to the S&P 500 Index in March, becoming only the third airline to receive the honour (after Southwest and Delta), was testimony to how far American has already come.

But American still has the toughest hurdle in merger integration ahead of it: a move to a single reservations system. Will it be a smooth and successful cutover, like Delta-Northwest’s, or more like the highly disruptive event that United-Continental experienced? UAL’s switchover in 2012 resulted in months of widespread flight delays and cancellations, business customer defections and an adverse profit impact.

Another challenge American faces this year is that it is heavily exposed to LCC growth hotspots: Southwest’s long-haul expansion out of Dallas Love Field and Spirit’s entry and rapid growth in many of American’s markets. American is therefore seeing greater PRASM pressures domestically than its peers.

In recent months many US airline stocks have been punished by sudden concerns by investors that the domestic industry capacity discipline is faltering, which analysts have argued is not the case. Because American has been on the frontline of the battles with LCCs, its stock has taken a mighty beating. As of June 23, AAL’s share price had fallen by 20% since the beginning of the year.

As a result, American has taken some action to appease investors and to ensure continuation of capacity discipline. It has modestly scaled back capacity growth plans and delayed some aircraft orders. Of course, since American continues to be highly profitable and has promising prospects (if it can avoid the merger integration pitfalls), most analysts continue to recommend the stock as a “buy”.

Another thing that the financial community will be watching for is how American allocates the significant free cash flow that it will be generating. Currently its priorities are to complete merger integration, renew the fleet, pay down expensive debt and invest in the product, but American is also already returning capital to shareholders in the form of share buybacks and dividends.

Turnaround story

AMR incurred adjusted net losses totalling $11.2bn in 2001-2012. US Airways lost $1.3bn in 2008-2009 but was otherwise profitable since 2006 (following the September 2005 closing of the US Airways-America West merger, which pulled US Airways from Chapter 11 and created an AWA-managed nationwide carrier).

But the AMR-US Airways combine began earning healthy profits even before the closing of the merger. The initial results were diluted by huge extraordinary charges related to the merger and restructuring, but excluding such items each quarter saw progressively stronger profits.

While AAG reported a GAAP net loss of $1.8bn for 2013, on an ex-item basis it had a $1.9bn net profit (mainly AMR results; US Airways only included for 22 days). In 2014, the first year of fully consolidated results, AAG had a GAAP net profit of $2.9bn and an ex-item net profit $4.2bn. The latter accounted for 9.8% of revenues.

The table right summarises the 2014 operating results by region. While Latin America was pushed into losses by the adverse economic conditions there, the Pacific recovered from previous losses and posted a good profit. The Atlantic, where American operates under the antitrust immunised agreement with BA, was outstanding: a profit margin of 22%.

The latest quarterly results illustrate how American is now outperforming its network peers. In the three months ended March 31, AAG achieved a 15.5% operating margin, compared to Delta’s 8.8% and UAL’s 9.4%. A year earlier, AAG’s operating margin was only 4.1% — behind Delta’s 7.8% but better than UAL’s negative 3.4% margin.

It must be noted, though, that the AAG-Delta margin differential in Q1 was entirely due to differences in employee profit sharing and fuel hedging. American has neither, while Delta reported $1.1bn of “settled hedge losses” and $136m in profit sharing payments for that period.

According to JP Morgan analysts, the absence of profit sharing “remains contractually sustainable until the decade’s end” at American. In contrast, Delta has a generous profit sharing programme that paid out $1.1bn to employees for 2014 (16% of their pay). The other two of the top four US carriers, UAL and Southwest, also have profit sharing programmes.

As regards fuel hedges, AAG’s mostly ex-US Airways top management shed all of AMR’s fuel hedging positions soon after the merger, to bring the carrier in line with US Airways’ no-hedging policy. AAG could reap $4bn of fuel cost savings in 2015, though those will be partly offset by higher non-fuel costs.

American is seeing greater non-fuel cost inflation than its peers in 2015 and 2016 because of the new joint labour contracts. The pilot and flight attendant deals that are already in place are expected to lift non-fuel CASM by 3-5% in 2015. But some of that will be offset by continued fleet renewal and aircraft upgauging.

Interestingly, American may not have a pilot cost disadvantage much longer. Delta’s recently concluded pilot deal is believed to raise pay rates by around 8% to restore parity with American’s.

This year American is seeing revenue pressures in both international and domestic markets. Internationally, there are headwinds related to FX, fuel surcharges and Venezuela. As the dominant US carrier serving Latin America, American is also severely affected by the currency devaluations and economic problems in that region, including a significant weakening of demand and PRASM on the Brazil routes.

Domestically, there are the new competitive challenges from Southwest and Spirit, as well as tough year-on-year PRASM comparisons through mid-2015.

Since the full expiry of the Wright Amendment in October 2014, Southwest has been aggressively adding long-haul flights out of Dallas Love Field, its home base. Its daily departures from Love Field have increased from 118 last year to around 180 this August. The super-low introductory fares on a large number of new routes have created enormous pricing pressure for American at its nearby DFW hub, which accounts for more than 10% of AAG’s revenues.

American has also blamed some of its PRASM weakness on increased competition from Spirit. It is not entirely clear why American feels the need to match Spirit’s fares, because it cannot really be interested in the type of traffic that a ULCC attracts. In any case, that fare-matching has to be on a very limited scale, so the PRASM impact cannot be significant.

The good news is that US domestic demand remains healthy, the year-on-year PRASM comparisons will ease after Q2, another round of capacity growth reductions by the top three carriers is expected later this summer, and the worst of the Love Field effects should dissipate by 2016.

American has taken several actions in recent months to trim capacity growth plans. In April it reduced this year’s planned ASM growth from 2-3% to 2% (the growth will be through increased stage length and upgauging). Subsequently, it delayed five 787 deliveries from 2016 to 2017-2018. American is known to be considering further growth rate reductions for the upcoming winter season.

In mid-June American deferred deliveries of 35 A320neos from 2017-2018 to 2021-2023 — a move that will improve flexibility to control capacity levels in those years. Like its peers, American appears interested in holding onto older aircraft longer now that fuel prices are at a lower level.

The fuel price windfall will mean American reporting an operating margin in the high-teens for 2015. The airline’s own estimate as of May 11 was 17-19%.

Integration milestones

2015 is a critical year for American in terms of merger integration. Two key milestones have already been achieved: combining the two FFPs (late March) and obtaining a single operating certificate from the FAA (early April). Integration has so far gone smoothly and on schedule.

Next will be the historically most challenging step: the reservations system cutover. American has had the advantage of being able to learn from the other carriers’ mistakes; also, many members of its current management completed a similar integration at US Airways-America West.

American’s plan includes several refinements. First, the reservations switchover will be done over a 90-day period (and separately from the merging of FFPs), contrasting with United’s decision to do everything (FFP, reservations) on a single day. Second, US Airways will be moved to the much larger AMR’s Sabre platform (contrasting with the strategy at United-Continental). Third, American is emphasising staff training, which it sees as a larger obstacle than the IT integration.

So American intends to begin combining the reservations systems in July and to complete the process in October, after which all bookings will be through American’s website and the US Airways brand will cease to exist. There could still be problems but those would be on a more limited scale.

American was fortunate to secure the key labour deals early in the integration process. New five-year joint collective bargaining agreements with pilots and flight attendants became effective in January. This was possible because American’s management recognised that, in light of the history of contentious labour relations at both AMR and US Airways, the only way to clinch joint contracts would be to build trust and restore pay rates.

The management made some special gestures. For example, they agreed to restore the $81m of pay rises that the flight attendants lost when they narrowly voted down an initial contract proposal in November and faced a less favourable deal imposed by arbitrators. That gesture may have paved the way for a good working relationship. The flight attendants now have the highest hourly rates among network peers.

The deal with the pilots (immediate 23% pay rise and 3% annually in 2015-2019) provided industry-leading base pay but left total compensation below Delta’s. The pilots had sought profit sharing but the management had refused.

Some of the pilot contract issues (including work rules) still need to be addressed. The often tricky issue of seniority list integration will be settled by arbitration; there are hearings scheduled in June-October and the deadline is December 9. American also still needs to reach joint contracts with other groups representing 50,000-plus employees.

While full behind-the-scenes integration, including that of flight operating systems, will take another couple of years, having a single reservations system will unlock a lot of opportunities, especially on the revenue side. One example is full codesharing. American can also start investing in its product and systems — something that has been on hold since December 2013. For example, American would have liked to make changes to its FFP and further unbundle its product — enhancements that competitors have made — but none of that is feasible until systems integration is completed. So American will have many additional revenue tailwinds in 2016 and 2017, and the original $1bn annual synergy target seems likely to be exceeded.

Capital deployment plans

Being the latest carrier to complete Chapter 11 restructuring and a merger, American’s spending priorities are different from Delta’s and United’s. At the company’s annual shareholder meeting in early June, CEO Doug Parker confirmed the two most important priorities: buying new aircraft and paying down high-interest debt.

Despite the Chapter 11, AAG carries a relatively high debt load. Because of continued significant aircraft deliveries, its total debt has increased in the past 18 months. That contrasts with Delta’s, and to a lesser extent UAL’s, efforts to reduce debt in recent years.

Although American is not expected to start reducing its total debt soon, it is reducing debt that carries high interest rates. It has paid off some $3bn of such debt since December 2013, from cash reserves or through refinancings, taking advantage of low interest rates. American has also completed several EETCs to lock in low-cost, long-term financing for large numbers of new aircraft deliveries.

American is in the middle of a massive re-fleeting effort that will see deliveries of 60-75 mainline aircraft annually over the next several years. According to a late April filing, in 2015 AAG is taking 75 mainline aircraft — seven A319s, 35 A321s, 18 737-800s, two 777-300ERs and 13 787-8s — and retiring 103 aircraft (nine A320s, 38 757s, six 767-200s, seven 767-300s and 43 MD-80s).

Fitch Ratings noted in a late-2014 report that AAG’s total capital spending would be about $5.5bn annually for the next several years, compared to UAL’s $3bn and Delta’s $2-3bn (all similarly sized airlines). But Fitch, like the rest of the financial community, accepts that AAG’s re-fleeting efforts are necessary; after all, in March the fleet still included 132 MD-80s, which have an average age of over 22 years. The upgrade from MD-80s to 737NGs and A320s will also see CASM benefits through a higher seat count.

On the widebody front, American has firm orders for 42 787s (plus 58 purchase rights) and has just deployed the type internationally, initially to Beijing and Buenos Aires. The airline will be taking both 787-8s and 787-9s. It still has three firm orders for the 777-300ER, which will bring that fleet to 20 units by the end of 2016. Deliveries of the 22 A350 XWBs will begin in 2017.

But American’s cash flow generation has been so strong that it was also able to start returning capital to shareholders just seven months after exiting Chapter 11. The company introduced a $1bn share buyback programme and brought back dividends in July 2014. The buybacks were completed a year ahead of schedule, so in January AAG put in place a new $2bn programme that it hopes to complete by the end of 2016.

By Heini Nuutinen