American Airlines Group:
Destroying value? Sep/Oct 2019

Consolidation of the three US network carriers and Southwest into four dominant carriers is perceived to have restored profitability and financial stability. But five years after the takeover of US Airways, American Airlines Group (AAG) has a balance sheet net worth of less than zero. How has this happened?

AAG was formed from the merger of US Airways and American Airlines out of Chapter 11 bankruptcy protection in 2014 to create the world’s largest airline by traffic and fleet. The merger seemed to be the final stage in the consolidation of the US industry. The top three network carriers along with Southwest account for 80% of total domestic capacity, and the industry moved into significant positive earnings power for the first time since Carter’s deregulation Act of 1978.

American indeed achieved its strongest ever financial results in the first year after the merger: adjusted operating profits in 2015 of $7.3bn and adjusted net profits of $6.3bn. And in the five years to end 2018 it generated $27bn in operating profits compared with a combined total of $1bn in the 25 years between 1978 and 2013.

As background, it is worth looking at the management’s statements and actions over the past few years. At its inaugural investor day in 2017 (see Aviation Strategy November 2017) the management expressed significant optimism that it could continue to provide strong returns. It pointed to targets that it would be able to achieve pretax profits of between $3bn and $7bn through the cycle, that merger synergies would continue to accrue, and the future was rosy. It could not lose money again.

Following the merger American went through a major fleet re-equipment programme of acquiring 519 new and retiring 484 aircraft — a total of $28bn and an average annual $5.4bn in capital expenditure — that brought the fleet down to a manageable average age of 10.6 years, one of the youngest fleets in the US industry. It still has some pretty ancient equipment in the fleet — including 21 767s, 34 757s, 9 A330-300s and 47 777-200s all of which have an average age of over 18 years (see table), and the fleet re-equipment programme continues (the last remaining 30 MD80s left the fleet this year).

A major element of the fleet restructuring has been increasing aircraft sizes, seat harmonisation and reduction of complex subfleet configurations. As the graph shows, by 2020 the group will have shifted the fleet’s seat size “centre of gravity” up a level: small RJs replaced by 2-class RJs; 100-150 seat jets to 150-200 seats; and 200-250 seat widebodies to over 250 seats. This the company states results in a “more efficient fleet better suited to the network”; while by 2022 it will have reduced the number of sub-fleets by over 40% from 2016 “improving customer experience and reducing operational friction”.

After that splurge in spending, capex will be slowing over the next few years towards $2bn in 2021, which it states will allow it to generate “significant” levels of free cash flow in 2020 and beyond.

One airline

Five years on from the merger with US Airways, the group states that the integration of the two airlines is virtually complete, and management can turn their efforts to improving revenue management and margins. The company is aggressively pursuing growth at its most profitable hubs at Dallas-Fort Worth, Charlotte and Washington DC (where it respectively has 85%, 89% and 58% of total slots), “adding high margin flying to the network”. Capacity expansion at DFW is allowing it to add 15 new gates and 100 new daily departures in 2019, while it expects to have an extra 7 gates at Charlotte in 2020 and 14 up-gauged gates at Washington Reagan in 2021.

Early signs from the expansion at DFW, the company says, has exceeded expectations. In the second quarter of this year its capacity at the airport grew by 6.3% while unit revenues increased by 1.6% driving a $175m increase in revenues at the hub in the second quarter.

American has introduced other initiatives that it expects to improve revenue and margins. It has standardised the cabin configuration of the 737s at 172 seats and A321ceos at 190 seats (helping to reduce its plethora of fleet sub-types); is aiming to close a “load-factor gap” with competitors in off-peak periods; has introduced “instant upsell” allowing passengers to upgrade their seat post-purchase; introduced pre-paid bags, initially domestic only; and has introduced an automated auction process for oversold denied boarding at the gates.

At that investor day, management suggested that its strategic priorities were to complete merger integration, meet pension and debt obligations, and invest in the business. It stated that it would prepay high cost debt and would return to shareholders any cash in excess of $7bn. It implied that it was fed up with the short term attitude of the US capital markets — it stopped reporting monthly traffic, capacity and unit revenue data — maintaining that its long-term strategic focus should overcome short term negative issues. CEO Doug Parker even offered a bet of a bottle of wine to a 59 year old hedge fund analyst that the shares, then trading at below $40, would hit 60 before he did. The stock did reach $58 the following January, but has since halved in value (see chart) while those of its three main competitors — Delta, United and Southwest — have performed moderately well.

What’s going wrong?

All the major US carriers have seen their margins erode since the peak of profitability in 2015, but American’s have fallen faster. But American does not hedge its jet fuel, and its relatively high proportion of regional jet flights in its network naturally give it a disadvantage on unit cost fuel consumption. Oil touched a nadir in January 2016 with Brent Crude just below $30/bbl and since then nearly tripled to a recent peak of $85/bbl in November 2018. Analysis of the DoT Form 41 data (see table) shows that American’s system margins have fallen by nine percentage points from the peak in 2015 compared with six, four and seven points respectively for Delta, United and Southwest.

In absolute terms the greatest fall in profitability for American has been in the domestic market, declining from a run-rate of $4.5bn in 2015 to $2bn for the year to end June 2019.

Benefiting from its strong hub in Miami, and as the largest US carrier to the region, it has tended to generate good returns from its Latin American routes (see chart) and up to now at least has maintained a leading position (although it had to write off some $60m from intangible assets when the US signed an open skies agreement with Brazil in 2017).

Surprisingly, according to our analysis of the DoT data, it has made exceedingly poor returns on the Atlantic in the last three years. In the year to June 2019 it appears to have achieved an operating margin of merely 1.8% — a paltry profit of $105m on revenues of $5.8bn — down from a margin of 11% in 2015.

These figures do not take account of the Joint Venture accounting reconciliation with its partners in IAG and Finnair, but must be exceedingly disappointing in comparison with Delta’s 20%, and United’s 15% operating margin over the same period.

It is difficult to determine why this is so. But it may be that its lack of international hub presence — relative to Delta and United — in the US North East essential markets of New York and Boston and Washington preclude it from premium traffic and yield on the most important routes on the Atlantic to anywhere except London. In New York JFK It has allowed its share of slots to fall to 15% from 20% — well behind Delta (34%) and JetBlue (34%) — but capacity overall is down 7% in the number of flights and 18% in the number of seats in the past ten years.

At the same time American’s performance on Pacific routes has been lacklustre. It is the weakest operator on the region despite its joint venture with oneworld partners JAL, links with Cathay, China Southern (in which it has a modest stake) and China Eastern and its hub in Los Angeles (where it has 22% of the slots, half that of competitor Delta). It falls well behind the market leader United. It has been increasing capacity strongly in the past few years, but has recently dropped Chinese destinations out of Chicago (where it is second fiddle to United at its home base). According to the latest figures American generated a negative operating margin of 18% in the latest four quarters on the Pacific and has only generated an operating profit on the region in two out of the past twenty years.

Delta’s LatAm coup

In a strategic coup, Delta has managed to steal LatAm — the largest player in South America — from American’s influence on the South American continent. American and IAG had been trying to get an anti-trust immune joint venture with fellow oneworld member LatAm, that had recently been thwarted by the Chilean authorities. In September Delta announced it would be taking a 20% stake in LatAm, assume some of LatAm’s A350 future deliveries, and ditch its 9% stake in Gol (to satisfy local competition authorities). LatAm will presumably leave the oneworld alliance.

Delta will probably not face the same regulatory censure from Chile to the establishment of a joint venture with LatAm, and has the opportunity with this deal to propel itself into a leading position on services between the US and South America through its Atlanta hub, or at least undermine American’s strong position in Miami.

LatAm will leave the oneworld alliance, but may not join SkyTeam. This perhaps fits in with Delta’s belief that the Branded Global Alliances have passed their sell-by-date and that its model of acquiring stakes and providing management input in partner airlines is the new way forward. (For Delta’s growing portfolio of airline investments see Aviation Strategy June 2019.)

American brushed off concerns of the deal saying that the “current relationship with LatAm only provided $20m in incremental annual revenues”.

737MAX and Machinists

This year meanwhile it has two additional problems. The grounding of the 737MAX8 fleet only involved 24 out of the group’s 1,550 aircraft — it has 76 of the type on order, nine of which were to have been delivered in the second quarter — but with 7,600 flights cancelled has had a knock on effect on the network. For the moment the group has removed the aircraft from its schedules until November, and stated that the grounding had a negative impact on its second quarter results of $185m and that it expected a full year hit to pretax profits of $400m.

Secondly, it has failed to come to a new agreement with the machinists' union. Industrial relations have somewhat deteriorated with American management accusing the unions of orchestrating a go-slow resulting in a deleterious impact on operations. It received a temporary restraining order in the courts to stop the process and is awaiting a permanent injunction decision. Additionally, it saw a 15% increase in maintenance payments in the second quarter as the company increases the number of aircraft moving to power-by-the-hour contracts.

Balance sheet undermined

If this weren’t enough, the group’s balance sheet has been shot to pieces by changes in accounting reporting standards. In 2018 the group adopted the new standard of accounting for revenue from customers that among other things forced it to change the way it accounted for mileage credits in the frequent flyer programme. Previously the liability was recorded on the basis of marginal cost of providing a free flight, but this has now moved to an average fare. The result has been to add $5bn in liabilities, $2bn in deferred tax assets and a $3bn reduction in shareholder funds.

Secondly, it has adopted the new accounting policy for operating leases. The US FASB has taken a slightly different approach from the IASB (see Aviation Strategy April 2016), but it results in a $9bn addition to assets and liabilities.

The result is to give American Airlines Group a balance sheet with physical fixed assets of $44bn, debt of $30bn, and negative net assets of $22m at the end of June 2019. This latter includes goodwill and intangible assets of $6.2bn, which a sceptical analyst might exclude.

And yet in the past five years it has concentrating on returning “value to shareholders”. It has spent a total of $12.2bn repurchasing shares (financed mainly through debt) and paid out $1.12bn in dividends. Dividends are fine: they are physical. The concept of share repurchasing is that by redeeming equity you reduce the total number of shares in circulation, reduce your average weighted cost of capital (at negative real interest rates, equity is expensive), increase earnings per share from what it would have been, and therefore make the shares more attractive. The hope is that this will increase value. For AAG this hasn’t worked. At the current price of $27 a share the group has a market capitalisation of a mere $12bn, some $24bn lower than the $36bn it enjoyed at the end of 2014 equivalent to twice the amount it has spent on stock repurchases.

It doesn’t appear that Wall Street is convinced that this strategy is creating value.