American: Playing the
long game November 2017

September 28 marked an important event for US airline analysts and investors: American Airlines Group (AAG), the world’s largest airline by traffic, held its first investor day since the closing of the AMR-US Airways merger and AMR’s exit from Chapter 11 in December 2013. What were the key messages?

First there were the typical investor day comments: American’s executives said that they were “incredibly excited and bullish” about the airline’s future. They talked about plans to create substantial value for shareholders. And yes, the stock is grossly undervalued.

But the event had an unusual theme: “Playing the long game”. CEO Doug Parker and his team declared that they were focusing on the longer term and also tried to persuade analysts and investors to shift their thinking. Wall Street’s focus on short-term metrics such as monthly RASM has been a source of frustration for US airline managements in recent years.

Also noteworthy was Parker’s remark that he does not think American will ever lose money again (he muttered it, as opposed to saying it arrogantly). American expects to earn at least $3bn in pretax profit even in the worst years, with the peak years bringing in as much as $7bn.

Parker described the post-2013 era of higher profitability at American as the “new world”. He urged everyone to make the “leap of faith”, which he defines as “understanding and appreciating that this industry and our airline have been materially and permanently transformed”. The old world was about survival, the short term, “burning the furniture” and “managing through intimidation”. The new world is about thriving, the long term, investing in the future and “inspiration through leadership”.

American’s management laid out four long-term strategic objectives that reflect the new philosophy: build a world-class product; drive efficiencies; make culture a competitive advantage; and “think forward, lead forward”. The latter refers to adoption of new technology that improves passengers’ experience or makes it easier for employees to do their jobs.

As a result of efforts to build trust with employees, American is seeing a significant increase in labour costs. However, American has also identified $3.9bn of revenue and cost opportunities in the next four years that will offset some of the cost pressures. That includes $1bn of cost savings in part related to the merger and $2.9bn of “commercial projects”, of which the most important ones are the Basic Economy and Premium Economy product offerings.

On a positive note, as American’s fleet renewal programme nears completion and capex needs decrease, the airline expects to turn its attention to deleveraging the balance sheet.

Perpetual profitability?

In 2011 when he was at US Airways, Doug Parker was the first US airline CEO to argue, to a mostly sceptical audience, that things had changed permanently for the US airline industry. Among analysts, JP Morgan’s Jamie Baker was an early proponent of the idea that airlines had evolved into a “viable, long-term business where adequate returns on invested capital can confidently be anticipated” (Aviation Strategy, Jan/Feb 2013).

Six years on, the idea has become more widely accepted. 2017 will be the eighth consecutive year of healthy profitability for the US airline industry. Delta, which led the US legacies’ profit recovery (because it was the first to restructure and complete a merger in 2008), is now achieving financial metrics that rank among the top 10% of S&P industrials.

The reasons for the legacies’ changed fortunes are well documented: a decade of restructuring; many Chapter 11 visits, extensive consolidation, lack of new entrants, years of tight capacity discipline, lucrative new ancillary revenue streams and return-oriented management teams. Two additional factors have come to play in recent years: sharply reduced fuel prices, and continued strong domestic air travel demand.

However, US investors still worry that the industry could slip back into the bad old ways. Every time there is a mere hint of an airline stepping up capacity growth, a competitive skirmish developing at some hub or RASM growth not meeting expectations, airline share prices plummet.

American faces the additional challenge that it has only reported healthy profits since 2013, because it was the last of the legacies to restructure and complete a merger. Since then American has overtaken United but has not closed the operating margin gap with Delta.

But American’s post-2013 profits are impressive. According to the investor day presentation, AAG has earned $19.2bn in aggregate pretax profits in the past four years (including a consensus estimate for 2017), which compares with a mere $1bn pretax profit achieved by American and US Airways on a combined basis in the 35 years from 1978 to 2013.

The surge in profits in 2014-2017 could be interpreted as just another (albeit bigger) peak in the cycle, but to Parker it represents further proof that American has transformed itself. He expects American’s pretax profits to fluctuate in the $3bn-$7bn range and average $5bn annually. The management incentive compensation plan has been set around those targets.

Parker argued that if the management is correct about American’s prospects, the company’s NPV is well above the current levels. He suggested that the share price should be “at least $75” or 63% higher than the $46 price that day.

Parker also felt that Wall Street had wrongly labelled developments such as United’s decision to fight ULCC Spirit in Denver as “bad behaviour”. “There is nothing unusual about an airline adding capacity at its hub if it feels it does not have its [fair] share”, he said, adding that it is low-risk growth since an airline has a competitive advantage at its hub. Also, he made the point that it was entirely rational for supply to increase when the cost of production declines (such as when fuel prices fall).

US airlines stocks have been heavily punished for such misunderstandings this year. At the end of October, the NYSE Arca Airline Index was down 3.8% year-to-date. American’s share price beat the Index slightly in that it was up 1.1% in the first 10 months of the year.

Although American’s share price rose in the two weeks after the investor day, the gains were wiped out during the airline’s Q3 earnings call on 26 October. The results were better than expected, with the RASM performance and outlook being particularly strong, but investors reacted badly to news that American may grow its system ASMs by 2.5% in 2018 on a flat fleet count.

The share price correction prompted JP Morgan to upgrade American from neutral to overweight and increase its year-end 2018 price target from $53 to $65. The analysts noted Parker’s prediction that RASM growth would outpace ex-fuel CASM growth in 2018, giving them “reasonable confidence in normalised margin growth”.

One problem bothering some investors is that, despite continued healthy GDP growth, US airline profits are declining this year and 2018 also looks lacklustre for American. Analysts’ consensus estimates at the beginning of November see AAG’s adjusted net profit declining from $3.2bn in 2016 to $2.3bn this year and remaining at that level in 2018.

AAG earned adjusted pretax profits of $4.2bn, $6.3bn and $5.1bn in 2014, 2015 and 2016, respectively, on the basis of which the $5bn “average” year projection looks very reasonable. However, American now faces three leaner years, with profits fluctuating between the “worst year” and “average year” levels, despite a strong US economy.

Shifting focus to the longer term

Some investors may feel that, given the lacklustre short/medium term prospects, it is in American’s interest to try to shift focus to the longer term. But such a move has many benefits and it may even start a trend in the US airline industry.

American has stopped reporting monthly traffic and is guiding to quarterly and annual expectations. Starting in 2018, it plans to lay out “long-term, clear financial objectives” and provide three years' guidance for both fleet and unit costs.

Among the North American carriers, Air Canada, too, has stopped reporting monthly traffic. More airlines could well follow suit.

Culture is critical

American reached new joint agreements with its work groups quickly (though the deal with the mechanics was on an interim basis), because the management recognised that, in light of the history of contentious labour relations at both AMR and US Airways, the only way to agree joint contracts was to build trust and restore pay rates.

But even with the labour deals in place, building trust has been difficult. Since American’s management believes that a good employee culture is critical for a service-oriented company, it has gone to extraordinary lengths to build trust with employees.

In 2015 CEO Parker gave up his contract (and associated benefits and protections) and switched to working on the same “at will” basis as the airline’s employees. Subsequently he gave up his salary, opting instead to be paid only in stock. In March 2016 American unilaterally instituted a profit-sharing programme. And in April 2017 American offered a mid-contract pay increase of up to 8% to its flying personnel.

The mid-contract pay increases, which sent shockwaves through Wall Street as they will cost American an additional $230m in 2017 and $350m in both 2018 and 2019, were unprecedented in the airline industry. But the reasons are easy to understand. Since American signed its post-merger contracts, Delta’s pilots have seen their pay soar under a new agreement, and United’s pilots (thanks to a snap-back provision) have seen their pay automatically match Delta’s. Parker said that American’s workers were so far behind Delta’s and United’s and the contract terms were still so long (until 2020) that “it did not feel right for us to continue to leave that gap in place.”

American’s move will not cause any pay escalation at Delta or United. Parker also told analysts: “If any of you are building models that are based upon American having some sort of labour cost advantage over a sustainable period of time, I encourage you to change your assumptions”.

In another first for a legacy carrier, American wants to make culture a “competitive advantage” (think Southwest Airlines). It will not be the easiest thing to measure (employee surveys, engagement scores and attrition rates are possible tools), but the management prefers to frame it as an “investment” in frontline employees that will help revenue generation. The planned $2.9bn commercial initiatives will not materialise in full if the workforce is not truly motivated. Therefore American believes that its new labour philosophy is in shareholders’ best interest.

Serving all segments

American’s management made it clear that even as the airline is intensely focused on providing for the premium sector, it will also fight tooth and nail to keep its share of the most price-sensitive travellers.

The management believes that attributes such as the world’s largest network, strong JVs and alliances, leading loyalty programme, powerful hubs and the huge domestic market make American uniquely well positioned to serve every type of customer. They waxed enthusiastically about the benefits of the hub-and-spoke business model in fending off ULCCs.

Past efforts at segmenting the market were too simplistic, left many gaps and did not provide what passengers wanted. Now American feels that it has a product offering for every point along the demand curve, including two powerful weapons called “Basic Economy” and “Premium Economy”.

Basic Economy is an unbundled, still superior product offered by the US legacies at the same price as the ULCCs’ economy product. Pioneered by Delta, it has also been introduced by United and American in the domestic market this year. American had it available across the continental US by early September and has described it as a “game changer”.

The early indications are that American’s Basic Economy has been more successful than United’s, because the latter introduced it too quickly and made it too restrictive (for example, not allowing upgrades). About half of American’s Basic Economy customers are upgrading to the higher main cabin fare, which allows carry-on bags etc, so the move is definitely paying off financially. That said, American has not yet decided whether to expand the Basic Economy offering internationally to tackle LCC competition in markets such as the transatlantic.

Internationally, American is seeing a revenue benefit from its Premium Economy offering, which was introduced in October 2016 on the 787-9s and is now being added to the existing 777/A330 long haul fleet by the end of 2018. The project is still in its early stages but American is seeing “great results” with a premium of 50% on the economy fare.

American continues to make significant investments in its highest-end product offerings (Flagship Business and Flagship First), as well as further develop products that fill a gap on the demand curve, such as Main Cabin Extra (better legroom at the front of the economy cabin, preferred boarding for a fee).

These segmentation moves are a key part of American’s plan to maintain overall revenue outperformance and offset cost increases. In the past four quarters American has led the industry in terms of unit revenue improvement and the management expects that to continue in 2018.

Driving efficiencies

American is still integrating after the merger. The $1bn further opportunity from “Project One Airline” in the next four years is made up of 400-plus different efficiency-related projects.

The remaining major capital projects include flight attendant operational integration (by late 2018), HR and payroll integration (first phase in early 2018) and tech operations integration (another 2-3 years).

Another important project is standardising the seat configurations for different aircraft types following the merger. American currently operates 52 different “sub-fleet combos” but is reducing that number to 30 over three years. It will make the aircraft easier to schedule, improve utilisation and even enable new markets to be served.

American continues to reap benefits from fleet renewal. Since the merger it has brought in 496 new aircraft (by end-2017) and retired almost as many older aircraft (469), reducing the average age of the fleet to 10 years.

The fleet transformation has been driven by larger replacement aircraft, upgauging existing aircraft and longer stage length flying. The five-year plan to 2021 sees a significant increase in the number of larger (two-class) RJs, 161-200 seat narrowbody aircraft and 250-plus seat widebody aircraft, with corresponding reductions in smaller aircraft in those three categories.

There were no changes to the fleet plan at the investor day. 2018 will see only 22 new mainline aircraft deliveries, down from 57 this year. But as the A321neos start arriving, total deliveries will jump to 47 in both 2019 and 2020 and may remain at that level in 2021-2022. The overall fleet size will grow only slightly as deliveries will be accompanied by retirements, though the upgauging strategy will result in modest ASM growth.

With the anticipated efficiency gains from Project One and fleet renewal, American is targeting only 2% ex-fuel unit cost growth in 2018 and “below 2%” growth in subsequent years. However, those projections exclude the impact of any new labour deals.

Improving capital structure

After a significant $22.9bn in capital investments in 2014-2017, or about $5.7bn annually, now that its fleet renewal is nearing completion American will see total capex fall to around $3.9bn a year in 2018-2020.

In terms of future cash allocation, the priorities are to complete merger integration, meet pension and debt obligations and invest in the business. After that American will prepay high-cost debt. And finally, American will return to shareholders any cash in excess of $7bn.

American has maintained a stronger cash position than its peers because of its higher level of debt. At the end of September its total liquidity was $8.3bn or 20% of annualised revenues, while long-term debt and capital leases amounted to $24.9bn. But even as deleveraging gets under way, American is maintaining its $7bn minimum liquidity target.

American was unusually quick to start returning capital to shareholders after bankruptcy. It has returned over $10bn in share repurchases and $700m in dividends since mid-2014. If strong cash flow continues, shareholders can expect the buybacks to be expanded in the coming years.

The aggressive re-fleeting programme, which was financed at very low interest rates, has given American a significant competitive advantage, both in terms of lower costs and a better product. It is something Delta and United will have to do at some point. However, the high level of debt also poses a risk in a downturn, so the opportunity to reduce its gearing comes none too soon.