The week of Jan 20, 2020 was a classic example of why so many investors don’t like investing in the airline industry. A number of airlines experienced both positive and negative changes that were three to four times the percentage changes in market indices. In just a week, the threat of the spread of a deadly virus from Asia, gyrating oil prices, and continued uncertainty from Boeing about the MAX created enormous uncertainty for investors. And, on top of all that uncertainty, most of the U.S. airline industry completed the reporting process for 4th quarter and full year 2019 financials. Despite all the noise, the external turbulence that impacted airline stocks during earnings week in January 2020 was less significant in explaining US airline stock movements and valuations than the numbers from those earnings reports.
Just ten months ago, I wrote the Seeking Alpha article “Is American Airlines Headed for Cruise Altitude?” (NASDAQ:AAL) just weeks after AAL stock hit its now 52 week high of $37.23. This past Friday, AAL closed at $27.64, 26% below AAL’s 52 week high but, perhaps more significantly, almost half of AAL’s 5 year high which was reached just two years ago. Response to my article and the fact that more than half of sell side analysts covering AAL currently rate it “bullish” or “very bullish” indicates there remains enormous hope that the company and the stock can turn around. Shortly after AAL’s emergence from bankruptcy and its merger with USAirways, AAL’s market cap was near $40 billion, on par with Delta Air Lines (NYSE:DAL). Despite the largest buyback program in U.S. airline history, AAL’s market cap is less than one-third of DAL’s and AAL stock has been the worst performing U.S. airline stock over the past five years.
source: Seeking Alpha
AAL’s Sinking Stock Price
AAL’s earnings call provided some insight into AAL’s stock performance but a comparison of its financial results to its peers contains a number of other clues not only as to how AAL got into the situation it is in now but also the likelihood of it being able to correct the issues which have weighed down its stock performance.
There have been many articles written about AAL over the past year and most note its industry-high indebtedness. Company execs have acknowledged the high levels of debt but have justified it because of the hundreds of new aircraft American has acquired over the past five years. Interestingly, AAL has never provided any financial benefit that has come from its younger aircraft fleet; in fact, a comparison of income statements for American, Delta and United (NASDAQ:UAL) show that American spent more both on fuel and aircraft maintenance than either of its peers even though they are all within a few percentages of each other in total revenue.
AAL execs have noted for several quarters that their fleet spending will be slowing and, with their reduced capex, their ability to reduce debt will increase. They expect to generate as much as $6 billion in free cash over the next two years after years of having virtually no free cash flow. AAL management does seem to be addressing part of investor concerns and there is hope that the level of indebtedness will at least stop growing and might start to diminish over the next few years.
3.7 and 11.46
There are two numbers that are far more significant in explaining AAL’s stock performance. The first is AAL’s net income margin for 2019 which was 3.7%. Of the carriers that have reported so far, DAL reported a net income margin of 10.1% while LUV’s NI margin was 10.3%. When earnings season is over, AAL will almost certainly end up with the lowest net margin among U.S. airlines for 2019.
Delta and Southwest are likely to showcase the strongest financial performance among large jet U.S. airlines and certainly among the big 4 (also including United) for 2019. In order to understand the reason for AAL’s much lower net income margin than DAL or LUV, we need to understand the second critical number, 11.46. The unit of production in the U.S. airline industry is the Available Seat Mile or ASM. 11.46 was AAL’s 2019 cost per available seat mile or CASM on its consolidated operation (its mainline and regional flights) excluding fuel, profit sharing and special items (CASM ex). While seat mile costs differ by business model with legacy carriers such as DAL and UAL having the highest costs and also by the distance of airline flights, AAL and DAL have similar lengths of flight while UAL has longer flights, which tend to reduce the revenue and cost on an ASM basis. American and Delta are also the closest in revenue size among U.S. airlines so comparisons between the two are about as valid as can be made among U.S. airlines. DAL’s consolidated CASM-ex was 10.52, 9% lower than AAL’s. In addition to its CASM disadvantage to Delta, American also has a 6% unit revenue (RASM) disadvantage, meaning that Delta generates 6% more revenue than American for every unit of production and Delta’s cost of production is 9% lower than American’s. In an industry where putting just one more paying passenger on every flight can move the system margin, it isn’t hard to see why AAL’s margins are so much lower than its peers.
In order to understand AAL’s cost disadvantage, we must look at its major cost items. As noted, AAL spends nearly $900 million more on fuel for its mainline and regional operations than Delta, due both to AAL’s less efficient revenue generation but also because AAL paid five more cents per gallon (more than 2%). Given that both airlines consumed more than 4 billion gallons of jet fuel in 2019, a 2% difference in cost even on the same volume matters. To be fair, AAL’s fuel cost was in line for the industry; DAL had below average jet fuel costs because of its refinery and fuel procurement strategies. American’s hub locations also impact the amount of ASMs it has to fly; its largest hub, DFW is a further distance from many of the U.S. top business markets making connections over DFW longer than over other hubs.
Yet another reason for AAL’s cost disadvantage is its labor costs which are directly attributable to a much larger labor force. While airlines have varying work rules and outsource and insource different functions, AAL still employs tens of thousands more employees than Delta or United to generate comparable levels of revenue. AAL’s higher employment levels are in part due to the American-USAirways merger which came about because of efforts by current AAL and former USAirways CEO Doug Parker’s plan to orchestrate a merger while AMR, the former parent of American Airlines, was in Chapter 11 bankruptcy reorganization, wresting control of the company from AMR executives who were proposing a standalone American reorganization. Parker won the support of American’s labor unions but in the process failed to enact many of the work rule changes that were necessary to create industry-comparable labor efficiencies. To compound matters, many of USAirways ground employees were represented by the International Association of Machinists (IAM) while the Transport Workers Union (TWU) represented large portions of American’s ground employees. The two formed an association to represent the combined workforce but most of the employees that are represented by the association do not have a joint contract six years after the merger, meaning some work is fenced to either the former USAirways or former American employee groups.
Network and Competitiveness
Several revenue generating factors influence AAL’s cost structure. First, the combined American-USAirways has an abundance of hubs on the east coast (New York LaGuardia and Kennedy, Philadelphia, Washington D.C., Charlotte and Miami). In the early years after the merger, American realized its hubs were competing against each other for connecting passengers which limited its ability to grow unit revenues; its solution at the time was to reduce the average aircraft size which created inefficiencies even at the expense of higher unit revenues.
In the years since, American’s presence in New York City has shrunk, the only airline that is smaller in NYC than it was five years ago. Part of the reason for American’s need to shrink its size in NYC is its unit cost disadvantage; every other airline can produce an airline seat for less than American. Competing in highly competitive markets is certain to lead to losses for American. The greatest beneficiary of American’s reductions in New York City has been Delta which has larger operations at the same NYC airports as American; JetBlue has a large operation at JFK and has benefited from American’s reductions there.
American is now focusing its growth at its hubs at Washington National airport (which is slot-controlled which limits competition); Charlotte, the only competitive hub in the southeast U.S. to Delta’s hub in Atlanta; and Dallas/Ft. Worth, American’s home and the 2nd largest U.S. carrier hub. There are no other competitive hubs at any of those three American hubs which American has repeatedly called its most profitable hubs although there are other airline hubs at other airports in the Washington D.C. and Dallas metro areas.
I discussed the international marketplace for the big 3 US global airlines in this article so will not repeat the details I noted there. To summarize, American underperforms Delta and United on much of its international route system and reports to the DOT that it loses hundreds of millions of dollars per year flying to Asia and operates its transatlantic route system at just above breakeven profitability. American’s Asia weakness is to China while its transatlantic revenue weakness is in continental Europe where Delta and United’s primary joint venture partners are located. American says its Latin America network, the largest of the three airlines, is strongly profitable. American’s cost disadvantage will be most pronounced on its longest flights which likely is part of the reason that its Asia network is its least profitable.
Perhaps one of American’s most significant strategic threats is Delta’s decision to partner with and form a joint venture with Latam, Latin America’s largest airline. Latam is the second largest airline in terms of international capacity at Miami, where American operates its largest Latin America gateway; Miami is unique in the U.S. airline world in that American offers the only U.S. carrier service from Miami, the largest gateway to Latin America, other than two Delta flights/day to Havana; JetBlue, Spirit, and Southwest all have large operations at nearby Ft. Lauderdale which include flights to parts of Latin America and the Caribbean that are competitive with American’s Miami hub. Delta is the second largest airline at Miami in terms of flights and seats offered behind American. Delta and Latam are seeking an antitrust immunized joint venture. Delta and Latam also have significant operations at New York’s JFK airport where American’s flights to S. America have been one of its strategic strengths. Delta has already announced a 50% increase in seats from Miami beginning this summer and will likely announce another round of flight additions before the winter travel period (which is peak travel season for S. America). I discussed the Delta – Latam deal in this Seeking Alpha article.
American has been quite vocal about seeking compensation from Boeing for the MAX grounding and has received a partial, confidential settlement for 2019. However, DOT data shows that American gained domestic market share as of the third quarter of 2019 using the most recently available data; the MAX certainly limited American’s ability to grow domestically but it did not stop it from gaining at the expense of some of its competitors – at least from a market share standpoint. While American appears to want to be able to aggressively grow in order to help push down its unit costs and take advantage of a favorable domestic airline environment, it has not been as negatively impacted as its fellow Texas-based rival, Southwest.
From a service standpoint, American’s reputation took a hit in 2019 due to conflicts with labor which resulted in an increase in delayed and cancelled flights in 2019. The latest DOT data, however, shows that American and its regional carriers had better on-time through late 2019 than United but below Delta and Southwest, among the largest airlines. Still, the Wall Street Journal ranked American at the bottom of the U.S. airline industry for business travel in 2019 – while Delta ended up at the top.
U.S. Dept. of Transportation Air Travel Consumer Report Source: DOT
AAL Executive Response
American’s challenges have not been a secret to the investor community and analysts have added pointed questions of AAL execs in quarterly earnings calls; the transcripts of AAL’s quarterly calls are available on Seeking Alpha. The most recent earnings call included several insightful comments about AAL’s profitability relative to its peers.
You look at the EBITDAR margins for the year just ended we’re going to — we come out a little less than two points behind United for the year and about six points behind Delta. So I look at those and think that doesn’t seem right. We should — there’s no reason that American Airlines should have margins that are lower than United. There may be a structural reason at this point in time that we would be lower than Delta as United is. That structural reason being that they (Delta) had so much of their capacity flying in and out of really, really profitable hubs. But we’re not — I’m not trying to say that there’s some structural reason that can’t be closed but it may not be able to be closed in the really near-term. As we end up growing Dallas and Charlotte over time in our network I think that can be closed.
How much how fast? Hard to say. Conservatively, I think, we should easily be able to get one point here. So again let’s for 2020 assume that we not only get that point, but we stay where we are in the gap. And then a couple more years we’re at or near United and then — and then over three years ahead of United and — or by one point or so and closing that and having that gap and half again still.
Doug Parker, CEO, American Airlines
source: Seeking Alpha
AAL execs believe they can close the margin gap with United over time but are less confident about their ability to do it compared to Delta which American recognizes has structural advantages that American cannot duplicate. While American has not moved to close any of its underperforming hubs, it does believe it can shift resources to its more profitable hubs and thus perhaps surpass UAL’s profitability while also reducing the gap with DAL. Most significantly, AAL execs are unwilling to commit to a timeline for substantial improvement in margin compared to its two global carrier peers; AAL also underperforms every low cost and ultra low cost carrier in the U.S. as well.
AAL continues to talk about its fleet renewal, believing that the addition of newer technology international aircraft can allow it to compete more effectively in the off-season. From an overall competitive standpoint, Southwest will likely displace American has having the youngest fleet among the big 4 carriers when MAX deliveries resume while Delta is aggressively inducting new, larger, and more fuel efficient aircraft into its fleet faster than any other U.S. airline right now while United is delaying delivery of some international aircraft while also acquiring used aircraft and retaining older, less fuel efficient aircraft more than any of the other big 4 airlines. United’s debt – which is not as high as American’s but higher than Delta and Southwest’s – is likely to increase dramatically as UAL’s capex swells before it slows down fleet spending. United now has the oldest fleet among U.S. airlines and the gap between UAL and the rest of the industry will likely grow. From a fleet and balance sheet standpoint, American execs might be right that American will gain advantages over United in the next few years.
American execs also addressed the labor cost issue…
We have one more of these contracts to do. That’s in — that’s one more to actually get our labor costs in line. We have one more joint collective bargain agreement to get done. That will happen in 2020. Once we do that you will then be at a point where our labor costs in general across the border largely in line with theirs so you won’t see that continued kind of pressure.
Doug Parker, CEO, American Airlines
Source: Seeking Alpha
Of course, settling labor contracts require negotiation and it is far from clear how AAL might settle its contract with its largest group of work groups if it hasn’t already in a way that will reduce its labor costs. All of the big 3 US airlines are in contract negotiations with their pilot unions right now while contracts for other labor groups at American will become amendable in 2020.
AAL, DJIA and competitor 5 year chart. Source: Yahoo Finance
A mountain of strategic challenges
American Airlines faces a number of strategic challenges including high costs which have resulted in growth of competitors in key American markets. American’s debt levels are high and its cash flow will still be below competitive levels even based on AAL’s projections from reduced capex. AAL’s domestic revenue generation is stronger in general than significant parts of its international network. AAL’s ability to compete with Delta and United’s global networks requires it to serve parts of the world where it has continually struggled to generate competitive revenues or profits. American’s service continues to be rated poorly. And finally, AAL stock has been the worst performing U.S. airline stock over the past five years – most of the time since American emerged from bankruptcy and merged with USAirways.
Prospects for American’s future
Several scenarios appear to be possible for AAL.
The first, and most likely scenario, is that AAL execs will continue to incrementally try to correct some of the issues which have weighed down the company – but with little change in the long-term trajectory of the company. AAL remains the least profitable, most indebted U.S. airline. Doug Parker and his team will likely be able to demonstrate individual positive steps even if American’s position esp. relative to its peers is not likely to improve.
While American will likely succeed at some initiatives, its competitors are launching their own initiatives which will likely lead to incrementally larger improvements for AAL’s competitors than for AAL. For example, AAL touts its investments in fleet spending and now says previous levels of spending will slow, but Delta and Southwest both are inducting dozens of new aircraft per year into their fleets which will certainly help improve their financial metrics.
The second scenario which is less likely in the short-term but more likely in the mid to long-term is that American’s lack of cost competitiveness will make it more and more vulnerable to competitors. Before it filed for chapter 11 bankruptcy in 2011, AMR’s unit costs were about 10% higher than Delta’s; the decade of the 2000s was the beginning of American’s share losses in New York City, first predominantly to JetBlue and then in the 2010s to Delta.
American’s primary cost challenge is that it is grossly overstaffed compared to other airlines and aviation history shows that it is virtually impossible to cut the number of employees necessary to restore AAL’s cost competitiveness outside of bankruptcy reorganization where labor contracts are modified as necessary to ensure the future survival of the company. Given that AAL’s high costs are leading to shrinking market share in some of the U.S.’ largest markets, American cannot sustain multiple more years of cost disadvantage and competitor carrier growth.
There is simply a very high degree of risk for American Airlines with a likely continued loss of market share and high value revenue, esp. in international markets even as AAL continues to acquire expensive new technology aircraft to support its international network even as competitors win larger and larger shares of American’s domestic markets.
American Airlines still generates more than $40 billion in annual revenue, making it the second largest airline by revenue in the world. It has valuable positions in many of the U.S.’ top markets even if its share in those markets is decreasing.
While investors value AAL the least of the big 4 U.S. airlines on a market cap basis, it is likely AAL stock will continue its five year long decline primarily because AAL is years away from turning away its margin underperformance, even by the best estimates of its executive team. As AAL focuses on generating cash, it is not likely to buy back stock at the levels it has done over the past five years.
AAL investors need to be willing to consider that American may not be able to turn the company around from a competitive financial perspective. While the U.S. airline industry has been more stable over the past 10 years than it has been in decades, history proves that the level of cost disadvantage which AAL now has relative to its competitors has always resulted in bankruptcy reorganization, sale of assets, or cessation of operations.
Disclosure: I am/we are long DAL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.