American Airlines: Flying on Faith

alex
25 Jun, 2003
New York City

As long as only the capital structure is changing, but not the management handling of the business and the relationship with the unions, all the new cash obtained, earned in good times, or secured through guarantees will be still burned out, eventual

The U.S. commercial aviation impact on the nation's economy in 2000 was estimated to be more than $800 billion, or 8% of the GDP, and 10 million jobs. These figures, taken from the study done by DRI–WEFA, Inc. and the Campbell-Hill Aviation Group, Inc., were quoted in the alarming report on the state of the sector by the Air Transport Association of Washington, DC. The trade group's membership claims 95% of the passenger and cargo traffic in the United States.

On the background, there is the history of U.S. airline bankruptcies – one each year on the average since 1989. The immediate threat in March, 2003 was that if the world's largest carrier, American Airlines, would follow the second-largest United to the bankruptcy court, a domino effect of competitive bankruptcies across the industry was almost imminent.

On the other hand, there is a sense of expediency, mutual understanding, managerial efficiency, and even a good deal of optimism accompanying every company in the weeks before it files for bankruptcy protection. AMR ((AMR)), parent of the world's largest airline American Airlines, made no exception. By March, 2003, AMR management seemed hell-bent to avoid the Chapter 11 filing with its cost reduction plan.

Upon success, AMR's lenders were expected to renegotiate or waive the covenants on more than $800 million of debt that are to be tested and almost unavoidably violated by June 30, 2003. The lenders were expected to free AMR from its obligation to maintain liquidity at $1.5 billion in cash and short-term paper plus 50% of the net book value of its unencumbered aircraft. Apart from those near-term triggers, what was sought was mainly faith. Faith that a company ending 2001 with $3 billion in cash, burning $5.8 billion on operating basis through December, 2002, and having its $13 billion of debt cut deeper into junk by Moody's on Feb., 10, 2003 and by S&P on Feb., 28, 2003, is viable as a going concern.

What AMR's management offered was to reduce its operating costs through emergency negotiations with the labor unions. Faced with a possible bankruptcy, the airline's pilots were expected to accept a $660 million pay cut, its flight attendants to live with $340 million less than contracted, and the transport workers to agree to a $620 million reduction of their wages. The success of these talks was what the management presented as the way to avoid bankruptcy.

Labor Pains and Gains

Wages, salaries, and benefits represent the largest portion in the airlines' cost structure, and also the most-sensitive one. When American and the other airlines embarked on their emergency cost-cutting efforts, labor cost wasn't the first place they looked for savings, but as the management was identifying all other possible options, the unions knew negotiations were just a matter of time.

Even if the three unions – Allied Pilots Association (APA), Association of Professional Flight Attendants (AFPA), and Transport Workers Union (TWU) – acknowledged that some concessions were inevitable, they would never accept anything that can threaten the core of their existence, namely their bargaining power. The past history of labor relations shows that the American employees never hesitated to remind the management of it, no matter if their contracts were due for amendment or not. On Feb., 15, 1997, American pilots went on strike and Clinton's Presidential Emergency Board ordered them back to work under the Railway Labor Act. The new negotiations ended with an agreement ratified in May, 1997, under which pilots, among other things, received options to buy AMR stock at $10 less than the average fair market value on the date of grant. This contract became amendable Aug., 31, 2001. In February, 1999, however, after the acquisition of Reno Air, the pilots staged a sickout that caused costly flight cancellations across American's system. Even after the court held the APA in contempt, a new agreement dealing with the Reno workforce was reached, including further extensions to the existing APA contract.
In 2001, the 'fast-track' 120-day negotiations in American led to pay increases between 15% and 22%. In the same year Delta ((DAL)) negotiated a compound pilot pay increase between 24% and 39% over five years, which was about 1% over the deal United Airlines pilots have reached prior to that. The same wage-increase spiral, when workers in different airlines always looked for an equivalent or better deal than their counterparts, was present in the machinists' sector. United Airlines' machinists threatened to go on strike citing their wage of $25.60 an hour, compared to American machinists' $34 an hour. The lower wages at United were part of the deal in 1994, when they received 55% of United's stock together with the pilots. Apart from the competition on the air travel market, there has always been an ongoing, and far from unspoken, competition between the labor unions in securing better contracts.

Union contracts did not only block wage cuts. They also had provisions such as limiting use of smaller planes on longer routes. On the other hand, when there were job cuts, the most affected were lower-wage workers, and those also received severance packages. The immediate result was that the remaining higher-wage staff made the average wage level even higher, and the average wage level is what negotiations always seek to raise further.

American management was asking this unionized workforce to accept drastic cuts under the threat of a bankruptcy filing. The threat, serious as it is, in retrospect is merely the 14th major airline bankruptcy in 14 years, fourth only for the former TWA staff. In this 14-year period, airline labor unions managed to win significant pay increases despite the companies' frequent visits to the bankruptcy court. If someone has learned how to maneuver in the tumultuous airline business, it was exactly labor.
One is easily left with the impression that the wage-increase spiral is the main problem lying before American's efforts in cost containment. The 'do-or-die' negotiations centered on the same issue also point to that conclusion. Rising oil prices are the second most-often cited reason for the airline's woes. However, the picture is not that simple, on a comparison of the labor and fuel costs between American and the most financially sound major U.S. airline, Southwest ((LUV)). As a percentage of total expenses, those costs are comparable if not slightly higher at Southwest, which in 2002 posted its 30th consecutive year of profit. Furthermore, Southwest expects labor costs to increase in 2003 due to workforce additions, higher wage rates and higher anticipated healthcare costs. Still, in 2002, the profit-sharing agreement at Southwest led to a 30% decrease in its employee retirement plans expense, as the available earnings for profit sharing were lower.

The Business That No One Wanted

After the U.S. airline industry was deregulated in 1978, the debate which operating model will be most beneficial for the consumer and for the airline industry placed the focus on the combination between the hub-and-spoke operation and full-fare oriented product. By mid-1990s, the 'common wisdom' both in the industry and the economic science was that, simply put, the airline that gets best hubs and most of the business travel, wins. One such study, carried out in 1995 by economist Pablo T. Spiller from the University of Berkeley, Steven Berry of Yale, and Michael Carnall of the University of Illinois, concluded that the hub carriers not only enjoy between 15% and 20% in operational savings compared to non-hub carriers, but that business travelers flying hub carriers paid nearly 20% more than those flying non-hub airlines. The point-to-point flight for the low-fare 'leisure' traveler was a business no one seemed to care about.
The opponents of this view asserted that when a hub is operated by one major airline, it hampers competition, and also has additional operating costs. The international large hub carriers have higher expenses coming from operating different types of aircraft and providing meals to travelers, for instance. Southwest operates only Boeing 737, and thus has much simpler operation, maintenance, and training. By 2003, those insisting that direct-flight, no-frills carriers like Southwest are more cost-efficient, are obviously a clear majority.

Southwest entered 2003 with $1.82 billion cash on hand, which is $200 million more than its total long-term debt, excellent credit ratings, and a fleet that went from three Boeing 737 aircraft in 1971 to 375 planes in 2002. The Dallas, Texas-based company is the second-largest U.S. carrier in terms of number of scheduled domestic departures. Southwest not only appears to be everything American isn't, but what is more, everything American and the other two big names – United and Delta – never aimed to be.

The problem, however, appears to be not in the economics of the hub-and-spoke versus point-to-point model but rather on the excessive reliance on the 'common wisdom' in the airline industry, instead of the business common sense.

Southwest and other discount carriers were bound from day one to that 'unattractive' leisure traveler and that 'outdated' direct-flight, secondary airport operation. Those airlines were constantly aware that the 'common wisdom' economics were against them in an industry where one major player goes bankrupt every year. For decades, their managements had to deal on a daily basis with the same issues American and United had to solve within months or file for bankruptcy protection.

For discount carriers, the handling of the rising labor costs and oil-price fluctuations were clearly the difference between a viable and a bankrupt airline. Southwest most-recent revenue and earnings history show that it wasn't shielded from the business slump after Sept., 11, 2001. However, the company entered the challenging period more smoothly and much better prepared in terms of liquidity than its larger competitors. For discount carriers the accent has always been on the streamlined, cost-efficient operation. As the generated cash kept growing, so did the fleet and the coverage. For the hub carriers, however, growth was primary and the profits were expected to come with the territory.

For American, the goal was to get bigger, to get bigger chunk of business market, and to keep the hubs busy. Being No. 1 in the 'good' market was obviously thought to make the airline impervious. Furthermore, American's financial structure was clearly growth-oriented. Entering 2002, the company had firm aircraft purchase commitments for $1.3 billion in 2002, $1.7 billion in 2003, $1.2 billion in 2004, and $1.9 billion from 2005 to 2008. In 2001 alone, AMR issued $2.6 billion of debt instruments, called enhanced equipment trust certificates, used to finance those purchases.

Cost and Consequence

The usual explanation is that Sept., 11, 2001 in combination with rising oil prices, and the already slumping economy stopped American's growth in its tracks. The company, however, had three distinct phases in its development as a business over the past twelve years, and its problems started much earlier than 2001.

The Gulf War Crisis between Aug., 1990 and Feb., 1991, was definitely a challenging time for the airlines, but for AMR stock it was marked only by a small trough. In 1992, AMR had a small operating loss of $25 million on American passenger revenues of $12 billion. By 1996, the company steadily improved its profitability to reach $1.8 billion operating earnings on $13.6 billion in passenger revenues. This was the period when American served as an illustration how promising the hub-and-spoke, business-oriented model was.

The second phase started with the profit decline in 1997 on higher passenger revenues. In 1998, however, AMR posted record profit of nearly $2 billion. The impression that the airline industry has finally found its groove drove the stock price to its all-time high of 83.25 in June, 1998, when it was split 2 for 1. The earnings fluctuations between 1997 and 1999 were attributed to the labor disputes, the strike and the sickout. However, by the end of 2000 it was obvious that American's earnings curve has lost its upward momentum, even if the revenue growth was still present.
The logical question was if between 1997 and 2000 the operating profit has declined by 13% while revenues were up 15%, what was going to happen if revenues would decline, too? To such a legitimate concern the management's answer was the acquisition of the bankrupt TWA in 2001 – a move that was much closer to the growth ideology than to that of streamlining and efficiency.

In August 2002, the management did announce 'undertaking series of fundamental business changes.' Those included 'de-peaking' of the Chicago hub, 'simplifying' the fleet, launching automation initiatives to improve customer service, changing distribution methods, 'modifying the in-flight product', and initiating a broad range of cost savings programs. The overbearing impression, however, was that those measures weren't taken as a regular tweaking of the business to improve profitability, but rather under pressure to save the airline. The all-important difference is that in the first case, there would be time and money allocated to achieve the goals, while in the second case, there wouldn't.

What happened is clearly seen in the rightmost part of the chart, Phase III. As the management kept insisting that the airline industry is ill-prepared for the change in the revenue environment, in number terms it meant that if revenues declined by as little as 4% in one year – 2001, and 8% on the next year, the cost structure of the airline caused an immediate tailspin to Chapter 11 with no cash cushion to soften the impact.

The shortcomings of American's business model became all too visible in 2001. In 2002, American had to fill close to 90% of its capacity to break even. The gap between the actual load and the break-even target seems impossible to shrink without changes that are much more fundamental than the proposed so far.

Government Gives

So far, the government has shown little inclination to help the carriers more than it did with the Air Stabilization Act in 2001 and 2002. In the short-term, the refusal for loan guarantees, which technically led to United's filing for bankruptcy protection, shows that the administration doesn't subscribe to the viability of the present business plans. For the longer term, the business environment can definitely benefit from a reduction in the taxes that are sizeable part of the ticket price, and even more from the federalization of the insurance costs.

This measure has also been implemented as a one-time relief. The Homeland Security Act of 2002 mandated the federal government to provide third party, passenger and hull war-risk insurance coverage to commercial carriers through August, 31, 2003, which may be extended by the government through December, 31, 2003. The measure was a response to the sharp increase of the premiums by the aviation insurers after Sept., 11, 2001, and not as a permanent change.

The regulators aren't only a side that gives or refuses short-term relief. The Transportation Department did agree to give American and British Airways antitrust immunity to form an alliance in January, 2002, if the airlines gave away 224 takeoff and landing slots between U.S. airports and London's Heathrow. However, the deal was rejected by American and British Airways managements because 'the regulatory price is too high.' Once again, an alliance that would allow American to streamline its business by coordination of pricing, schedules, and profits, unhampered by antitrust laws, was sacrificed for the sake of hub domination.

Perpetual Turbulence

In the 25 years of U.S. airlines' deregulated history, the main goals – consumer benefits and competition – are more or less achieved, even if the picture hardly benefits the world's largest carrier. American Airlines can not count on the business environment becoming friendlier, even with the ailing competitors. In fact, the competitive pressure has intensified significantly in 2002, as the discount carriers competed with 75% of American's available seat miles, up 10% from 65% in 2001. There are cheaper tickets available for more passengers on more routes.

The change of traveling habits is a cause of major carriers' problems, but it is also a consequence. Airlines cutting flights under bankruptcy protection can hardly be called stable. People would prefer reliable airlines with guaranteed flights, especially the coveted business travelers and frequent fliers.

The competitive picture in 2003 has another troubling characteristic – there is another round of consumer-chasing, this time around it is the leisure flier. United, Delta (through Song) and Midwest Express ((MEH)) already announced their plans for the low-fare market. Low fares alone, however, do not guarantee the consumer, as the demises of United's Shuttle, Continental's ((CAL)) Continental Lite, and US Air's Metrojet operations have proved. The success of Southwest is not the cheap ticket, not the direct flight, not the decongested secondary airfields, the Boeing 737 or their combination. It is the internal accord within the company which allowed it to become a sustainable business and not just an air transportation provider.

For American's both management and labor, the focus in March still remained in the short-term options, despite the numerous 'long-term prospects' statements. The save-the-company priority is not much different from the get-real-big one, as far as its investors are concerned. The salvage of such a large operation, usually called restructuring, from capital perspective is merely replacing one form of indebtedness with another – be that debtor-in-possession financing, loan guarantees, or even another tapping the stock market. The airline will fly as many flights as it can afford, and sell as many tickets as the market allows it to, but the way this is converted into sustainable cash flows is a matter of day-to-day decisions and not of one-time fixed capital structure and branded product.

As long as only the capital structure is changing, but not the management handling of the business and the relationship with the unions, all the new cash obtained, earned in good times, or secured through guarantees will be still burned out, eventually, and the airline stocks will always be the same cyclical gamble they have always been in the past fifteen years.