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  • ANALYSIS: Has American slipped to number three?

ANALYSIS: Has American slipped to number three?

American Airlines financially lagged its peers in the second quarter, prompting some changes in strategy and concerns from Wall Street on whether it has fallen behind its peers.

"Our competitors are doing a nice job and one of them had a lot more upside than we did," said Doug Parker, chairman and chief executive of the Fort Worth-based carrier, in response to analysts' questions during a quarterly earnings call on 26 July. "But it doesn't mean we don’t think we're going to go do what we planned to do, which is to be the best airline in the world."

Operating expenses grew faster than revenues in the second quarter, driven largely by a 39% jump in fuel costs. While other carriers felt the impact of fuel as well, revenue growth at American was at least three percentage points slower than at its competitors Delta Air Lines and United Airlines – prompting the questions around its revenue-generating initiatives.

"Has American stepped into the shoes that United once occupied? Maybe, that is simply the construct of the industry going forward," said Jamie Baker, an analyst at JP Morgan, during the call on 26 July. "You're going to have one chronic outperformer, let's call that Delta, you have the silver medallist, that's United, and, inevitably American brings up the rear."

Parker says he "vehemently" disagrees with this conclusion, emphasising the carrier's long-term outlook, rather than quarterly performance.

Indeed, while American management acknowledged the poor results and outlined plans to rectify them, it did not go nearly as far as the semi-regular apologies for sub-par performance from United management during its worst days in 2012 and 2013.

A number of factors have had an impact on the second quarter for American. Fuel expenses increased by $700 million year on year due to higher oil prices, and an IT issue at its PSA Airlines subsidiary forced the cancellation of thousands of flights in June.

The airline is taking action. It has cut capacity growth into 2019, is modifying its lowest no-frills fares and deferred aircraft deliveries, among other strategic changes, in an effort to boost returns.

But these changes will not benefit American in the coming quarter. The carrier forecasts a pre-tax margin excluding special items of 5-7% in the seasonally strong third quarter, a number that Evercore analyst Duane Pfennigwerth points out is down compared with the same period in each of the past five years.

"We heard some tiny steps in the right direction," he wrote in a report on 26 July. "It feels like more is required to change this long-term margin trajectory."

INTELLIGENT GROWTH

American plans to focus its growth on primarily two hubs: Charlotte and Dallas/Fort Worth. These are its most profitable bases and where it sees the greatest opportunity to generate higher returns as it slows growth into 2019, executives say.

"We think that we're sizing the airline that's right for American and American's network and American's customers," said Robert Isom, the airline's president, during the 26 July call. "We really like the opportunity for us in DFW and Charlotte."

American will add seven gates in Charlotte from the fourth quarter, and 15 gates in Dallas/Fort Worth from early 2019 that will allow it to accelerate growth at both airports. Those capacity additions, however, will be partially funded through strategic reductions elsewhere in its system.

The carrier plans to reduce utilisation flying and "underperforming" routes at its other hubs – which include Miami, Los Angeles, New York, Philadelphia, Phoenix and Washington National – to support the growth at Charlotte and Dallas/Fort Worth, executives say.

American executives decline to say what underperforming markets could be cut when asked during the call. However, they cited recent reductions in Brazil and China as examples of what to look for.

The carrier has reduced frequencies to both Rio de Janeiro and São Paulo and will suspend service to Belo Horizonte in August. It will end service between Beijing and Chicago O'Hare in October.

"We're expanding our network intelligently," says Parker.

American now plans to grow full-year capacity by roughly 2.2% in 2018, a half-a-percentage point reduction from its previous forecast, says Isom.

The airline has reduced capacity growth by 0.6 points to roughly 3.3% in the third quarter, and by one point to up roughly 1.6% in the fourth quarter.

Slowing growth should help American raise fares, boosting revenues and covering the run-up in fuel prices. Total unit revenues are forecast to increase by 1-3% in the third quarter, after a 2.1% increase during the three months ending in June.

BUOYING REVENUE

American is changing the rules for its basic economy fares as part of its effort to buoy revenues. It will remove restrictions on large carry-on bags in September, aligning its no-frills offering with that at Delta.

"The carry-on bag policy left us uncompetitive from a product attribute perspective," says Isom.

American hopes to increase the number of travellers who see its fares as a result of the change, thus increasing bookings and ancillary revenues – even as it predicts fewer people viewing basic economy fares and then booking a higher fare class.

"We think this is going to increase the scope of coverage of the product," says Don Casey, senior vice-president of revenue management at American, on the call.

The airline expects basic economy fares after the carry-on bag changes to generate more than $100 million in incremental revenues annually, he says.

United will remain the only mainline carrier that restricts customers booked in basic economy from bringing large carry-on bags on board flights.

CAPITAL SAVINGS

American is making a number of moves to reduce costs, most notably deferring nearly two dozen aircraft deliveries. It pushed 22 Airbus A321neos to 2024 and later from 2019-2021, cutting what it claims is $1.2 billion in capital expenditures from its capital commitments over the next three years.

"This is the result of, given the existing environment, making sure that we actually want to take airplanes in those times and we've come to the conclusion that we don’t," says Parker on the aircraft deferrals, referring to both fuel prices and the revenue environment.

The A321neo deferral differs from American's decision to push back deliveries of 40 Boeing 737 Max 8s in April, a move that it said at the time gave it "capacity flexibility".

The airline will retain older aircraft in its fleet, continue to upgauge its regional fleet, including with the 30 large regional jets it ordered for replacement in May, and the continuing densification of its A321 and 737-800 fleets. It is adding at least three seats for 190 on the A321s, and 12 seats for 172 on the 737-800s.

In addition, American has lowered its growth outlook for the rest of the year. Unit costs (CASM) excluding fuel and special items are forecast to increase by roughly 1% in the third quarter and about 1.5% for all of 2018.

American previously expected an increase of around 2% in full-year CASM, excluding fuel and special items this year.

The carrier aims to hold growth in non-fuel unit costs at 1-2% per year in 2019 and 2020.

"2019 certainly feels like it'll be a better year than 2018," says Parker, citing the combination of moderated capacity growth, tweaking its revenue generation strategy and other cost cuts.

The question investors are asking, though, is whether the commitments are enough to counter United's momentum and Delta's leadership.

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