Thinking About American’s Contrarian Path to Transformation

The list is long of those kicking American Airlines for not producing near-term results because that is, after all, what Wall Street wants and needs.  Wall Street’s lead striker and headline maker has been Jamie Baker, airline equity analyst at JP Morgan Chase.  Baker was quoted in a Wall Street Journal story last week saying AMR's poor financial results and worsening margin deficit raises questions about the wisdom of a giant aircraft purchase. He said,  “We cannot reconcile spending incremental capital while failing to earn returns on [the] existing capital base.”

It was Baker who, on a company earnings call that outlined some near-term strategies to address American’s underperformance, first asked AMR executives, “Is that all you got?”  In the WSJ story referenced above, Baker stated “we think the best thing AMR can do is figure out a way to generate more profitable flying with the current fleet." 

Jamie, is that all you got?

Baker and much of Wall Street’s short-sightedness is perplexing, even for a group that has a hard time seeing six months ahead.  I agree American’s quarterly revenue performance relative to peers was disappointing and concerning, as pointed out by Bank of America/Merrill Lynch analyst Glenn Engel. The point I think the Street is missing is American’s re-fleeting isn’t about six months from now or even next year. It’s about transforming a Robert Crandall vintage 1983 airline spending nary a dime. 

American’s MD80 fleet has basically been around since the earth cooled.  And it shows.  American flies more small narrowbody aircraft (150 seats and less) than any network carrier except for Southwest.  In 2009 (2010 data incomplete/incorrect) it’s the fuel guzzling, maintenance intense 140 seat per aircraft fleet flies about 9.7 hours per day (less than its peers); with an average stage length of 870 miles (about the same as its peers); and less than 4 departures per day (less than its peers).  More importantly, on those missions, the fleet burns 957 gallons of jet fuel per block hour – the same amount of burn as in 1995 when jet fuel was 56 cents per gallon – not $3.00+ per gallon.  No airline, except for maybe portions of Delta’s fleet, has to keep more spares available to maintain some sort of schedule integrity and thus have the potential for more operating leverage than American from a re-fleeting order.

And yet Baker and Wall Street want American to do more with less than its industry peers?  Maybe – and this isn’t a stretch - that aging fleet contributes to some to the airline’s under performance?  I’d say yes even though it’s difficult to quantify and I like my numbers cold and hard.  Perhaps most puzzling is the Street never offers a better time to re-fleet. When was it supposed to take place?  When it was too late and even more spares would have been required to maintain some semblance of a schedule?  That might have slaked some analysts’ thirst for capacity cuts, but that type of cutting is eerily close to shuttering an airline… and more expensive than marginal revenue improvements might lead you to believe.

Let’s Think About This Aircraft Order

American is not alone.  All of the industry, especially the more mature United, US Airways, Delta and Southwest – yes Southwest - all face some sort of replacement order.  It is just that American has a more real-time issue than do those that effectively used bankruptcy – not Southwest - and other means to get rid of aircraft with poor operating economics.  I am not being self-righteous… bankruptcy was necessary to address many legacy issues that would have buried others in the airline graveyard.  Fleet replacement is not like going to the store and grabbing something off the shelf.  Long lead times define aircraft purchases. 

What is wrong with placing an order at the bottom of the cycle versus the top of the cycle? It's a long-standing industry practice to do the opposite. It’s been a proven recipe for bad economics by adding capacity during a weakening economy that only leads to even poorer results. This quarter was less about writing down results than communicating a contrarian message – a re-fleeting announcement.  The rest of the industry, along with American, has been engaged in balance sheet repair over the past two years. 

The Street immediately pointed to the increased financial leverage associated with the new order and the fact that even though American will finance the first 230 aircraft with operating leases there will be a need to adjust upward the Fort Worth carrier’s debt by seven times the lease cost to reflect the long term commitment stemming from the lease financing negotiated with Boeing and Airbus. American’s hard won terms with the manufacturers does little to nothing to impact the company’s near term liquidity.  There is nothing to stop American from further balance sheet repair should operating results improve over the next five years as the first 230 aircraft are delivered.

Keep in mind, this order isn’t just about American. It’s also very much about Boeing and Airbus. They’ve thrown their balance sheets on the table as well, betting on American’s strategy and willing to take on the cost of building planes with no cash up front. That doesn’t normally happen in the airline industry. That’s serious backing and just how much of a deal both manufacturers gave American could very well be a game changer.

This Order Is About Both Finance and Competitive Positioning

When comparing American’s small narrowbody economics with Continental’s, American burns 262 more gallons per block hour than does the newly Chicago-based carrier.  I use Continental because its fleet is the most modern among the network carriers. Let’s not forget Continental began its re-fleeting project at the bottom of a profit cycle beginning in 1995 upon exiting bankruptcy #2. At 10 hours per day per month and with fuel assumed to be $3 per gallon, American’s new planes would immediately save $236,000 per month per airplane in fuel costs versus its MD80 fleet.  For every 10 cent increase in the cost of jet fuel, American would save an additional $8,000 per month per aircraft.

Few fleets have realized maintenance cost increases like American’s narrowbodies over the past decade.  I appreciate there are many ways to pay for maintenance expenses across the life of an aircraft, but during the honeymoon period of 5-10 years, American will, at least, not be paying $600 per block hour just to keep its MD80s in the air.  Instead it will likely save about $400-450 per hour.  Using the same calculus as in fuel savings, that saves the company another $135,000 per month per aircraft.

Yes, American still has to pay for the airplanes. As a general rule, the lease cost of an airplane is one percent of the sticker price.  If the retail cost of the various airplanes is $40 million per copy, then the lease cost is somewhere around $400,000 per month.  The fuel and maintenance savings are estimated at $370,000 per airplane per month. 

But wait a minute. We know that American did not pay retail for the airplanes.  Reuters reported American will only pay 70 percent of the list price on the Airbus equipment.  Airbus disputes that and I normally don’t believe numbers bantered around in the press, so let’s split the difference. Assume American is paying 85 percent of sticker price.  That brings the operating lease cost of the first 230 airplanes to $340,000 per month.  Even Wall Street can do this math.  If the planes cost $340,000 per month and the potential exists to save $370,000 per plane per month (and we haven’t talked about ancillary revenue possibilities from IFE, crew cost efficiencies from a simpler fleet once complexity costs are addressed, crew cost savings from a more reliable fleet, new passenger acceptance of a modern fleet etc), all of a sudden, American’s income statement and thus its balance sheet looks much different.

Is The Fleet Order Itself Transformational?

In a word, no.  Or maybe, sort of. The fleet is transformed, but that alone doesn’t necessarily transform the way American works today.  What would make this order even more exciting is to see a pilot agreement that really is transformational and recognizes the sub optimum economics of the U.S. domestic market.  What if the pilots were to negotiate pay banding, training language that does not create a bubble and benefit packages better resembling what corporate America provides its employees?  That would really make things interesting.  Problem is, those are all long-term realizations, which makes no one in New York any happier than they are today.

Another benefit from a pilot deal that could be labor transformational is to break the current regional – mainline mold.  If the economics of the smaller mainline airplanes (pilots, flight attendants and airplane) just ordered can match the economics of the largest regional jet airplanes out there, then much of the discussion over scope just might be over.  American needs access to more 76 seat aircraft (existing scope relief) with two class service, but the ask of the mainline pilots would not be further relief into the 90 and 120 seat range – unless of course there is no headway with APA making necessary changes.

Another thing to consider is, if some of the new planes are less efficient than even newer models or the price of oil goes significantly higher, the leasing options let American re-fleet the re-fleet.

Odds and Ends

Some say that American’s transatlantic partners are not the same airlines today as they were in yesteryear – namely British Airways.  That may be true in some respects, but either way, 1 + 1 is greater than 1 and that addresses those that believe American and their London counterpart are but half of their previous selves.  It was nice to read BA’s earnings release Wednesday morning citing improved traffic flows from American.  That will only continue to get better.  Realizing the full benefits of the joint business agreements is transformational for American as it evolves from a single entity into a much broader network.

But the most important fight taking place to transform American – and the industry for that matter – is the fight with the Global Distribution Systems.  Imagine the revenue benefits that will accrue to American in addition to just passenger revenue if they are able to package the product for the individual consumer.  If they are successful in breaking the monopolistic practices and reclaim their inventory – now that is transformational.

Taken together, there are some interesting possibilities taking shape in Fort Worth, Texas.  What needs to take shape immediately are the unit revenue benefits supposedly coming from the cornerstone strategy.  As analysts have correctly pointed out, that hasn't happened yet, which might explain the Street’s shortsightedness about other things American.

Look, I’ve been teasingly picking on Baker, Keay (indirectly) and Wall Street types. I realize their job is gauging the near-term forecast for clients.  But we’ve gotten so wrapped-up in Street predictions and instant opinions we’ve forgotten long-term, especially in the airline industry, like January 2015. American is resetting itself with a bold move that, honestly, shocked competitors and analysts. It deserves credit for making an astounding and first comer economic deal. Whether it works won’t be known 24 months (or five years given the jet fuel price) from now or even possibly 72 months.

But I doubt anyone is going to be asking if that’s all American’s got anytime soon.

To The GDS's: Either Evolve Or Dissolve -- It's That Simple

In the March 12 Economics column of The New York Times, University of Chicago economist Richard Thaler correctly titles his piece as it pertains to the airline industry:  “This Data Isn’t Dull. It Improves Lives.” The column then goes on to distort the intentions of the airline industry. 

At the heart of the matter is the relationship of the airline industry to the Global Distribution Systems (GDS).  Every time an air travel consumer works with a travel agency, the information being supplied by the agent is likely provided by a GDS.  The data necessary to enable the agent is supplied by the airlines to the GDS.   

In the early years following deregulation of the airline industry, GDS were largely owned by airlines and used to provide information to intermediaries to sell tickets on particular carriers.  The systems were biased toward the airline(s) providing the technology to the travel industry community.  These massive networks were built using the technology prevalent at the time – prior to the advent of the internet – and GDS were compensated for providing and maintaining vast private networks and for acting as gatekeepers between agents and airlines.

In fairly short order, the government stepped in to regulate the bias.  As a result, the GDS were no longer a distribution tool aiding the airline(s) that invested in the technology directly; rather they became a tool of the travel industry to sell a service.  Today, the airlines pay an intermediary to distribute their product – and they are paying a price much higher than the prevalent transaction costs. The airlines’ costs reflect an outdated model replete with older and more expensive technology as the GDS fight to sustain their large networks and maintain their role as gatekeeper.

But the intermediaries don’t pay the airlines for the airline-created content they use to lure customers to their respective websites so they can sell hotel stays and rental cars.  It makes no sense.

Name a financially successful industry that turns over control of its inventory to an intermediary. I can’t think of one either.

Airline travel is now available for purchase on multiple channels via the internet, including through the airlines’ own websites. Those sites typically provide carriers with the most control over the shopping experience while also being the lowest cost channel for the transaction. It is simply much cheaper and more efficient to use newer, internet –based technology to distribute tickets without the need for a “gatekeeper” between airlines and agents.   

Now the airlines also want to be able to go directly to their customers via their own channel.  Not that the airlines do not value the higher yield business that comes from agencies.  The motive is not, as some detractors have said, because airlines want you only to shop at their sites or not reveal what the cost of a trip is if you check two bags.  Rather, airlines are looking for ways to differentiate themselves by offering additional products and services to their customers that enhance the travel experience. This information is something the GDS cannot provide today without a significant investment in their systems.

Duopolists are typically reluctant to invest new capital unless it is absolutely essential to protect its cash cow

The airlines don’t necessarily want - or need – to drive all transactions to their sites and there is still a role GDS can play in this process. GDS could be content aggregators, allowing customers to easily compare fares. Right now, though, that’s a role GDS seems unwilling to take on perhaps worried about risking their fees.  

There are other factors at play here as well. First, airlines know their particular customers better than the government or the GDS. Plus; the GDS haven’t evolved as the industry has dramatically changed.  

Today’s GDS force the airlines to compete only on two factors; service and price. By limiting areas how airlines compete, the product offered is the definition of pure commodity. This was true in 1983 just as it is today. 

Despite the airline industry’s efforts to remove more than $20 billion in expenses over the past decade, the price of another commodity essential to its business increased more than fourfold – oil.  The airline industry is left with little choice, if it is to ever be a sustainable business, but to begin the process of de-commoditizing its product and finding new revenue sources.  To do so, means fundamentally altering its legacy relationship with the GDS and recapturing control over its inventory.

The airline industry has found new ways to generate revenue by offering customers products they value and are willing to pay for, including seat upgrades, passing through security faster or day passes to airport clubs. Bag fees, now charged by the majority of U.S. carriers, reflect a more accurate way to pay for what you use. In other words, customers that don’t check bags no longer subsidize the cost of those who do.  

Yet the GDS and supporters claim airlines aren’t being “transparent” in their pricing that they do not want to reveal the total cost of trip to a passenger.  Few industries have price transparency like the airline industry – compare it to cell phone contracts – and the majority of customers know exactly what they’re paying for when they travel.

Thaler is right; the data supplied to the GDS is anything but dull and service and price competition have benefited many by making air travel affordable to the masses. This will certainly continue as the competition is as hungry today as ever.

This is not a fight about defending the purity of data or somehow withholding it from those whose only aim is to presumably help customers. No one, including the GDS, can really dispute that this information comes from the airlines.

Despite the rhetoric, it’s also not about protecting customers from an industry desperate to reach more. This is about protecting an outdated mode of operation and stifling innovation.  The GDS duopoly cannot move fast enough for an industry that sells “time saved”.  The GDS doesn’t want its revenue tap turned off. It’s time the GDS recognizes it can’t support interests other than their ultimate customer – the airlines.  The airlines are simply looking to adapt to new economic realities and help their ultimate customer – the person who actually buys a ticket.

Duopolist.  Monopolist.  Neither is accepted in the airline business.  Now the airline business says it is time that vendors servicing the airline industry cannot be duopolists or monopolists either.  It is all part of the evolution of the business that began in 2002.