Will AMR's Chapter 11 Ground Its Competitors?

Includes: AAL, ALK, DAL, JBLU, UAL
by: Adam Levine-Weinberg

Last month, I wrote that airline stocks were likely to pull back in the near-term, as investors took profits from the December 2011/January 2012 run-up. Indeed, since that time most airline stocks are down 10-20% even though the broader market has moved higher. The two major catalysts I cited at the time were 1) rising oil prices, and 2) concern that AMR's (AAMRQ.PK) turnaround plan would hurt competitors, particularly those with significant route overlap, like United (NYSE:UAL). It is difficult to predict the future trajectory of oil prices, so I will instead focus on the likely impacts of American's restructuring.

On February 1, AMR laid out a plan to cut costs by $2 billion over the next five years, with $1.25 billion coming from reduced labor costs. Meanwhile the company hopes to increase revenue by $1 billion and increase the number of flights by 20%. Increasing capacity generally drives down fares, and could thus be viewed as a negative for the industry.

However, it is important to view all of this as a bargaining position rather than a "plan". At the time that the company filed for Chapter 11, its leaders stated that American faced an $800 million labor cost disadvantage compared to its competitors. Since that time, the unions for flight attendants at United and US Airways (among others) have won significant pay raises in negotiations. So the disadvantage is probably even smaller today. American will thus probably have trouble convincing a judge that $1.25 billion in labor cost reductions are necessary. By starting with a high target, AMR management is trying to give itself plenty of room to negotiate smaller cuts.

At the same time, "increased departures" does not necessarily mean increased capacity. Last month, American had roughly 1 billion ASMs on its regional affiliate Eagle, compared to 12 billion ASMs on its mainline operations. Including the few "American Connection" flights operated out of Chicago, regional capacity makes up at most 9% of total AMR system capacity. By contrast, at rival Delta (NYSE:DAL) regional capacity made up nearly 14% of the total last month. American's management has made it very clear that they want to change the pilot contract to allow more regional flying, particularly on 70 seat jets. Since these planes have half the capacity of American's aging MD-80 fleet, it is entirely possible that AMR could increase departures by 20% while increasing capacity in the single digits.

Of course, it's also important to note that this increase is not set in stone. Here, AMR may be trying to soften the blow for employees by suggesting that laid-off workers might be able to rejoin the company eventually and, more importantly, that there will not be a second round of layoffs in the future. AMR's main network competitors, Delta and United, thus have less to fear than AMR's announcement seemed to imply.

Some of the smaller carriers may actually benefit from AMR's plan to broaden its network. JetBlue (NASDAQ:JBLU), which has an interline agreement with American, may be able to upgrade that arrangement to a full codeshare. American clearly wants to increase its customers' choices, but has been unable to do so due to scope rules in its' pilot contract. Chapter 11 creates a way forward, and the combination of the two carriers' networks at JFK would be a big plus for both. Meanwhile, Alaska (NYSE:ALK), which already codeshares with American, might be able to increase cooperation on that front. Ultimately, American might be interested in merging with Alaska, which has a very strong hub in Seattle that could potentially become a significant transpacific gateway.

In short, while AMR may not be making deep capacity cuts as initially expected, their reorganization will not seriously threaten the other airlines from a competitive standpoint. Labor cost cuts will likely bring AMR inline with the rest of the industry. Capacity increases, if any, will be modest, especially since they will be spread over five years. And some of AMR's partners may be particular beneficiaries of American's desire to outsource more flying.

Disclosure: I am long UAL.

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