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AMR Corporation (AMR)

Q3 2007 Earnings Call

October 17, 2007 2:00 pm ET

Executives

Gerard Arpey - Chairman, President and CEO

Kenji Hashimoto - MD of IR

Tom Horton - CFO, EVP Finance

Analysts

Frank Boroch - Bear Stearns

Gary Chase - Lehman Brothers

Robert Barry - Goldman Sachs

Michael Linenberg - Merrill Lynch

Jamie Baker – JP Morgan

Dan McKenzie - CSFB

Bob McAdoo - Avondale Partners

Ray Neidl - Calyon Securities

Kevin Crissey - UBS

William Greene - Morgan Stanley

Presentation

Operator

Ladies and gentleman, thank you for standing by. We do appreciate your patience today, while the conference assembled; and good afternoon.

Welcome to AMR’s third quarter 2007 earnings conference call.

Now, at this point and during the presentation, we do have all your phone lines muted, or in a listen-only mode. However, after the executive teams’ prepared remarks, there will be opportunities for your questions.

Now, just to note, we’ll be taking questions first from the members of the analyst community that has joined us; and then immediately after their session, we’ll be moving into the media portion of the call.

As a reminder, today’s call is being recorded for replay purposes. So, with that being said, let’s get right into this third quarter agenda.

Here’s Kenji Hashimoto, Managing Director of Investor Relations.

Kenji Hashimoto

Good afternoon, everyone. Thank you for joining us on today’s earnings call.

Similar to last quarter, Gerard Arpey will provide an overview of our performance, and then Tom Horton will provide the details regarding our earnings for the third quarter, along with some guidance of the remainder of 2007 and a few perspectives on 2008.

After that, we will be happy to take your questions. In the interests of time, please limit your questions to one, with one follow-up.

Our earnings releaser earlier today contains highlights of our financial results for the quarter. This release continues to provide additional information regarding SEC performance and cost guidance, which should assist you in having accurate information about our performance and outlook.

In addition, the earnings release contains reconciliations of any non-GAAP financial measurement we may discuss.

This release, along with a web cast of today’s call, is available on the investor relations section of 8A.com.

Finally, let me note that many of our comments today on our outlook for revenue and earnings, cost estimates and forecast of capacity, traffic, load factor, fuel costs and other matters constitute forward-looking statements. These matters are subject to a number of factors that could cause actual results to differ from our expectations.

These factors include changes in economics, business and financial conditions, high fuel prices and other factors referred to in our SEC filing, including our 2006 annual report on form 10-K(a).

With that, I’ll turn the call over to Gerard.

Gerard Arpey

Thank you Kenji. Good afternoon everyone. As you saw this morning in our press release, we earned a third quarter net profit of $175 million, which includes a $40 million out-of-period charge. This compares favorably to the third quarter of 2006’s net profit of $15 million, which included a $99 million special item.

This is the highest third quarter profit since the year 2000, when oil was only $28 per barrel, versus today’s nearly $90 per barrel.

Obviously, oil prices are a very big concern for us in the industry right now. Tom will talk to you more about that in a moment but suffice it to say that, just like any other cost in our company, we’ve got to find a way to pass it on to our customers. We have led several price increases with the run-up in oil costs lately, and we will have to see where all that shuttles out in the market; but I figured it’s fair to say we are alarmed at the level of oil prices as we see them today.

Our traffic levels were strong in the third quarter, setting another record load factor of 83.9%. Our Pacific and Latin American results were particularly strong and we were pleased that the Department of Transportation awarded us the right to serve the Chicago Bejing market effective in 2009.

We are also excited about our planned service from Chicago to Moscow, beginning next summer.

We are continuing our cautious approach to capacity, while making prudent investments in our product. At this point, the majority of our 767’s have completed their interior refurbishment, which includes our next generation business class heat, and our customer feedback has been outstanding on the new seats and the new interiors. Our triple 7’s will be standardized around our flagship suite 1st class product and that will also include, in the business class cabin, our next generation business-class seat. That project will be completed by next summer.

We have several Admiral’s club renovations under way right now, giving many of our clubs a needed facelift, and we recently completed and opened the final phase of our new JFK facility. I was very grateful that Mayor Bloomberg came out helped us inaugurate the final phase of that project.

I am also pleased with the progress we have continued to make on the balance sheet front. We paid down another $560 million dollars in long term date and capital leases in the third quarter of this year. Our net interest expense for the first 9 months of this year was down $133 million. I think Tom Horton and his team have done an outstanding job, particularly in the first half of this year when the capital markets were a little more friendly than they are now, to get ahead of some of this stuff, and so I’m pleased with the progress that we have made there. As you all saw in the release, we ended the quarter with $5.8 billion dollars in cash.

It’s also good to see that we were able to contribute another $200 million to our various defined benefit pension plans in the quarter, bringing our year-to-date total to $380 million.

I think our financial performance can be measured in many ways; profitability, balance sheet strength, pension funding, and reinvestment in our products and services. On all these measures, we have been continuing our positive momentum, and we’re pleased by that.

We are also continuing to give careful consideration to the best use of our strategic assets and the impact these decisions might have in the long run for our shareholders; and Tom will elaborate on some of our thinking in just a moment. So, let me turn things over to Tom and he’ll take you through the details regarding our third quarter performance in the outlook for the balance of the year. Tom.

Tom Horton

Thanks, Gerard, and good afternoon, everyone.

As Gerard said, in the third quarter we earned $175 million versus $15 million in the third quarter of last year. Both years include special items, which I’d like to briefly touch on.

As indicated in our release four weeks ago, this year’s third quarter includes an out-of-period charge of $40 million, related to an adjustment for additional salary and benefit expense from prior periods. $40 million of this charge is attributable to the years 2003 through 2006, and $10 million of the charge relates to the first half of ’07.

And some of you may recall that last year’s third quarter had a special item related to marking to market our fuel hedges. In the third quarter of last year we experienced a fuel price decline that reduced the book value of certain outstanding fuel hedge contracts and resulted in a $99 million non-cash charge in the other income and expense line.

So, for the remainder of the call, I’ll exclude the impact of special items and out-of-period charges, to more accurately reflect our performance on an ongoing basis.

This quarter demonstrated our continue momentum, despite high fuel prices. We have had six consecutive profitable quarters; and while we still have a long way to go, we believe we are moving down the right track by continuing our capacity discipline while we strengthen our balance sheet and reinvest in key products, services, and in our fleet.

So, moving to our numbers. Let’s start with our third quarter revenue performance.

For the quarter, mainline unit revenue increased by 5% year over year, on record load factors. Our unit revenue for our consolidated system was up 4.7%.

Before we get started on the entity-specific revenue results, I want to remind you that, since the beginning of this year, we have included this data in the earnings release, for your convenience.

In our domestic markets, third quarter unit revenue increased versus last year. And this year-over-year improvement was sequentially better than first and second quarter of this year.

As we have noted in the past, our revenue results are not yet impacted by changes to our advantage frequent flyer programs mileage expiration period. The reason we announced from 36 months to 18 months expiration period for miles, will be effective December 15 of this year. At that time we expect to recognize the affect of expired miles through a one-time benefit.

Before leaving the domestic discussion, one item I’d like to note is that our ongoing focus on enhancing AA.com is paying off. Recently, the Forester Group ranged AA.com as the best web site in the airline industry.

Moving on to international. While moderating, our international continued to be strong, as third quarter unit revenue increased versus 2006, on both yield and load factor improvement. We had positive performance across all entities, with all having unit revenue improvement.

While Pacific’s strong performance was influenced by our cancellations of Dallas-Osaka and San Hose-Tokyo, at the end of October last year, this entity has been performing very strongly on an absolute basis.

We have been trying to bolster our network to the Pacific and are happy to say that we have been awarded Chicago-Bejing service, effective 2009, which will compliment our Chicago-Shanghai flying, along with all of our Tokyo flying, and robust alliance relationships in the Pacific.

Atlantic third quarter unit revenue performance versus last year also improved. And there is a lot going on to upgrade our product. As Gerard mentioned, we continue to make progress on upgrading our business class seats on our 777 and 767, 300 aircraft.

At this point, over 80% of our 767 300’s have the new product, and we expect that project to be complete by early January.

In addition, on the triple 7, the first class product will be standardized around our flagship suite by the end of next year. And the next generation business class fee will be on the entire triple 7 fleet by mid-2008.

We have also been busy refining our schedule. Recently, we have announced JFK to Barcelona and Milan, along with Chicago to Moscow; and we are very excited about these additional opportunities to broaden our already deep network.

Finally, Latin America continued its positive performances, as unit revenue increased year-over-year, despite last year’s very strong third quarter 13% increase, in an increasingly competitive environment in some markets.

In addition to the added flights to San Jose, Cost Rica and Santo Domingo from south Florida, that I mentioned last quarter, we have recently announced new service from Chicago to Buenos Aires, DFW to Panama City, and Miami to Barancia Colombia.

Rounding out the international discussion, I would like to touch on a couple of pieces of positive alliance news. On November 1, Dragonair will be joining Oneworld. Dragonair serves 19 destinations in China and has regularly been named in customer surveys as the best airline serving China.

Earlier in the quarter, we filed with the DOT for anti-trust immunity with Iberia, Finnair, Malev and Royal Jordanian. It follows to allow the five airlines to cooperate in a wide variety of areas that will provide a better travel experience for our customers.

Turning to other revenue items, third quarter revenue for our regional affiliate operation increased by 0.6% compared to last year, and showed a positive unit revenue improvement versus last year.

Total cargo revenue decreased by 8% year over year. Freight revenue, including fuel surcharge, was down 4%.

As we discussed last quarter, this expected performance was driven by lower freight and mail traffic year over year.

Finally, in the third quarter, our other revenue line was up 5.7% year over year, at $352 million.

Moving on to expenses. We continue to face head winds in our costs, as we had accelerated depreciation from previously planned aircraft cabin refurbishment projects; certain salary and benefit investments, to improve the customer experience; higher revenue-related expenses; and water cancellations in July.

Excluding fuel and the out-of-period charge, our unit costs rose by 4% mainline and 4.2% consolidated.

Our fuel price came in about even with last year’s third quarter, at $2.18 consolidated. Despite the somewhat flat fuel price versus last year, fuel price still remains historically high and volatile; and I will get into our fourth quarter thoughts in a moment.

So, if fuel goes high, conservation continues to be one of our top priorities, as we continue to explore opportunities for more savings.

We just completed a wing light installation on all the 737’s, and anticipate completion on the entire 757 fleet by fourth quarter of next year.

We also continue to do many smaller things, such as converting all MBA tail comps to be more aerodynamic; and replacing beverage carts with lighter weight versions, which would save 20 lbs. per cart.

Moving to non-operating costs, these were better year-over-year by $26 million in the quarter, driven by improvements in both interest income and interest expense, as we had both higher cash balances and lower debt balances.

Now, turning to the balance sheet, we entered the quarter with $5.8 billion dollars in cash, including $447 million dollars in restricted cash.

In the third quarter, our scheduled principle payments on long term debt and capital leases totaled $560 million, which leaves a remaining $294 million in scheduled payments for the fourth quarter.

In addition, we prepaid $32 million of Eagle Aircraft debt and announced our intention to prepay $545 million in aircraft debt later in the fourth quarter.

As a result of scheduled principle payments, as well as incremental efforts to strengthen our balance sheet, we lowered our net interest expense for the first nine months of year by $133 million.

Our capital expenditures totaled $146 million in the third quarter.

On the pension front, we contributed $200 million to our defined benefit pension plans in the third quarter, for a total of $380 million so far this year.

As a reminder, we’ve signed an agreement to sell our stake in ARINC, the air-to-ground communications company. We expect to close this deal later this quarter; and when the transaction closes, we expect to receive proceeds of approximately $194 million, and record a one-time gain of $140 million, assuming the closing conditions are satisfied.

So, in sum, it’s fair to say that, while there is still much work ahead, we have made some solid progress on the balance sheet. Our total debt, as defined in the earnings release, is now $16.6 billion. Our net debt, defined as total debt, less unrestricted cash and short term investments, is now $11.2 billion. That represents a 2.8 billion dollar or 20% reduction in net debt versus the same time last year.

Moving to guidance, our full year 2007 mainline capacity is now expected to decrease about 2%, compared to 2006.

Both load factor for the fourth quarter is currently about half a point higher than at this point last year.

On the fuel side, fuel prices continue to be high and volatile. As we stated in our earnings release, the fourth quarter price is anticipated to be $2.27, with a full year consolidated price forecast of $2.10 per gallon. I would like to note that the fourth quarter estimated price is 20% higher than last year’s actual fourth quarter price.

In regards to hedging, we continue to follow a strategy of systematically laying in hedges, using primarily collars, to dampen volatility. We have 40% of our fourth quarter consumption capped at $69 a barrel, and our mainline consumption is anticipated to be approximately 700 million gallons in the fourth quarter.

As discussed previously, we continue to work towards our goal of achieving $300 million in cost savings for 2007. This is driven by our cost initiative such as distribution cost savings, schedule and fleet simplification, and ongoing fuel conservation initiatives.

As the data in the earnings release indicates, the weather impact on first-half unit costs puts more pressure on our goal to contain full year unit costs.

Our original goal was to keep mainline unit costs, excluding fuel and profit sharing, flat with last year. When we excluded the weather impact from our mainline unit costs, we are, unfortunately, still falling a bit short.

We are taking steps to enhance our focus on containing costs for the company; and everyone is dedicated to contributing to this effort. One recent example is that we are consolidating our reservations offices, which will result in the Cincinnati reservations office closing later next year.

Moving to our cash forecast, we expect capital expenditures of more than $600 million in 2007; which excludes the possible impact of future pre-delivery deposits, associated with future aircraft commitments, as we execute on our fleet renewal strategy.

Our schedule principle repayments are still expected to equal $1.3 billion for a full year.

Adding in debt retirement, early debt retirement, full year debt pay-down is expected to be $2.3 billion; and we’ve made total expected pension contributions for 2007, of $380 million.

Finally, a quick update on our fleet renewal strategy that we announced in March.

At that time, we stated our intention to pull forward all 47 Boeing 737 commitments into the 2009/2012 time frame, ahead of their previous 2013/2016 delivery schedules; and we have been executing on that plan throughout the year.

In the first half of 2007, as you already know, we accelerated the delivery of nine 737 800s into early 2009. And, as we note in our press release today, in the third quarter, we pulled forward three 737’s for delivery in the second half of 2009.

In addition, on October 1, we notified Boeing of our intent to take delivery of an additional 737 in early 2009, representing our first 737 commitment beyond the initial 47 aircraft.

All told, we now have a scheduled delivery of 13 737’s through 2009. Any decisions to accelerate additional 737 aircraft deliveries will depend on factors such as economic and industry conditions, and the financial condition of the company.

We believe this is a very prudent and flexible approach that allows us to match our fleet to the market conditions, while leading us down a path of improved fuel efficiency and lower emissions.

Looking forward to next year, we are still finalizing our budget, so we’ll have more information to share with you on our next call.

Right now, our 2008 plan calls for a mainline capacity increase of a little of over 1% compared to 2007.

By entity, we are currently planning for about a 0.5% increase in 2008 domestic capacity, while international capacity is planned to increase by about 3%.

However, keep in mind that we are expecting to under-fly our 2007 schedule by a significant portion, approximately 1.2%, primarily driven by weather. So, on a schedule-to-schedule basis, our system capacity is roughly flat.

So, to summarize our outlook, high fuel prices are a big concern for the fourth quarter, which is our seasonally weaker quarter. We continue to work to improve the balance sheet; and, of course, we will continue to make a very measured approach toward capacity and continue to dig deep to find more improvement in our cost structure.

While plenty of challenges remain ahead, we are working hard to build on the progress achieved thus far.

And finally, we thought it would be appropriate to briefly discuss a matter that’s top-of-mind for many of you, as it is for us; mainly, how we are approaching value creation related to certain businesses under the A&R umbrella.

It goes without saying that we are committed to deploying our resources, to enhance shareholder value. This naturally includes investments, to support and grow our core business, as well as opportunities to deleverage our balance sheet, and other strategic options, such as asset divestitures that we might consider, to improve shareholder returns.

With regard to the latter point, we are proud of our long track record of building businesses over the years. When it made sense for our shareholders, we would take appropriate steps to unlock the value we have created.

Examples include the IPO of Sabre Group, and the subsequent full spin-off in 2000; and the sale of AMR Services, AMR coms, and TSR in the late 1990’s.

Characteristics of these businesses included market leading positions in their respective industries, separate support and management structures, and the prospect of benefiting from clear market comparisons with their peers, to more appropriately reflect their full value and potential.

Additionally, we looked at whether the divestiture of these businesses made sense for, and did not aversely affect, AMR.

Today, we are continuing this process of building businesses; and we are fortunate to have a master range of strategic assets that contributes significant value to AMR.

At the same time, we are always looking to determine the best structure and strategy for each of these businesses, in order to enhance shareholder value.

Included in this category are such diverse groups as American Eagle, our regional airlines; American Beacon Advisors, our investment advisory subsidiary; our maintenance repair and overhaul operation, or MRO; and Advantage, the word’s most popular frequent flyer program.

For each of these businesses, there are arguments for some type of value-enhancing activity; but there are also strategic and practical challenges.

We need to consider the strategic in the relationships of the businesses. In particular, the potential impact on the synergies of the businesses versus the potential value creation from separation.

As with all companies, we need to evaluate whether there are any implications down the line that might cause what appears to be a smart decision on its face, to be questionable in retrospect.

Therefore, we are carefully considering the pros and cons as we make our decisions. Let me discuss a few of these in more detail.

American Eagle is a fully developed operating unit with an industry leadership position, a strong management team, and annual revenues of approximately $2.4 billion.

The potential benefits of pursuing some type of divestiture include: proving Eagle with the structure, incentives and opportunities to grow its business, while also enabling American to focus on its mainline business and ensure continued access to cost-competitive regional feed over time.

However, we must make certain that any transaction does not merely become an extensive financing but, rather, one that liberates value and takes into account the impact on American.

Similarly, American Beacon Advisors is a successful money management business, with a strong management team and annual revenues that have grown steadily to nearly $100 million. Assets under management have more then doubled, to $65 billion, with the majority of these assets being unrelated to American since 2003, when we put it up for sale and entertained offers to buy it.

We chose not to pursue the sale because we thought that the offers undervalued the business, relative to keeping and building it, in part, because of the then-weaker financial condition of AMR. Since that time, AMR's financial condition has improved significantly and we have aggressively grown Beacon and diversified its business base to become less dependent on AMR. We continue to study the appropriate path that makes the most sense for this business and for our shareholders.

Our MRO has a lot of potential to grow its base of third party maintenance business, but it is still early on in its development and I would note that the vast majority of its business is AMR-derived. We believe that it would be premature to make a judgment on its long-term potential without the benefit of more time.

With regard to the potential separation of the Advantage Program, let me share with you some of our thinking to date. It is an interesting idea; one that has received a lot of attention at our company and of late, in our industry as well, and one that we continue to think about.

The structure most often cited would involve dividing AMR into two parts: a cash-flow driven business with potential to generate ongoing dividends, and the remaining business without the Advantage cash flow. This raises fundamental questions that must be addressed regarding cash usage, risk profile, and the current environment and capital structure.

In addition, it goes without saying that our frequent flyer program is deeply intertwined with AMR, and has been strategically integral to the long-term success of American Airlines and American Eagle. It is the cornerstone for how we interact with our best customers. Any value-enhancing action must be carefully analyzed within that context.

For example, beyond all the marketing and licensing complexities, if the loyalty program were separated from AMR, the question of who would own and control those customers, by definition, American Airlines' best and most frequent travelers, must be carefully considered. These are some of the factors that make separation more complicated than it might first appear, but I want to underscore that we are evaluating the Advantage business in the context of building shareholder value.

Finally, I also want to mention that we'll be looking at how to best provide financial disclosure and metrics for these businesses that will improve transparency, and we expect to provide more on that during our next earnings call.

With that, Gerard and I would be happy to take your questions regarding our quarterly results.

Question-and-Answer Session

Operator

Your first question comes from Frank Boroch - Bear Stearns.

Frank Boroch - Bear Stearns

Tom, if you could maybe give us a sense of how unit revenue performed across the hubs in the quarter, that would be helpful.

Tom Horton

Our domestic unit revenue in the quarter was up 4.8%. As you break that down, it was up about 5.5% to TransCON, Dallas was up about 2.8%, Chicago was up 3.8%, Miami was up a little over 3%, and St. Louis was up almost 8%.

Frank Boroch - Bear Stearns

You alluded to the policy change, the expiration policy change coming in December. Can you give us a sense of the magnitude, the revenue impact you're expecting from the 18-month expiration period?

Tom Horton

We're still working on it. It will depend on the results of that work, but it will be measured in the tens of millions of dollars in revenue.

Frank Boroch - Bear Stearns

Is there anything happening in the Atlantic division, in terms of, your revenue seems to be underperforming a little bit the broader industry?

Tom Horton

I think that's a fair question. Our Trans-Atlantic performance continues to be impacted by the weak market environment in London. As you know, about half of our Trans-Atlantic capacity is London compared to the rest of the U.S. industry, which is around the 20% range for their Trans-Atlantic capacity.

London has struggled for a number of reasons. It's struggled with higher taxes, ongoing security concerns, and I think it's fair to say increased competition. If you look at the pricing environment in London, it continues to be extremely competitive, and you've seen aggressive pricing led by BA and Virgin. The London point of sale yields are down year over year, despite the beneficial impact of the exchange rate fluctuations on our UK point of sale yields. Pricing has been a bit weak and the premium traffic results have also been impacted by some of the factors I just mentioned, but also by increased capacity by other airlines in the New York and Chicago markets. So London's really been a bit weaker than the rest of Europe.

Operator

Your next question comes from Gary Chase - Lehman Brothers.

Gary Chase - Lehman Brothers

Tom, could you elaborate a little bit? You said that despite the weather-related issues, you do have a couple of things that are running a little bit over on the cost side. Could you just elaborate a little bit on what you're doing to stem that?

For both of you guys, as you look into 2008, what do you think the opportunities are on non-labor costs, something that you've done a really exceptional job of controlling over the last couple of years? Can you go through another year where you offset inflation in the business with some of these initiatives that you've been rolling out?

Tom Horton

I'll start off, let Gerard chime in if he likes. Our costs were a little bit higher than we had hoped for in the quarter and I'll give you a couple of the reasons why. We had additional labor expense for investments in improved dependability. No secret that it has been a very difficult year for the whole industry, very difficult summer from a dependability standpoint, so we've made some investments there.

We've also made some investments on improving our aircraft interiors. This sort of thing I think is likely to occur in the short run, but it's really too soon to call it a long-term trend, but we're going to keep working on our dependability metrics.

We did accelerate some depreciation expense associated with some of the aircraft cabin improvement projects we have going on, so the way that works is if you replace interior components, you have to write off the assets that you have on the books. So there's some of that in the numbers.

Third, a little bit of a good news/bad news story, and that is we do have higher unit revenues and some of our costs are revenue-related as you know, so we have higher revenue-related expenses.

To your question, we are very focused on costs, as we have been, I think everybody on the call knows we've been grinding costs out of here for a long time and we continue to do so. A few things that we have in the works right now, as I mentioned, consolidating our reservation centers which resulted in the closing of the Cincinnati res office. We're working at grinding more costs out at JFK, now that we're back down to a single terminal. We keep our focus on distribution cost opportunities and there may be a few things there that we're working on but will be incremental to what we've done thus far.

We have a very aggressive fuel conservation initiative ongoing. I mentioned a couple of the things in my opening remarks, but I can tell you that every month we sit down and we go through a long list of opportunities to improve our fuel burn. We're very focused, and you're going to see us keep the pressure on costs.

Rolling into next year, we haven't yet completed our budget, so I can't tell you what our cost reduction target is going to be, but the more costs you take out the harder it gets to find the next dollar of savings.

Gary Chase - Lehman Brothers

A bigger question behind it, embedded in the fuel forecast for the fourth quarter, if you use even yesterday’s, they are now out of date. Two days ago, they are really out of date. What's the spot assumption behind the 227 you've got out there, just so we know?

Tom Horton

Let me round that up here, it's probably just a couple of days ago.

Gary Chase - Lehman Brothers

While you're thinking about that, Tom, the important one is, obviously with fuel changing as much as it has even this week, that's a significant number for you if you look over the span of say 2008. I'm curious for the capacity plan that you articulated earlier, which is flattish on a scheduled basis, up a touch. Is that contemplating $80 oil and at what point might you revisit that just given what we've seen here over the last few weeks?

Tom Horton

Let me just come back to your first question. The spot price in the forward curve that was embedded in the fourth quarter guidance was as of October 1st. So you can go back and look at what the spot was on October 1st. It was considerably lower than where oil is today.

I mean, you're right on point, because oil has just been extraordinary for this industry. If you go back to January and look at the average price of oil at the beginning of this year, so the month of January, the average price was around $54 a barrel; it's $88 today. That's $34 a barrel. That equates to over $2.5 billion a year in costs on an annualized run rate. So it is extraordinary. You're absolutely right. I think the whole industry will have to look at that and consider that in making capacity plans for 2008.

Our capacity plans at this point, we think, are pretty conservative, as they have been for the past several years, on a schedule-to-schedule basis, we're basically holding our capacity flat, while the rest of the industry looks like it's going to be up around 3.5%.

Gerard Arpey

The only thing I would add to Tom's comments would be to underscore the sentiment in your question which is what I alluded to in my prepared remarks, which was the fact that not just American but the industry's is going to have to find way to recover these costs, and I think if we're not able to do that, it does very much call into question our operating plan for next year and the levels of flying that we want to anticipate. So I think that's clearly something we're going to be paying close attention to as we finalize the plan for next year.

Operator

Your next question comes from Robert Barry - Goldman Sachs.

Robert Barry - Goldman Sachs

Maybe just a follow-up on that, I was wondering if you could give us any color on just how you're thinking about maybe even what you're seeing in the market vis-a-vis recovering some of those costs? Because even though the market doesn't seem to be acting like it, the economists tell me we're moving into a cyclical slowdown here. How are you thinking about that? What are you actually seeing, looking out the next couple months?

Tom Horton

Well as I mentioned a minute ago, our advanced bookings are up a little bit year-over-year in the fourth quarter, not a lot but off of some pretty high load factors last year so that, I think, is a modest positive. There have been, over the course of the last few days, some price increases; one that we led, and one that was led by our competitor across town. Those are modest price increases, but I think much-needed, given what's going on with oil.

If you look at the third quarter of '07, even setting those two price increases aside, there have been something like nine price increases out of 11 attempts, and so the industry, as Gerard said in his remarks, the industry is going to have to recover its costs of inputs, or it's not going to be profitable.

Robert Barry - Goldman Sachs

When you said earlier also that you thought the rest of the industry would be up 3.5%, was that domestic capacity?

Tom Horton

That was system-wide.

Robert Barry - Goldman Sachs

Could you tell us how much the FX did impact RASM in the Atlantic and then Latin America?

Tom Horton

It looks to us like if you just held point of sale mix constant and you use last year's exchange rate, that would lower our Europe RASM by a couple of points. That's if you assume that a weaker dollar doesn't impact U.S. demand and point of sale mix. So that would say FX drove a 2 point improvement in our year-over-year RASM.

However, as we dig into that a little bit deeper, we saw much lower U.S. point of sale demand and stronger Europe point of sale demand, and as you probably know, our Europe point of sale traffic is generally lower yielding, and we saw a lot of aggressive price discounting for both U.S. and Europe point of sale, which I pointed out a minute ago.

Given the overall demand picture we saw, the lower year over year sale levels and the point of sale shift to lower yielding Europe point of sale suggests that the net benefit of a weaker dollar was really quite modest.

Robert Barry - Goldman Sachs

As we look into '08, how should we think about modeling the depreciation, given the dynamic of the accelerated depreciation?

Tom Horton

Depreciation will be relatively flat to down a little bit, that's the way you should think about it.

Operator

Your next question comes from Michael Linenberg - Merrill Lynch.

Michael Linenberg - Merrill Lynch

Tom, I appreciate all the detail here on all the various entities. Are you prepared to give us the revenue number for Advantage?

Tom Horton

Mike, we're still thinking about what actually will be disclosed. I think with respect to the businesses that are most developed, like Eagle and Beacon, it would be revenues and perhaps profitability. Advantage is obviously not the same stage as those two businesses. So we'll have to think a little bit more about that. One of the things we're going to think about is, what of this data is competitively sensitive to us? So we have to balance transparency with, with competitively sensitive data.

Michael Linenberg - Merrill Lynch

My second question, with the announcement of the Delta Air France JV this morning, obviously markets like Heathrow to Atlanta and New York, I think most people were expecting that, the fact that they are looking beyond that to markets like LA-Heathrow, a market that you serve. Thoughts on the announcement? Does it create a sense of urgency within your organization that you maybe have to pursue something a bit more comprehensive with one of your partners? Should we stay tuned/ Should we anticipate something as we approach the March 30th start date of open skies?

Gerard Arpey

Michael, I'll start and maybe Tom can add some color. I think much of what we've read, including some of the specific markets that you commented on, I think were anticipated by us. I would go back to some of Tom's comments about the London market in general. I think anyone who thinks that is going to be an easy market or a panaceas for terrific profits is really not mindful of what's been occurring in the London market for many months now.

We regret the fact that we have not been able to get to the point where we have immunity with British Airways, but I continue to be optimistic that we will get to the point where we can be successful in an immunity application with British Airways, because I think the regulators are going to have to start looking at these markets. Not in terms of individual airlines and individual city pairs, but they are going to have to look at the world and look at the way airlines are now competing across alliances.

If they begin to look at the way the airlines actually compete as opposed to the historic ways that they have looked at this industry, they will see that what we're trying to do with British Airways is really pro-competitive to be able to compete with what the other alliances are doing.

I remain optimistic that we're going to get there someday and I think when we do, we'll be able to hold our own in London with everybody.

Tom Horton

In the meantime, we're very focused on our own product in London. I mentioned some of the product upgrades we're making earlier, but also some of the schedule changes, so as of this next summer, we're going to operate up to 20 daily round trips from the U.S. to London airport, so I think we'll be a formidable competitor for anybody who enters that market.

Michael Linenberg - Merrill Lynch

Tom, just one last one. , you gave us some '08 debt, et cetera. I think the pension legislation, I think you start seeing the benefit of that in '08. I could be wrong then, but do you have an early read of what that cash contribution looks like for '08 or is that for the next call?

Tom Horton

I think we're going to put that actually in our 10-Q. You know how the pension legislation works, it doesn't change the company's total future contributions, but it does give us more flexibility in the near term. So our '08 required minimum contribution is really quite modest after the new legislation. But our practice has been, all else equal, to fund something like our ongoing normal service costs.

That number for '08 is on the order of $350 million. That's not required, but that's sort of what right now sitting here today, what we think we would contribute for '08.

Operator

Your next question comes from Jamie Baker – JP Morgan.

Jamie Baker - JP Morgan

Good afternoon, gentlemen. Gerard, I appreciate all of Tom's commentary today, but oil's almost $90 here. You've told us again today that you're evaluating consolidation and asset spend. The situation with the pilots actually seems to be deteriorating, at least from our vantage point. London competition, you concede it is only going to get worse from here, and last time your stock was down at this level, I think you were expected to be losing money.

So I have to ask the same question that I asked of Delta yesterday. How much more time do you need before you reach some of these important conclusions, decisions in terms of M&A and asset spends?

Gerard Arpey

Jamie, I think we worked hard to outline our thinking on the potential strategic assets we have in our thought process. In terms of a timeframe, this is an issue that is a matter that we are giving careful consideration as we speak. When we reach the appropriate conclusions, you'll hear about that, but I think we're giving it the appropriate consideration, and all of the issues that Tom discussed, I think, need to be thoughtfully considered before we draw any conclusions.

With respect to consolidation, the biggest question I think we've acknowledged is that we understand the fragmentation in this industry and the challenges that that fragmentation has caused the industry. Historically, there have been a lot of obstacles to airline industry consolidation. That's because this industry is unique compared to other industries that have found it easier to find their way to a more stable industry environment, and I've talked about that with you and others in the past, Jamie. That the obstacles have been the government, organized labor and the amount of liquidity you need to make these complex mergers a success.

Now, whether or not those will remain obstacles for us or other carriers I'm not prepared to elaborate on, but those are historic considerations that have contributed to the airline industry being in the condition it is today. Just like the other things we've talked about. We're giving careful consideration to options that we have ahead of us, but we've also got to be practical about a lot of this stuff, which we're trying to be.

Jamie Baker - JP Morgan

Gerard, maybe it's just me, but there just doesn't seem to be much of a sense of urgency. Perhaps that's just my own flawed interpretation, but I'm sure some of your stakeholders would agree with me. As a follow-up, Tom as it relates to Eagle, do you consider your current cost of regional fee to be above market, above competing market rates? If so any approximation as to how much?

Tom Horton

Well, we've recently restructured our deal with Eagle to get it to a rate that we think approximates market. Then the question becomes does Eagle has competitive costs to go out and grow its business? I think that's a very legitimate question, one the whole team is working on. But as to our costs, that deal has been structured where we think the market is.

Gerard Arpey

Jamie, that's one of the things that we've been working on this year, is putting in place a market rate, market-based relationship between American and Eagle, so we would have the possibility of considering alternative ownership structures, but you have to do that before you get to that point.

Tom Horton

Jamie, I would just add to what Gerard said. These are all complicated things, but I want to assure you that this review process I described earlier is a, is a real priority for the company and our shareholders, but it's obviously in all of our interests to deliver that so that we get the right answer.

Operator

Your next question comes from Dan McKenzie - CSFB.

Dan McKenzie - CSFB

I just wanted to circle back on the capacity plans. Higher fuel prices, higher fares suggest less people traveling next year, yet AMR's capacity plan appear really moderately bullish on demand, given flat capacity. So really how high can fares go without causing demand destruction? Where is the demand coming from, business/leisure, stimulated with lower fares? Any perspective would be helpful.

Gerard Arpey

I think you raise an important question. There is elasticity in this business. One of the things that we are concerned about and are keeping a watchful eye on is demand. At this point, as I mentioned, our advanced bookings are up a little bit for the fourth quarter, but as prices go higher in the industry and the economic situation looks increasingly uncertain, I think the question is at what point we see demand growth abate? So we're just going to have to watch that on a day by day basis. We've been very measured about our capacity. We think that's an absolutely essential part of this company's recovery and essential to the industry's recovery. I think flat capacity for right now feels about right on a schedule to schedule basis, feels about right for '08, but we're going keep an eye on that.

Dan McKenzie - CSFB

Any initial read on corporate travel spending for next year? Up, down?

Gerard Arpey

I haven't heard. We haven't picked up an appreciable direction one way or the other. There has been a little bit of rumbling around less travel in the financial services sector. We haven't seen a lot of that just yet.

Dan McKenzie - CSFB

Should investors rule out share buybacks or dividends, given AMR's debt and fleet obligations, if AMR does decide to monetize the non-core holdings?

Tom Horton

It would be premature to talk about what we would do with cash generated from a transaction we haven't even done yet, so I wouldn't speculate on that. I would tell you that our recent focus has been putting our cash to use to improve balance sheet, buy back and retire debt, funding the pension is a priority for us, and funding CapEx but doing it in a prudent and sensible way, as I described earlier on.

So that's been the priority near term. Our focus has been on really building the company's financial flexibility, and building its foundation for the future. As to what we would do in the future with respect to anything generated from monetization.

Operator

Your next question comes from Bob McAdoo - Avondale Partners.

Bob McAdoo - Avondale Partners

A couple of questions. You talk about adjusting the cost of the fee from Eagle. I assume that has to come by adjusting the pro rate relationship between Eagle and American? Has that been done very recently, or has that been far enough back that there's some way we can get a sense of how that's moved and where that might be? Obviously the costs of Eagle probably haven't changed any.

Gerard Arpey

Bob, what we've been working on is structuring the relationship between Eagle and American, much like the market structures. So in many of these agreements, the major airline keeps all of the revenue and then pays the commuter partner for services on a bunch of different measures; some of it per departure, some per flight hour, and so that's what we've been working on this year. We've put in place this year what we believe to be a market-based relationship between American and American Eagle, so that American Airlines is receiving feed on a market basis, and that has been our objective and a consideration for thinking about a transaction long term, is making sure that over the long run, American has access to cost-effective feed.

We think we've put in place that kind of agreement. So it's not a pro rate agreement. It's a big airline keeps all the revenue and pays the partner for its feed services.

Tom Horton

The standard industry capacity.

Bob McAdoo - Avondale Partners

The real question I'm trying to figure out, is there a way from the kind of public data that we get in terms of the individual statements for American Airlines versus the parent and all of that, and anything that might be filed in DOT schedules, that would give us any real way to get a sense of how much that's changed or where the current rate is versus some of the other guys?

Gerard Arpey

We made that change as of midyear. As mentioned earlier, we're working on some additional disclosures, which we will be able to get you more insight into that, Bob.

Bob McAdoo - Avondale Partners

One other real quick one. You got the 13 737s that are coming in. First, are they just like the existing 800s, are there differences there? Are they replacing airplanes that are being sent to the desert, or are they adds to the fleet? How do we think about that?

Gerard Arpey

It's all replacement aircraft. We have no plans for growth in aircraft at this point. The 737 800s there are some modest differences, but they are basically the same airplane.

Operator

Your next question comes from Ray Neidl - Calyon Securities.

Ray Neidl - Calyon Securities

I just wanted to verify what you were talking about before. Looks to me like international capacity growth, you're kind of leveling off going forward. Delta and Continental appear to be aggressively growing the Atlantic out of New York and other places, and Northwest and United probably aggressively growing the Pacific, which is restricted, especially into China.

Is that synopsis pretty accurate? Are you giving up, for the time being anyway, on the international capacity growth that you were doing? In regard to the Delta/Air France situation, if they bring in Northwest with antitrust, which you don't have with British Airways, what does that do to your international operation, leaving your domestic operation if Delta and Northwest get together on an antitrust basis?

Tom Horton

I will start with a baseline on the facts. We said our system capacity was going to be up a little over 1% in '08; domestic, about 0.05%; international, up around 3% and if you adjust for the weather effect, international is going to be up a little bit year over year.

We do have some international growth, some important changes to our international network for '08. We've got the Stanstead flying, we've got DFW Buenos Aries and I mentioned some of the Latin adds, Chicago-Moscow. So we're making some changes where we think it makes sense. Obviously we would like to do more flying to China, but we won't be able to do that until our new Beijing award takes effect in '09.

I think it's fair to say that we already have a pretty robust international network, both Trans-Atlantic and into Latin America and into the Pacific, particularly when you consider our alliance relationships, which we think are the best in the industry.

So, we have maybe a little less sense of urgency about growing our network to fill gaps. Again, I think it's important for us all to remember this is a cyclical business and the international parts of our business tend to be even more cyclical, so we try to be measured in the way we manage our capacity so that we don't overshoot demand.

Ray Neidl - Calyon Securities

With antitrust, as Delta has with Air France, if they manage to bring in Northwest-KLM how does that effect you not only internationally, but domestically?

Tom Horton

It gives us renewed focus on our relationship with British Airways. As you know, we've tried to get antitrust immunity in the past and with the increased service at Heathrow, we're going to have to see if that represents an opportunity for us to achieve antitrust immunity in the future. Those are the sorts of things we talk to BA about all the time.

Ray Neidl - Calyon Securities

The government is talking about doing something with the congestion by next summer in the U.S.; either pricing by movement, in other words, raising the prices of smaller aircraft landings, or even restricting, major hub restrictions in the Northeast and New York and that could even spread to Dallas and so forth.

Would that be a positive, do you think, for the industry and for American? Would it bring some discipline to them, as far as capacity goes, and if there's restrictions on capacity, does that mean that the airlines would have the latitude to increase prices?

Gerard Arpey

Ray, I think that the congestion problem in the Northeast in particular is a very serious problem, and of course today it manifests itself in poor customer service, because you're just trying to put ten pounds of sugar in a five pound sack, and that results in a tremendous number of delays and in really adverse weather, a lot of cancellations.

From our standpoint, I think that the model that was followed in Chicago was a pretty good model in terms of solving the same problem that existed at O'Hare. The government allowed us to work in concert with the government and our competitor, our principal competitor in Chicago to draw down capacity to levels that we could operate reliably. We did that under some duress from the government, but recognizing it was a good outcome in terms of the operation.

If you look at Kennedy in particular, and look at the growth in the number of flights over the past few years, I think the same model would be appropriate there and I think it would be good for the industry to follow it. I think it would have a much bigger effect than trying to change how much you charge to land at 4:00 versus a different time, because I don't think that's going to have much impact on the way airlines schedule, because the airlines are simply trying to schedule when people want to fly. There's not enough leverage in changing your landing fees across the day to really have that big an impact on the daily schedule.

Ray Neidl - Calyon Securities

Finally, are you going to start accruing for pilot expenses with the contract becoming amendable going forward? Are you still shooting for a neutral contract? Any salary increases would have to be compensated for by productivity improvements?

Tom Horton

Ray, the way the accounting rules work on such things, is you accrue when something is probable and reasonably estimable and I don't think we're to that point yet and when we are, we would do the accounting accordingly.

Operator

Your next question comes from Kevin Crissey - UBS.

Kevin Crissey - UBS

Hi, guys. I just was wondering what the positive sales pitch on say an American Eagle spin? I mean, you listed it first among the businesses that could potentially be monetized and expressed as a proxy, it doesn't strike me as a particularly good investment for the investment community.

What's the positive sales pitch? I see it from the American, AMR's perspective, but what's some of the investors prospective, why would they want to buy an above market American Eagle?

Gerard Arpey

I don't think we're quite ready to be making a sales pitch on it, because we haven't made any decision just yet. What I would say about the, the way we're thinking about it is if Eagle were to be separated, I think it would create a structure and we try to create incentives and opportunities to grow that business, while letting American focus on what it does best and make sure that we have access to cost competitive regional feed over time. So that's the way we're thinking about it, and whether we ever get around to making that sales pitch, I think that's the subject for another day.

Operator

Your final question comes from William Greene - Morgan Stanley.

William Greene - Morgan Stanley

Gerard, can I just ask you a little bit about the labor stuff? As Jamie sort of mentioned earlier in his question, it is sort of deteriorating, and it seems like rhetoric is escalating. So how do you stop that cycle? Can you? How do you make sure you get a deal that works for you and the union?

Gerard Arpey

Bill, I think the rhetoric across the industry is pretty high right now and I continue to believe as a matter of principle that the best outcome for our employees -- all of our employees, our pilots -- can be achieved through involvement in collaboration. I think this is a complicated business with lots of challenges, and including the employee stakeholders in a collaborative, constructive dialogue I think will, and in fact I think we have a demonstrated track record of that leading to a better outcome for employees.

I'm just going to continue with the principles that I've used since I became CEO in 2003, and try to have a constructive dialogue at the negotiating table, and try to use the facts to educate our workforce and educate our unions about our competitive position. I think what we have to do is balance the interest of everyone's desire to have a better personal outcome with the reality that we have to be a competitive company. If we're not a competitive company, that's not going to lead to a good outcome for employees.

I just will continue to be guided by the facts and the truths, and, and hopefully that will lead to a constructive outcome for all the stakeholders.

William Greene - Morgan Stanley

Have you seen any impact from Virgin America on the TransCON?

Gerard Arpey

Yes, of course. Any time you get a new competitor in a market when you've got enough capacity in the market to begin with, you have a negative impact. So, yes.

William Greene - Morgan Stanley

How much?

Gerard Arpey

I don't know that I could quantify that. I don't know if any of my colleagues can. Bill, we face a lot of low cost carrier pressure across our system, and Virgin America is pressuring the TransCON market. We got a low cost carrier trying to build a hub in Fort Lauderdale, and we are very aggressive in terms of our pricing structure. Everybody can compete on the basis of product and service and schedule, and we think we do a pretty good job on all those fronts and we're going to be very price competitive, but that means in a lot of these markets it's having an impact.

Operator

That does conclude the analyst portion of our Q&A session.

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Source: AMR Q3 2007 Earnings Call Transcript
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