Is Bankruptcy The Best Solution For AMR?

| About: American Airlines (AAL)

AMR (AMR) had an interesting 3Q earnings conference call today. Management’s unstated message: If labor unions do not moderate their demands (or accept concessions), the company ends up in bankruptcy court.

The company is on track to lose $1.4 billion in 2011 and $1-$1.4 billion in 2012. If our base-case[1] assumptions of GDP growth, fuel, and revenue are in the ballpark, the company's liquidity will fall to a level that could force the company to seek the protection of a Chapter 11 filing sometime in 2012.

The company has a revenue and cost disadvantage, but it’s the labor cost differentials that matters most.

Free cash flow is likely to be cumulatively negative by $2-$2.5 billion this year and next, and the company's cash balance will fall to around $2.5 billion by the end of 2012. The company could reduce CAPEX and start parking aircraft to stem the gushing red ink, but that's not a long-term solution.

AMR management wants longer-term growth, and there is no growth on the horizon because of balance sheet leverage and projected losses. Moreover, end-of-the-year adjustments to pension and health care obligations and costs will be material, as discount rate and plan returns are much lower than what was estimated at the end of last year.

If the company eventually files bankruptcy, which is likely in my estimation, one thing to look for is how much ownership of the new company (it legally dies in a bankruptcy) the management and pilots secure. Management and pilots can make a lot of money post-bankruptcy if both parties get a certain percentage of the new company. The downside is that pilots and other employees will lose their defined benefit plans, as the PBGC will force an involuntary termination.

I suspect that the management is using the threat of bankruptcy to gain leverage in negotiations. Several solutions − from the management's perspective − are as follows: (1) b-scale wages for new hires, (2) increased productivity, and (3) defined contribution plans (vs. defined benefit plans) for new employees. Starting a new commuter airline with new hires is also an option that has merit.

It's likely that most shareholders already anticipate a future bankruptcy, and the company is already technically bankrupt, given the -$27 per share book value when adjusted pension [unfunded] obligations are included. Without major labor concessions, in my view, AMR management can benefit from a bankruptcy by securing a percentage of ownership in the new company post-bankruptcy. If my estimates are correct, this value is likely in the $200-$400 million range and even more if a merger with US Airways (LCC) can be consummated. The pilots could secure a similar amount if they are smart. A merger would increase industry pricing power and provide cost and revenue synergies for the combined company.

A less negative outlook for GDP growth, relative to the base-case, results in an improved liquidity position and better cash flow projections. Losses in 2012 under this scenario could be in the $500 million-$1 billion range. However (and given a slightly more rosy scenario), the company will still lose money in 2012 and may be lucky to break-even in 2013.

[1] Earnings estimates in the volatile airline industry are based on a snapshot of assumptions, with certain variables that have wide variances. Hence, base-case projections are nothing more than an educated “best guess” based on a reasonable set of assumptions. Assumptions constantly change, and so do estimates.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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