American Airlines' Bankruptcy: The Endgame Solution

Includes: AAL, DAL, JBLU, LUV, UAL
by: Vaughn Cordle, CFA

The airline industry’s long and winding road from deregulation to sustained profitability is not complete with the bankruptcy of American (NASDAQ:AMR). The industry still has much more work to do before it is fit for long-term investment. In my estimation, this effort will require more uneconomic capacity pulled out of the system. American will likely reduce its domestic capacity by 10-20% as it restructures in an effort to achieve economic sustainability.

Regardless of the ugly nature of merging two suboptimal business models and different unions, American's best option is to merge with US Airways. This further consolidation will effectively move the industry's structure to one that can price the product at a level that can potentially attract and maintain shareholder support. My best guess is that US Airways will present a reorganization plan that produces a value that will exceed that which is presented by AA management if it attempts to remain independent. If AA management has the creditors' best interest in mind, it will present a plan that includes a merger with US Airways and one that brings in Doug Parker to run the new airline that emerges.

The benefits of deregulation, to the air-transportation consumer, are reflected in the $70 billion (inflation-adjusted) net losses the industry reported over the 2000-2010 period. In other words, the value produced by the industry went to the consumer (and employees), not the owners of the assets. The legacy airlines competed on price to maintain market share, which was effectively bought at a loss. This focus on market share over profits is why the industry produced 8-10% too much capacity, on average, in the industry over the last 10 years.

Legacy airline managers had to maintain market share because of the belief that shrinking would raise unit costs more than it would benefit revenues. Moreover, the changing composition of the industry, as so-called low-cost airlines made up an ever-growing share of the market, drove down average fares and unit revenues, making that perception of the cost penalty vs. unit revenue tradeoff of shrinking capacity even harder for legacy airline managers to justify. In addition to depressing unit revenues, faster-growing airlines lower [relative] unit costs and, in turn, increase the cost disadvantage of those airlines that do not grow or shrink over time. It’s a prisoners’ dilemma for the industry in game theory terms.

This change in industry composition has resulted in an industry concentration that is too low for these overleveraged and high-cost airlines to earn their capital costs. The solution has included mergers and [alliance] joint ventures that produce cost and revenue synergies that would not exist otherwise. Given the massive restructuring that has occurred since 9/11 and will continue with the bankruptcy of AA, a case can be made that the industry will, over the next 10 years, enjoy its highest level of profitability since deregulation. This is why we have recently made the case [to our fund clients] to buy the networks and several of the LCCs near their recent 52-week lows.

Many, especially airline employees, blame management incompetence for the failures of their airlines when the structure − bad industry fundamentals − is what really creates the bad economics. Hence, the structure had to change via mergers and consolidation. Even the very best CEOs could not produce profits at the big network airlines over the last two decades − outside of bankruptcy.

Against the backdrop of all of the above factors, AA and US Airways have become disadvantaged against the more profitable United (NASDAQ:UAL) and Delta (NYSE:DAL), who were able to use bankruptcies and mergers to reduce their competitive problems. As a result, they are left with too much leverage, inadaquate investment in competitive resources, and a workforce that is demoralized because it feels unfairly compensated. Unhappy employees hurt the top and bottom line of the business, resulting in a loss of market share over time as customer service quality suffers.

American risks being broken up and sold piecemeal if unions are unwilling to accept concessionary agreements that allow the airline to emerge from bankruptcy as a viable business worthy of investment. Alternatively, if the company emerges without the required cost structure, it risks a second bankruptcy at some point in the future as stronger competitors move to increase share at AA’s expense. A merger with US Airways would make American a larger, lower-cost, more appropriately leveraged airline that can profitably retain market share. Without a merger, it will emerge from bankruptcy as a much smaller, still-high-cost, and over-leveraged competitor that will continue to lose market share over time. The go-it-alone strategy risks further demoralizing employees because they will be at the bottom of the industry’s list in terms of total compensation. This resulting outcome would be a continuation of poor management and labor relationships and sets the stage for another showdown during future contract negotiations.

US Airline Pilots Association, America West pilots at US Airways, and Allied Pilot Association pilots at American are the three pilot groups that will have to deal with seniority issues that arise if there is a merger between American Airlines and US Airways. These three pilot groups, when combined, will enjoy a much higher level of total compensation via a merger between American and US Airways than would be the case if both companies remained independent. If the pilot unions, whose leadership struggles to lead effectively because they have to reflect the views of the majority of pilots who elect and direct them, could internalize a combination that creates more value for all stakeholders and the industry, they would support a plan that helps their members and the business that must be profitable if it is to support their livelihoods.

The majority of pilots and employees in general are unsophisticated by way of corporate strategy and finance and narrowly focus their leaderships' efforts on achieving leading industry wages and benefits. This myopia inhibits the creativity and out-of-the-box thinking that encompasses a more holistic approach and takes into account what the business needs to be competitive within the broader marketplace. If costs are too high, the business cannot grow, yet growth is required to survive over the longer term. If debt levels are too high, growth is not possible, because the required level of profitability cannot be attained. These descriptions fit both American and US Airways.

AA’s new Chairman and CEO, Tom Horton [and the Allied Pilot Association] should work toward an endgame solution to American’s competitive problem by developing a restructuring plan that includes a merger with US Airways. If he does not, US Airways’ Doug Parker has an opportunity to present the winning plan that solves both companies' competitive problems, and at the same time, increases industry concentration to a level necessary for it to cover capital costs over a full business cycle. It is not clear what Horton’s feelings on this subject are at this point, but a case can be made for a reorganization of American Airlines that can turbocharge future stakeholder returns if it includes a merger.

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