American Airlines Is Growing Its Biggest Hub Again

Summary

• American Airlines gets a disproportionate amount of profit from its two largest hubs: Dallas-Fort Worth and Charlotte.
• It gained 15 extra gates in Dallas earlier this year and will soon gain access to 5 additional gates in Charlotte, enabling growth at these high-margin hubs.
• The airline is now making plans to build two more gates at Dallas-Fort Worth International Airport prior to the 2020 summer peak season.

Entering 2019, American Airlines' (NASDAQ:AAL) top growth initiative was the expansion of its hub at Dallas-Fort Worth International Airport (DFW). The airline already operated 809 peak-day departures in Dallas during the summer of 2018, making it the second-busiest airline hub in the world. The "DFW 900" project aimed to grow the number of peak-day departures to 905 in the summer of 2019 to capitalize on the superior economics of dominant hubs.

American Airlines has longstanding plans to implement a similar strategy in Charlotte in 2020. However, a recent report from The Dallas Morning News revealed that the airline is also seeking approval to add two more gates at DFW in advance of the 2020 summer season. This would enable incremental margin-accretive growth at this key hub next year.

Chasing high-margin business

In a series of presentations last year, American Airlines executives explained the rationale for expanding at the carrier's two biggest hubs. At the time, the airline's overall pre-tax margin was 7.5%, but its Charlotte, DFW, and Washington, D.C. hubs had a combined 13.1% pre-tax margin. In other words, those three hubs were generating the vast majority of American Airlines' profit, while the rest of its operations were collectively barely profitable.

(Image source: American Airlines October 2018 presentation)

There's a reason why American Airlines' two largest hubs, DFW and Charlotte, are among its most profitable. (The Washington, D.C. hub is an unusual case because it is a slot-controlled airport that is much closer to the city center than either of the alternative D.C.-area airports.) The more daily flights and the more destinations served at a big hub, the greater the number of potential one-stop itineraries. That's good for the bottom line for two main reasons.

First, travelers using hubs to connect between small cities and other destinations tend to pay significantly higher fares, as most small markets have no low-cost carrier presence. By serving more small cities and maximizing the number of possible connections, an airline can capture more of this high-margin traffic.

Second, the greater the number of connecting flights available for people coming off of a given flight, the more options an airline's revenue management system has for filling that flight. Revenue management systems are designed to maximize revenue by varying fares based on demand and the number of seats available. When additional connecting opportunities exist, the potential demand pool is greater. As a result, the revenue management system doesn't have to offer as many discounted fares to fill the plane.

A strategy of boosting connectivity by adding flights at its hubs has been critical to United Airlines' (UAL) turnaround over the past few years. American Airlines wants to cash in on the same industry forces.

Strong initial results and plenty of runway left

The first step in capitalizing on the superior economics of large hubs is to obtain extra gates. Whereas point-to-point airlines can often squeeze more flights out of each gate by spreading out their scheduled flights across the whole day, that's a suboptimal strategy for hub-and-spoke carriers. A "banked" flight schedule - with lots of arrivals in a short window followed by lots of departures - maximizes revenue by providing the shortest connection times. That type of hub strategy requires lots of gates.

American Airlines' DFW 900 program was made possible by the airline gaining control of 15 new regional gates in a satellite concourse earlier this year. Those gates can support more than 100 daily departures by American's regional affiliates.

The early results from this growth initiative are very promising. In the third quarter, American Airlines increased its domestic capacity 9% at DFW and grew passenger unit revenue 3.5% year over year. That's a solid unit revenue result, particularly when you consider that new routes can take a year or more to reach peak profitability.

(Image source: American Airlines November 2019 presentation)

American Airlines will soon get access to five more gates in Charlotte, where the carrier currently operates 682 daily departures, serving 149 cities. Those extra gates will support an additional 35 daily departures. American also plans to use larger aircraft in Charlotte starting next year, driving incremental growth there.

The most recent news that American Airlines wants to add two more gates at DFW indicates that the airline intends to build on its 2019 growth at its largest hub. Those gates should allow the airline to add at least 15 daily departures to its schedule in Dallas next summer. There is ample demand to support that growth, due to DFW's central location in the U.S.

In total, American Airlines hopes to grow its capacity 5% year over year in 2020, with most of that growth coming in Dallas and Charlotte. That bodes well for the company's profitability.

2019 was a lost year for American Airlines: Will 2020 be better?

Back in January, American Airlines' management projected that adjusted earnings per share would soar to between $5.50 and $7.50 this year, up from $4.55 in 2018. However, the company's guidance has plunged over the course of the year, due to losses related to the Boeing (BA) 737 MAX grounding and a spike in flight cancellations related to a labor dispute with the airline's mechanics. American now expects full-year EPS between $4.50 and $5.50.

American Airlines has already postponed the return of the 737 MAX until March 5, 2020. The airline also intends to ramp up its 737 MAX flight schedule gradually. This means that the earnings headwind from the grounding will continue into the new year.

Nevertheless, the carrier's planned growth in its high-margin Charlotte and DFW hubs represents a meaningful earnings catalyst for 2020. Furthermore, once the 737 MAX gets back in the air, American Airlines should benefit from better fuel efficiency and lower nonfuel unit costs. As a result, profit growth is likely to accelerate next year, with further gains likely over the following two years as American Airlines finishes the implementation of its turnaround plan.

Disclosure: I am/we are long JAN 2020 $20 CALLS ON AAL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.