American Airlines reveals how critical distribution battle is for industry's future

The expected results, however, were not the most important story emerging from American's earnings call yesterday which revealed just how critical and important American's battle with the distribution industry is.

The earnings call clearly did little to assuage analysts' doubts as they continued their quarterly ritual of when they could hope to see a meaningful turnaround in AMR's fortunes. In answering that, the clouds parted on the rhetoric that industry executives have been using for more than a year on capacity and cost discipline as paths to raising revenues, revealing that the most important key to providing returns on investment was in merchandising, according to Mr Arpey.

The revelation resulted from one of the more interesting parries between analysts and executives.

Doubts about American's now tired admonition that its fortunes would improve on labour convergence combined with the trans-Atlantic and Pacific joint businesses, came from long-time critic Morgan Stanley analyst Jamie Baker, who previously asked if those factors were all the company had in its quiver.

Analysts ask if there are more arrows in AA's quiver

This year, he came at the question from American's glory days as industry leader and innovator, citing American's leadership on revenue management, frequent flyer programmes and a host of other innovations that are now industry standards.

"All these initiatives were provocative and shook things up," said Mr Baker. "Are you working on anything beyond cornerstone and new flights to Helsinki that will signal you are taking back your leadership position?"

The short answer was "no" as executives hammered equally hard at their single answer: the combination of joint businesses, its cornerstone strategy and the rest of the industry achieving labour parity would begin to show results when it reaches the full run rate by the end of 2012.

But the more important answer was American's single-handed attack on how the industry's product is distributed. That alone has the promise to change the game significantly and Mr Baker seemed to underestimate it. Indeed, after speaking of its well-known strategies and saying they are driving the company to a better position to close the margin gap with peers, Mr Arpey pointed that out.

"We are aggressively moving on the distribution front," he challenged. Indeed, President Tom Horton and CFO Bella Goren had earlier hit home several times that the key to flying out from under the industry's legacy baggage is increasing revenue. In fact, they seemed to be the key to forging the results industry executives want with a double-digit return on invested capital goes beyond joint business agreements and cost and capacity discipline is increasing revenues from merchandising.

"We think differently about the way we distribute the product," said Mr Arpey. "We put a lot of focus in terms of managing costs and that is an important consideration but the real leverage comes from being more aggressive and gaining control of our ability to merchandise. In the long term, every other company has been in bankruptcy at least once if not more but the track record of the industry shows a need to generate more revenues. We believe the most aggressive vehicle for doing that is through merchandising and we are leading the industry on that. The ability to merchandise will drive more revenues in the long run and we are already doing that although it is much overshadowed by the oil environment. If we stay on this path we will have the opportunity to generate more revenue."

Mr Baker seemed unconvinced saying while he would grant the GDS battle is big, the way tickets are sold has remained unchanged.

"Thinking of distribution from a cost stand point is the wrong way to think about it," Mr Arpey countered. "We have effectively had our hands tied in thinking of more ways to merchandise the product and we are doing on AA.com the merchandising we have not been able to do through traditional channels."

Ms Goren added there has been a general lack of understanding on what the end game is in the GDS battle. "That is to present our products and services in a manner in which customers have choices and we derive greater revenues," she said. "It is evolutionary and revolutionary at the same time and while we are going through hard times we are leading the effort."

Mr Horton concluded by saying: "By lowering our distribution costs it presents the opportunity to offer lower fares in addition to generating new revenues and developing a more direct and closer relationship with our customers and travel agency partners."

He noted negotiations with Sabre run through June 1, when the suspension of the AA/Sabre lawsuit expires. However, he seemed to indicate, while the company is negotiating in good faith, it would not hesitate to re-instate the suit. "We are using this time to negotiate but we have sued Orbitz and Travelport and Sabre is not named in that complaint," he said. "With respect to the two largest online travel agencies - Priceline and Expedia - we have struck deals that have achieved our objectives and allow us to proceed with Direct Connect."

Downside risk

When asked if the downside risk was worth it he said yes, "many times over" and, judging from the record of American's deals with OTAs and US Airways deal with Expedia to sell choice seats, the winds are in the airlines' favour. Even so, the big nut to crack is the GDSs.

The company would not discuss the impact of the distribution battle on the first quarter, but said, coupled with the Japanese triple disasters, the weather and the fuel farm fire in Miami, the four factors amounted to over USD100 million in lost revenues in the quarter. Weather forced the cancellation of 9000 flights in North Texas, Chicago and the Northeast with the Miami fire driving hundreds of other cancellations there.

Ms Goren confirmed the drop in US-Japan traffic was in the range of between 20% and 30% but suggested it was temporary given the same happened in other such disasters but traffic picked up again as the rebuilding got underway. She also noted bookings were closer in, leaving the market much more fluid than normal although the so-called Golden Week - the last week of April/first week of May - bookings were pretty strong.

When asked to comment on whether or not American agreed with characterisations that Expedia blinked when it cut a new deal with American in which the OTA would use American's Direct Connect, Mr Arpey told the Centre for Aviation the fact both parties reached an MOU means they were satisfied with the agreement. "We were very pleased that will be be distributing our product via Expedia," he parried. "Expedia has always been a good partner and we expect them to continue to be a good partner."

However, he was less certain about when the technology would catch up to allowing American to merchandise their products through the OTA.

"The timing of the technology is, of course, part of the debate," he told Centre for Aviation. "All I can say is stay tuned. I don't see technology as an obstacle. The technology is already there and we are using it on AA.com but it will take time."

Street is not buying it

Despite efforts to put a brave face on its industry-lagging results, it is clear analysts are finding it harder and harder to buy what American is selling about its future. They suggest that the much-touted labour gap between American and its peers will not narrow for the foreseeable future and they note the intense competition already at three of its five cornerstone hubs, Chicago, New York and Los Angeles. In addition, more competitors are pouring on service at a fourth cornerstone market - Miami - leaving Dallas as its sole fortress hub. Finally, they suggest there is no way for American to overcome its disadvantages outside of a major restructuring through merger or bankruptcy.

Analysts want more capacity adjustments for the airline despite the fact that increases are part of its joint-business strategy. American has already bested its original capacity cuts announced in March by an incremental 1% to 1.4% for the year, according to guidance released yesterday, but that will still result in a 2.2% gain over 2010. Domestic capacity will be down 0.5% and international capacity up 6.2% compared with 2010. Capacity on its consolidated network will be up 2.8% for 2011.

Ms Goren defended the airline's capacity plans again pointing to the five-year record. "Our 2011 capacity is down 9% versus 2006," she said, "while the overall airline industry down only 1% and other legacies are down 5.5% over the same time period. Our discipline on the capacity front over the five-year period is unmatched."

She acknowledged the softness in the trans-Atlantic attributing it to the capacity competitors were adding, saying it would be a short-term problem. "Long term, we are very optimistic on the trans-Atlantic because of the joint business."

Analysts also expressed concern that oil at USD111 per barrel would drive companies to scale back on travel. She acknowledged this was a challenge but so far demand was holding up and the revenue environment has strengthened.

For the second quarter, mainline capacity will be up 2.9% compared to 1Q-2010 including a drop in domestic capacity of 0.4%. International capacity will be up 8.1% with consolidated capacity in the quarter rising 3.9%.

Parity with peers

When asked how he would defend the company's continuous bad results and whether he was chafing against the doubt coming from analysts, Mr Arpey reiterated the impact of its higher labour costs, now set at USD800 million compared with the USD600 million previously stated.

"That's a large number for us to overcome," he said. "We have a long-term plan to work with labour to close the gap and allow the company to be competitive. In the meantime, we are doing everything necessary to create a strong network and partnerships and that combination will lead to success. I'm not chafing at anything, I'm just simply answering questions. In terms of the current results, if you have the US taxpayer funding the pensions you will produce better results. Another number I like to highlight is the fact that we continue to provide retiree medical benefits which our peers do not do."

He pointed out that 19 of the 30 labour agreements have, or are about to, become amendable. Among the remaining 11 through 2012, nine are at carriers involved in mergers, he added.

First quarter results

"I will remind you that 2010 got off to a difficult start as well, and working together we made a tremendous amount of progress as the year progressed," said Mr Arpey in his letter to employees.

He noted the loss of USD405 million ex special items, pointing out it was better than the USD452 million lost in the year-ago quarter. Its results were also better than the Thomson Financial consensus which was expected at USD446 million.

Including special items, the company's net loss was USD436 million for the quarter including approximately USD31 million in one-time, non-cash charges on certain sale/leaseback transactions. In the year-ago period, the company posted a net loss of USD505 million, including USD53 million special item on the devaluation of the Venezuelan currency.

Total operating revenues increased by 9.2%, or USD465 million, to USD5.53 billion compared to 1Q-2010 driven by those higher fares. However, American is expected to be the pace setter in the industry as increased revenues became overwhelmed with fuel hikes which added USD351 million to fuel costs in the first quarter compared to what would have been paid at last year's prices. The company predicted its fuel bill in 2011 would rise USD1 billion but now says it will be closer to USD2.1 billion.

Mainline unit revenue (RASM) rose 5% during the quarter on higher fares and strengthening business travel as load factor dropped 0.8 points to 77.1%. Indeed, the company reported that 1Q-2011's 5% increase in mainline RASM at 10.92 cents marks the highest first quarter RASM since 2003, when Mr Arpey joined the company. Consolidated passenger unit revenue grew 5.2%. It reported RASM increases in domestic and Latin America at 6.3% and international at 3%. Mainline yield rose 6.2% for the quarter, its fifth straight quarter of yield improvement. International yield increased in all three regions topped by Pacific at 5.6% to 11.86 cents.

Source: AMR Corp

Raising confidence

Interestingly, many of the comparisons made by the airline hark back to 2003 with some comparisons - other revenues for instance - as high as a 75% increase during the period. Similar to the company's release in the fourth quarter, such comparisons seemed designed to restore analyst faith in the embattled chief executive. Other revenues increased 11.6%, or USD68 million, to USD653 million during the first quarter.

Its reliance on the five-year, look back on comparisons continued to be questioned by analysts who seemed desperate to gain clarity on what the airline expected for the future. Despite numerous questions asked various ways, the airline would only point to expectations from its joint business.

"One of the things we can share is the fact that on a month-to-month basis, as the quarter progressed, we saw considerable improvement in our revenue performance vis a vis the industry," said Ms Goren. "We have put a lot of things in place that won't be fully reflected in our revenue performance until the end of next year."

Analysts specifically questioned the fact American was not cutting back capacity as much as peers. That prompted an argument about managing capacity for profitability to which Mr Horton responded with the company's long-term view on capacity while assuring them that the capacity will be revisited many times during the year.

"Our financial underperformance is well known," he said, "and capacity will not address that."

As expected, analysts expressed concern about the competitive capacity being poured into its cornerstone markets and whether it diluted American's expectations. American has increased JFK capacity 21%, Miami capacity 7% and LAX capacity 5%. Ms Goren reported that year-on-year revenue in all of the cornerstone markets improved making the environment much healthier with the "unprecedented fare activity which has been fully or partially successful at increasing fares."

Mr Horton agreed. "If you look at Chicago, we've seen Chicago unit revenue outperform the rest of the domestic system in a way that confirms our strategy," he said. "In markets like New York and LA, you can't be strong domestically unless you are strong internationally. We have a broad trans-con portfolio. We are strong with oneworld across the Pacific and Atlantic and we have a strong partnership with Alaska at Los Angeles giving us a good footprint. We view it not so much as a hub but a trans-Pacific gateway. If you look at the oneworld market share for premium seats out of LA we are extraordinarily well positioned."

Mr Arpey pointed to the expected benefits of its joint businesses with JAL, British Airways and Iberia as well as expected benefits from its plans to accelerate the retirement of 25 of its 219 MD-80s in the fourth quarter as part of its planned capacity cuts in response to fuel. They are being replaced by 737-800s being added to its current 152-aircraft 737-800 fleet.

It is also making other adjustments including to its plans to recall and add new hires but does not expect any layoffs. Its fleet renewal, already underway, includes two 777-300ERs set for delivery next year and in 2013 for a total of five in the fleet. Its 42 787s are scheduled for delivery in 2014.

Costs remains a challenge

Still, its mainline price per gallon jumped 23.6% to USD2.75 in the quarter, rising to 32% of total operating costs. Fuel bested wages, salaries and benefits by USD120 million, said the company, adding it was also the largest expense consecutively in 3Q-2007 through 4Q-2008 as well as the in the 2006 second and third quarters.

"High fuel prices remain one of the biggest challenges to our industry and our company. We believe our steps to aggressively increase revenues, reduce capacity, control non-fuel operating costs, and bolster liquidity will help us to better manage the challenges we currently face," said AMR Chairman and CEO Gerard Arpey. "While we clearly must achieve better results as we continue to strengthen our business, we have made some meaningful progress. I want to thank our people for their commitment to serving our customers, and I am confident that our overall strategy positions American well to address our current challenges and sets the stage for long-term success."

The company reported that its Fuel Smart program is expected to set record fuel savings of 134 million gallons, or USD411 million, at its system average price of USD3.07 per gallon for the year. Last year it achieved savings of 123 million gallons, or USD295 million, at an average system price of USD2.32 per gallon for the year.

Non-fuel unit cost performance was driven by American's cost control efforts and a modest increase in capacity. Total operating expenses totaled USD5.7 billion, up 7.4% for the quarter with total unit costs ex regionals and special items reached 13.32 cents per available seat mile, an increase of 4.4%. Ex fuel and special items its unit costs was 8.99 cents, down 1.8%.

Regional affiliate costs rose to USD721 million in the first quarter compared to USD629 million in 1Q-2010 as revenue passenger millions jumped 14.6% to 2.1 million and ASMs rose 13.8% to 3.155 billion. Load factor rose 0.5 points to 67.7%. Although regional affiliate revenues rose16% to USD577 million it was not enough to overcome the cost increases, as usual.

Source: AMR Corp

AMR ended the first quarter with approximately USD6.3 billion in cash and short-term investments including a restricted balance of USD455 million compared to USD5 billion and USD460 million in 1Q-2010. Liquidity was boosted by its March private offering of USD1 billion aggregate principal amount of 7.50% senior secured notes due in 2016 secured by route authorities, slots and airport facilities.

AMR's total debt was USD17.4 billion at the end of the first quarter of 2011, compared to USD15.9 billion a year earlier. AMR's Net Debt, which it defines as Total Debt less unrestricted cash and short-term investments, was USD11.6 billion at the end of the first quarter, compared to USD11.4 billion in the first quarter of 2010.

The executives said American's liquidity was boosted by its March USD1 billion offering backed by Heathrow and Tokyo franchises and gives the company the strongest liquidity position among the major airlines.