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American Airlines faces pressure to close margin gaps with peers as 1Q2017 margins are squeezed

American Airlines’ unit revenue outperformance versus its large global US airline peers in 4Q2016 was overshadowed by concerns about the airline’s projected unit cost inflation for 2017. American is joining most US airlines in battling rising unit costs while attempting to rebuild unit revenues that have languished in negative territory during the last couple of years.

The company believes its cost pressure should ease in 2018 as it completes the final stages of its merger integration with US Airways and undertakes a review of its cost structure post integration. The airline has not set any definitive cost targets, but has aspirational targets for a 2% increase, or less. Its rival Delta has similar cost targets over the long term.

American is also facing new pressure from markets about closing the competitive margin gap with Delta Air Lines after United boldly declared in late 2016 that it would surpass Delta’s margins by 2020. Now American is fielding questions about a timeframe for bringing its margins in line with Delta's.

To be fair, American is in the final stages of its integration, while United’s merger with Continental was botched for years before its current management overhaul. Perhaps the markets should exercise some level of patience with American as it works to fully complete its merger before demanding margins on par with Delta.

American's 4Q2016 passenger unit revenues best Delta and United

American joined its largest US airline peers in revising its 4Q2016 unit revenue forecast late in 2016 due to improving yields and continuing strength in close in bookings that began to take hold in 3Q2016. However, yields remain well below historical highs.

See related report: US airlines: a turnaround in unit revenue just as cost pressures rise in 2017

American’s total unit revenue grew 1.3% in 4Q2016. Its revised guidance at YE2016 was: flat to an increase of 2%, versus previous projections of a 1% to 3% decline. (Note: American only offers forward guidance for total unit revenues, rather than passenger unit revenue (PRASM.) 

The company’s passenger unit revenues in 4Q2016 grew 0.2%, versus declines for Delta and United. American boasted that its 1.3% increase in total unit revenue in 4Q2016 was the first positive result for any US airline in a year and a half, and the first positive result for a legacy airline in two years.

American, Delta and United passenger unit revenue performance: 4Q2016

American 0.2% increase
Delta 2.7% decrease
United 1.6% decrease

American continues to expect overall favourable revenue trends into 2017 and projects a TRASM increase of 2.5% to 4.5% for 1Q2017.

The company expects to post year-on-year gains in TRASM for every quarter in 2017. TRASM includes ancillary and other revenues including benefits from cobranded credit card agreements.

American, Delta and United unit revenue outlook: 1Q2017

American 2.5% to 4.5% increase in TRASM
Delta 2% increase in PRASM
United flat to a 1% increase in unit revenue
Southwest flat to 1% decrease in unit revenue

American’s unit revenue performance in 4Q2016 was tempered by an 8.5% rise in unit costs excluding fuel and special items. Most of the 2016 cost pressure was related to increased labour expense. American’s wages and benefits grew 17.4% year-on-year in 4Q2016, and 14.4% for the full year. Delta’s wages and benefit also increased 14% during 2016.

The company admitted its unit cost inflation during 2016 was higher than it would have liked, but highlighted that the increases were almost entirely driven by labour expenses. American CEO Doug Parker remarked that the wage resets were necessary, declaring: “Our people deserve these compensation increases and more”. 

Despite Mr Parker’s sentiments, American is in the middle of labour strife. Its pilots, who approved a new collective bargaining agreement in 2015 that in some ways set the stage for follow on negotiations at other airlines (including at Delta and Southwest), are complaining their pay rates are now lower than those at other airlines, according to the news outlet Bloomberg.

American is in the unenviable position of balancing between the need for adequate employee compensation on one hand, and growing concern from investors about unit cost increases outpacing the growth of unit costs on the other.

The company expects slower unit cost growth, excluding fuel and special items, of 4% in 2017, and believes the cost pressure should begin to taper off in 2018 as the final elements of its merger integration are complete. Its forecast for 2107 is slightly higher than Delta’s anticipated cost growth, and falls in the middle of United’s guidance.

Similarly to Delta's, American’s cost pressure appears to be weighted to 1H2017. Its unit costs excluding the items mentioned above are projected to grow 8% to 10% in 1Q2017 and 4% to 6% in 2Q2017. By 3Q2017 American’s cost inflation slows 1% to 3% and projections for the final quarter of 2017 show flat to 2% growth.

American, Delta and United projected unit costs excluding fuel for 2017

American 4% increase
Delta 2% to 3% increase
United 3.5% to 4.5% increase

During 2017 American is undertaking a review of its cost structure post integration, and also believes its asset utilisation and productivity should improve due to investments the company has made in those areas.

American is not offering specific cost targets for 2018, but does believe that during the 2018 and 2019 periods it can hold unit cost growth to no more than 2% – which is a similar goal to that of its rival Delta.

American believes it can close gaps with Delta by leveraging new revenue streams

After United concluded in late 2016 that it could best Delta’s margins by 2020 (using 2016 as a baseline), it appears markets are looking for clarity from American as to when it will close the margin gap with Delta.

See related report: United Airlines Part 2: Sustaining balance sheet strength while declaring ambitious margin targets

United’s pretax margin in 2016 was 10.4%, and excluding special items was 12.2%. American’s pretax margin for the year was 10.7%, and excluding special items reached 12.2%. Delta’s pretax margin for 2016 was 16.7%.

All airlines are likely to face margin pressure in 2017; for 1Q217 American is forecasting a 3% to 5% pretax margin, and United projects 0.5% to 2.5% pretax margin for the same time period. Delta has stated that its operating margin for 2017 will fall 100 to 200 basis points. The tepid margins guidances have shaken investors concerned about the effects of cost pressure on overall profitability.

See related report: United Airlines’ lofty margin goals draw scrutiny, after a tepid market guide for 1Q2017

American believes strides in its revenue performance will help the company close the margin gap with Delta, noting the roll out of its new segmented product suite, which includes a basic economy product.

The airline is joining other US airlines in working to improve revenue and yield management, and is also strengthening its sales force to bolster its corporate portfolio. Recently, American executives admitted that the airline has fewer corporate contracts than its competitors, and aims to close that gap during the next 12 months.

Overall, American believes 80% of closing the margin gap with its competitors comes from better execution of managing its own revenues, and 20% of regaining some of its natural lost share. United also believes its new product segmentation will help close competitive gaps with Delta, and has cited better revenue management and fleet renewal programmes as other elements contributing to the narrowing of Delta’s advantage.

Although American and United believe they have the proper tools in place to level the competitive playing field with Delta, no company operates in a vacuum.

Delta is not resting on its laurels as its competitors try to catch up to, and outpace, its margin performance. Delta also plans to improve its revenue management techniques, and leverage its first mover advantage in developing a basic economy by rolling the product out to all its domestic markets by YE2017. It expects to generate USD2.7 billion from its segmented products by 2020.

See related report: Delta Air Lines: cost pressure drives margin compression in 2017. Revenue generation is paramount

US airlines will not escape heightened margin scrutiny by investors in 2017

It was inevitable that as soon as United offered a definitive time period for closing the margin gap with Delta, the markets would look to American for similar declarations. But American is in the final stages of its merger integration, which unlike United’s merger, has been relatively smooth.

Given United’s rocky merger with Continental that closed in 2010, markets should expect the company to outline the ways it intends to close competitive gaps with its peers. American, too, at some point should be accountable for devising a strategy to bring its performance in certain financial metrics on par with those of its competitive peer set.

But a certain margin of tolerance should be reserved for American to complete the final stages of its merger integration before investors demand a timeframe for closing the margin gap with Delta.

Yet, in this unfair world that is not likely to occur, and margin performance appears to be a singular focus for US airline investors in 2017.

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