PREMIUM SEARCH Search by job title, geography and build a list of executive contacts
AMR Corp. (AMR
) and its American Airlines subsidiary, battered by huge losses, stand at the edge of bankruptcy. The results of crucial union votes on $1.8 billion in labor concessions are likely to determine their fate. (All unions involved, except for the flight attendants, have approved the concessions. The flight attendants will be allowed a second chance to vote on AMR's proposal after narrowly rejecting it in a poll concluded Apr. 15.) Both the parent company and the airline have a Standard & Poor's credit rating of CCC -- barely above default.
How did the world's largest airline and, until late 2001, one of the stronger U.S. carriers reach this point?
American's recent troubles began with the unprecedented decline in passenger revenues since the September 11, 2001, terrorist attacks. The entire U.S. industry -- and, to a lesser extent, airlines elsewhere -- has seen a plunge in passenger revenues that far exceeds past cyclical declines. The Air Transport Assn., the U.S. airlines' trade organization, has compiled historical data that show industrywide passenger revenues compared to nominal U.S. gross domestic product for each quarter since 1980. Passenger revenues have consistently averaged about 0.95% of GDP, with only modest fluctuation above (to slightly over 1%) or below (a little less than 0.9%) over that period.
UNPRECEDENTED SLUMP. But all that changed after September 11. Passenger revenues collapsed to around 0.7% of GDP and have remained at historically low levels. In a business with high operating and financial leverage, such an unprecedented slump translates into huge losses for most industry members.
While part of the decline represents a structural shift caused by rising competition from low-cost, low-fare carriers, the ease of shopping for cheap tickets on the Internet, and other factors, a larger portion appears to be related to the aftereffects of September 11. The relative importance of structural changes, normal cyclical factors, and new security concerns aren't likely to be clear for a while.
American, along with bankrupt United Air Lines and US Airways (UAWGQ
), which recently emerged from Chapter 11), has been hurt especially by high operating costs. Its cost disadvantage relative to other large hub-and-spoke airlines varies from moderate, vs. Delta Air Lines (DAL
) and Northwest Airlines (NWAC
), to fairly significant, vs. Continental Airlines (CAL
). The disparity compared to low-cost airlines such as Southwest Airlines (LUV
) is huge, though American and other large hub-and-spoke carriers continue to maintain a material -- though narrowing -- lead in total revenues against these competitors.
HAUNTED BY BUYBACKS. Labor is both the largest expense item (around 35% to 40% of pretax costs) and the largest cause of cost differences between one airline and another. Although pay rates are one source of the gap, work rules and their effect on productivity are at least as important. One example: Southwest pays its B737 pilots as much as most large airlines, but the Southwest pilots fly many more hours per month.
Substantial share repurchases by AMR in the late 1990s have also come back to haunt it. AMR bought back $2.6 billion of common stock during that time, when the U.S. airlines enjoyed a period of relative financial health. This amount was equal to 64% of its cumulative net income during 1997-2000 -- a proportion that was not out of line with those of its peers.
UAL was the least aggressive during this period (though it had undertaken a leveraged recapitalization in 1994 when employee stock-ownership plans bought a majority stake in the airline). Delta's buybacks equaled 47% of cumulative net income, while Continental's totaled 76%. Other carriers were more aggressive: Northwest's buyback outlays represented 111% of cumulative net income. Most remarkably, US Airways spent 137%.
"FREE" CASH FLOW? Why would players in a cash-hungry industry spend such large amounts on buybacks? Big U.S. airlines were under pressure from equity analysts and institutional investors at that time to "return value to shareholders" by distributing "free cash flow" and proceeds from the sale of noncore assets. The so-called "free cash flow" coveted by these investors was from operations after cash capital expenditures.
However, the investors clamoring for buybacks ignored the fact that carriers used leasing to acquire most aircraft and finance new airport projects. The airlines' true free cash flow, counting newly leased assets as capital expenditures, was often negative during this period, a fact that Standard & Poor's Ratings Services noted at the time. One other factor Standard & Poor's noted then was the credit risk created by buying common stock in a cyclical, highly leveraged industry.
American has been hurt by a disproportionate exposure to the industry's recent revenue weakness. It suffered from its direct involvement to the events of September 11, an accident at New York's John F. Kennedy International Airport in November, 2001, and an attempted terrorist attack on a trans-Atlantic flight (by the alleged "shoe-bomber") in December, 2001. The airline's operations are concentrated in markets that have seen particular revenue weakness: U.S. business travel, U.S.-Britain routes, and transcontinental routes.
PAINFUL TRADE-OFF. Strategic decisions taken by AMR's management have played a much smaller role in the outfit's current difficulties. AMR undertook two projects whose wisdom at the time was unclear, but which turned out to be damaging given subsequent events: The introduction of "more room in coach" seating and the early 2001 acquisition of bankrupt Trans World Airlines.
American removed seats to increase legroom with the idea of providing its passengers with a more attractive product. Whether it attracted a material number of additional business passengers isn't clear (no independent evidence is availble, though no competing airlines followed suit, so the diversion could not have been very large), but it certainly inflated American's cost per seat-mile by around 6%. In the current environment of weak business travel, that trade-off has hurt.
As for the TWA deal, although the asset acquisition wasn't especially expensive (AMR made a net cash outlay of $625 million, plus $2.2 billion of added leases, equal to about 10% of its current total debt), it increased capacity just as the overall market was weakening -- even prior to September 11.
SOME ADVANTAGES. However, AMR and American do enjoy relative strengths. AMR entered the industry downturn with one of the better balance sheets in airline group, substantial amounts of unencumbered assets, and good liquidity. Although American's revenue premium to the rest of the industry has deteriorated, the airline still has a substantial base of business travelers, the industry's largest (and very successful) frequent-flyer program, and a strong global network of routes. These strengths haven't been sufficient to avert financial crisis, but they should remain valuable if AMR and American eventually are forced into Chapter 11, likely enabling them to reorganize successfully.
One factor that has worked both for and against American and other U.S. airlines is the federal government's role. Airlines pay an unusually high level of fees and taxes, compared to other industries. A large portion of these levies is earmarked for aviation-related costs, such as security and air-traffic control. Moreover, airlines have been required to incur added expenses in response to mandated security measures (like strengthening cockpit doors) over the past 18 months.
Whether these taxes, fees, and mandated expenditures are justified is a question on which Standard & Poor's Ratings Services doesn't comment, as a matter of policy. However, it's clear that in the current very weak revenue environment, airlines have little pricing power to pass these added expenses on to passengers. They're effectively being forced to pay the levies themselves.
GOVERNMENT AID. On the other hand, the federal government has aided the airlines. It provided $4.5 billion of cash grants for passenger airlines after the September 11 attacks, backstop terrorism insurance, and a controversial federal loan-guarantee program (which AMR's management originally opposed and, in any case, never applied for). The federal budget just passed by Congress includes further aid for the airlines, consisting of a temporary suspension of security fees, reimbursement of some security costs, and a continuation of backstop terrorism insurance.
For better or worse, the federal government's role in the U.S. airline industry has increased for the foreseeable future. But this wasn't enough to keep giant carriers like United and US Airways from filing for bankruptcy. And it may not be sufficient to help beleaguered AMR and American avoid a similar fate.
Baggaley, a managing director for Standard & Poor's Ratings Services, is a credit analyst covering the airlines and managing the aerospace and transportation industries rating team
Any advice, analysis, or recommendations contained in articles labeled "Insight from Standard & Poor's" reflect the views of Standard & Poor's, which operates separately from and independently of BusinessWeek Online. It is possible that BWOL may from time to time publish information that is not consistent with advice, analysis, or recommendations that are published by Standard & Poor's. Standard & Poor's and BusinessWeek Online are each units of The McGraw-Hill Companies, Inc.
Get BusinessWeek directly on your desktop with our RSS feeds.
Add BusinessWeek news to your Web site with our headline feed.
Click to buy an e-print or reprint of a BusinessWeek or BusinessWeek Online story or video.
To subscribe online to BusinessWeek magazine, please click here.
Copyright 2003, Bloomberg L.P.
Printer-Friendly Version
