American Airlines Group Inc. (AAL, Financial) has found itself navigating turbulent skies as it grapples with several factors that threaten its profitability.
The latest blow comes in the form of escalating fuel and labor costs stemming from its recent collective bargaining agreement with the Allied Pilots Association union. The airline said openly that these issues will have a greater impact on its bottom line than it had anticipated. Despite a resurgence in passenger volumes, American Airlines has lost nearly 70% of its market value in the last five years and a meaningful recovery seems a distant reality.
Impact of rising jet fuel prices
Rising jet fuel prices have already taken a substantial toll on American’s profitability. The airline's revision of its initial estimate, now at $3 per gallon from an earlier estimate of $2.60 per gallon, underscores the magnitude of the challenge it faces. Data from the International Air Transport Association and S&P Global Commodity Insights reveal jet fuel prices have risen dramatically. For the week ending Sep. 8, prices averaged $127.88 per barrel, marking a notable increase from $97.78 per barrel recorded on July 7.
For better context, it is essential to consider the crack spread, a vital metric used in the aviation sector. Comparing the weekly average jet fuel price of $127.88 to the week's closing price of Brent crude oil at $91.65 per barrel, the crack spread comes to $36.23, which is among the highest recorded spreads in recent history.
Exhibit 1: Global average jet fuel price vs. crude oil price
Source: IATA
The revision to jet fuel price estimates by American, coupled with an ambitious labor deal that promises pilots a more than 40% pay increase over four years, has put immense pressure on the airline’s finances.
Challenges of pilot shortages
American Airlines is navigating economic challenges, including surging costs on all fronts and complex negotiations with its pilot union amid the broader issue of a severe shortage of pilots in the United States. Jefferies analysts have shed light on this pressing concern, estimating a shortfall of approximately 5,000 pilots. The implications of this shortage are far-reaching, with the supply-demand gap projected to persist until at least 2025, reaching a 12,000 deficit.
Impact of collective bargaining agreement
The recent adjustments in the collective bargaining agreement with the APA reflect the critical nature of this pilot shortage. Although APA has not disclosed the specific value of the revised deal with American Airlines, the company hinted that aligning the contract with United Airlines Holdings Inc. (UAL, Financial)'s agreement would substantially enhance its value. Estimates suggest a contract value exceeding $9 billion, a figure that underscores the significance of this contractual revision.
A key feature of the revised agreement is the provision allowing pay rate adjustments for American Airlines pilots to align with industry standards set by its peers at United Airlines and Delta Air Lines Inc. (DAL, Financial). United recently secured a labor deal that includes pay increases of up to 40.2% over four years, marking a significant milestone in often tense negotiations. United's pilot union hailed this tentative agreement as worth approximately $10 billion, a testament to the substantial improvements, including overtime and holiday pay, embedded in the contract. Cumulative pay increases are set to range from 34.5% to 40.2%, depending on the type of aircraft flown.
Delta Air Lines has also contributed to the industry's evolving landscape, ratifying a contract that offers over $7 billion in cumulative pay and benefits increases over four years. This agreement, with a 34% cumulative pay hike and various enhancements to benefits and work rules, has set a benchmark for contract negotiations at rival carriers. In a move mirroring United's deal, American plans to start the pay increases at the beginning of next year.
Financial challenges and debt reduction
In response to these mounting challenges, American Airlines made the decision to halve its operating margin forecast from 10% to 5%. This downturn is compounded by the weight of a massive debt burden the airline incurred in 2020, which now stands at a staggering $30 billion.
The second-quarter earnings report indicated progress in reducing total debt by approximately $9.4 billion from its peak in 2021 and the company is focused on trimming its total debt by $15 billion by the end of 2025. By the end of this year, American Airlines anticipates a further debt reduction of approximately $11 billion. This strategy aims to mitigate the impact of soaring operational costs while strengthening its balance sheet.
Exhibit 2: Debt reduction
Source: Earnings presentation
Revenue efficiency and growth strategies
American Airlines also faces challenges on the revenue front, with an expected decline of up to 6.5% in revenue per seat mile in the current quarter, which is in line with previous expectations. However, as the airline faces the challenge of striking a balance between meeting demand and optimizing profitability, it has increased flight volume to meet surging demand and offset the decline in revenue per mile. In the second quarter alone, the company operated nearly half a million flights, achieving an impressive average load factor of approximately 86%, along with delivering 11 more zero-canceled days than in the same period a year ago. These efforts align with broader industry trends. According to IATA, the global air traffic landscape has been on a notable upswing. In its market update provided on Sep. 6, IATA reported that total global air traffic in July 2023 surged by 26.2% compared to July 2022. Moreover, global traffic at the close of second quarter had rebounded to an impressive 95.6% of pre-Covid levels, underscoring the resilience and recovery of the aviation sector.
American Airlines is also positioning itself for growth in the latter part of this year with plans to take delivery of 23 new mainline aircraft. These acquisitions, now fully financed, build on the 13 deliveries in the first half of the year, with an additional 10 aircraft slated for year-end arrival. The regional fleet is not left behind as the airline recently signed agreements for the purchase of seven new Embraer 175 aircraft and seven used Bombardier CRJ 900 aircraft, set to begin operations starting in the fourth quarter. Further, the airline is also modernizing its fleet by retiring older narrowbody jets and exploring potential orders with both Boeing (BA, Financial) and Airbus (XPAR:AIR, Financial).
Even as the summer travel season slows down in the U.S., American Airlines is responding to travelers' demands by increasing flights to popular event destinations. Notably, the airline is set to provide expanded service to cities like Austin, Philadelphia, Miami, Tampa, Albuquerque, Dallas, Los Angeles and Greensboro during October, catering to events such as the United States Grand Prix and the International Hot Air Balloon Festival.
American Airlines is doing its best to navigate revenue efficiency challenges and grow, but the market is unlikely to reward the company before the company's strategies yield quantifiable results.
Conclusion
Amid macroeconomic challenges, American Airlines remains confident in turning a profit in the current quarter, albeit at a lower level compared to historical standards. However, it is evident the airline sector will continue to face additional challenges as it deals with a dynamic landscape characterized by rising prices amid the ongoing recovery of the travel sector. As a result, the company’s return to sustained profitability is expected to be a turbulent one, and investors will have to prepare for substantial volatility in net income in the coming quarters. Such volatility is likely to result in volatile stock prices as well.
