American Airlines in Chapter 11 Bankruptcy

On 29 November 2011, American Airlines filed for bankruptcy—the last legacy carrier in the US to do so after 11 September 2001. The aim of the filing is to cut labour costs and lower its debt.

Good timing for a bad situation

American Airlines tried for 10 years to avoid bankruptcy, even restructuring in 2003 to cut costs. Facing structurally higher fuel prices, a significant debt payment in December 2011 and the winter low season, the airline chose to file for Chapter 11 in November while it still had more than US$4 billion in cash. This cash reserve allows it to avoid debtor-in-possession financing so that it can remain autonomous in bankruptcy and not be beholden to creditors who would loan money to the airline to continue operating. This, coupled with new bankruptcy laws that give management only 18 months to file a turnaround plan exclusively, most likely means that the carrier will work fast to emerge from bankruptcy.

The cost disadvantage

In the 2003 restructuring, labour unions gave concessions, such as lower wages, to keep the company’s defined pension plan in place. However, other legacy carriers shed their pensions, along with other costs, in their bankruptcy filings. In its 2010 annual report, American Airlines estimated that it has a US$600 million labour cost disadvantage compared to other legacy carriers. The bankruptcy filing will give the airline more freedom to pare back its labour costs and modify work rules and scope provisions to improve productivity. However, the airline has not yet confirmed whether it will eliminate its defined pension plan.

The company is likely to pare back its corporate debt. As Airline Weekly pointed out in its 5 December issue, American Airlines’ interest costs (its largest non-operating expense) were 3.5% of its revenues in the first nine months of 2011, while United and Delta paid out just 2.6% of their revenues in interest expenditure over the same period.

Leases on aircraft are also expected to be terminated or renegotiated, especially for the smaller jets in the American Eagle fleet. The company will likely renegotiate its lease on its MD-80s, which are not fuel efficient and expensive to fly. However, Boyd Group International asserts that eliminating debt and pension burdens would make American Airlines profitable despite its heavy reliance on MD-80s, which constituted 34% of its fleet at the end of 2010.

Current strategy to remain in place

Its current “cornerstone strategy” (98% of arrivals or departures will be at one of its five major hubs: Dallas/Fort Worth, Chicago, Miami, Los Angeles and New York) is expected to remain in place during and after bankruptcy proceedings. Furthermore, the filing is not expected to impact its fleet renewal plan, which was announced in July 2011. The fleet renewal is expected to give American Airlines the youngest, most fuel-efficient fleet in the US within the next five years and is expected to be cost neutral.

However, the airline is expected to continue shrinking by cutting unprofitable flights. Some analysts speculate that the airline’s capacity could shrink by 10-20%.

A potential merger with US Airways?

The bankruptcy filing has sparked speculation that American Airlines may merge with US Airways to reap the benefits of consolidation (better capacity control, geographic diversity, economies of scale to cut costs and robust networks to drive revenues). A merger between American Airlines and US Airways would yield a stronger frequent flyer plan, a stronger oneworld alliance and dominance in Philadelphia, Charlotte and Washington DC (Reagan National Airport). However, there are significant cons to the merger. US Airways’ Phoenix hub is a money loser dominated by Southwest. Its Philadelphia hub overlaps with American airlines’ hub in New York (JFK). Furthermore, the merger would likely result in divestitures at Reagan National Airport – US Airways’ crown jewel. This is not to mention the significant risk in merging the airlines’ labour groups. US Airways still has not integrated the two pilot groups from its merger with America West in 2006.

Although the negatives of the merger outweigh the positives, it is possible that US Airways would put forward an offer. The airline firmly believes in consolidation and the merger would be a great way for the airline to increase its size. However, if American Airlines remains autonomous throughout its bankruptcy proceedings, it isn’t likely to agree to the merger—the downsides are far too great for the airline. Instead, the two airlines could begin a codesharing agreement, which would yield revenue synergies without any merger costs. Other potential codeshare partners are JetBlue (American Airlines and JetBlue already interline and have frequent flyer reciprocity) and Alaska Airlines. However, these codeshare agreements will only be possible if American Airlines can amend its pilot scope clause (a work rule in the pilots’ contracts that prohibits this type of codeshare) during the bankruptcy proceedings.

The future looks brighter

It is likely that American Airlines will exit bankruptcy within 18 months as a smaller, profitable carrier due to the elimination of its labour cost and debt disadvantages. It has strengths in its dominance at Dallas and Miami hubs and on its Latin American routes (which will be expanded if, as is likely, TAM joins the oneworld alliance in 2012). It also has competitive non-fuel/non-labour operating costs and its fleet renewal programme will give it a competitive advantage. However, bankruptcy cannot fix its revenue disadvantage against the bulked up United and Delta; these airlines dominate more hubs and are able to extract a yield premium because of it. Even with lower costs, it is not likely that American Airlines will be as profitable as those behemoths in future.