Strategic Report for AA

8/9/2019 Strategic Report for AA

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American Airlines

April 7, 2010 Page 1

Strategic Report forAmerican Airlines

Jed CullenKevin YamazakiDeirdre Chew

April 7, 2010


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Table of Contents

Executive Summary ............................................................................................3

Company History.................................................................................................4

Financial Analysis ...............................................................................................8

Current Financial Position..................................................................................8

Industry Comparable Analysis .........................................................................12

Stock Performance ..........................................................................................14

Management and Analyst Outlook................................................................... 15

Competitive Analysis ........................................................................................16

Internal Rivalry.................................................................................................17

Supplier Power ................................................................................................18 Buyer Power ....................................................................................................19

Entry and Exit .................................................................................................. 19

Substitutes and Complements .........................................................................20

SWOT Analysis .................................................................................................. 23

Strengths..........................................................................................................23

Weaknesses ....................................................................................................23

Opportunities ...................................................................................................24 Threats.............................................................................................................24

Strategic Recommendations............................................................................25

Address Labor Costs .......................................................................................25

Explore Maintenance Outsourcing...................................................................26

Continue Fuel Efficiency Initiatives ..................................................................27

Pursue Strategic Alliances............................................................................... 27

Enhance International Offerings ...................................................................... 27

Exercise Political Power of Legacy Carriers ....................................................28

Appendix ............................................................................................................30

References .........................................................................................................34


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Executive Summary

American Airlines, a brand that has weathered world wars, deregulation, fuel

price volatility and growing threats of terrorism, is continuing to face challenges

in the struggling airline industry. American Airlines is burdened by high labor

costs, a weak balance sheet, and perpetual union issues. While nearly all of

American’s legacy carrier peers are facing a difficult market environment, most

were able to achieve cost reductions through bankruptcy or bankruptcy

protection, a step that American Airlines has stated strongly that they will not

take. Furthermore, AA, like other legacy carriers, faces increasing competitive

pressure from low-cost carriers. The enhanced ability for consumers to compare

prices further exacerbates this pressure. Despite its excellent management team,

the company has recorded an annual loss in seven out of the past nine years.

American Airlines must address its high costs, improve its international

offerings, and find a solution to the competitive threat posed by low-cost carriers.

We recommend that AA avoid excessive concessions to the flight attendants

union, citing that AA flight attendants are among the best paid in the industry. To

further reduce costs, American should explore maintenance outsourcing, and

continue taking initiatives toward greater fuel efficiency.

With regards to American’s inability to compete with foreign carriers on

international routes, we believe that the company needs to invest in flat bed

seating in business class on long haul flights. We also believe that American

stands to gain by opening routes to Seoul and Hong Kong, which will link them to

new markets and are accessible without expanding the current fleet. To address

the domestic threat posed by low-cost carriers, we recommend that American

and other legacy airlines lobby for a tax credit system, distributed in an auction

method, to ease the burden on carriers who provide access to underserved areas.

These strategies, combined with planned fleet replacement and a recent interline

agreement with JetBlue, will position AA to thrive as the economy recovers.


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Company Overview and History

American Airlines, American Eagle, and AmericanConnection currently provide

scheduled service to 250 cities in 40 countries, with an average of over 3,400

daily flights. Together, these carriers operate a fleet of over 700 aircraft, and are

subsidiaries of the AMR Corporation. Though AMR was founded in 1982, the

American Airlines brand has been a major player in air travel for over three

quarters of a century.

In 1929, the Aviation Corporation acquired scores of independent airlines as the

airline industry experienced sweeping consolidation. The following year, the

Aviation Corporation changed its name to American Airways, to reflect the brand

under which many of the regional carriers flew. The company was headquartered

in New York, and ran routes from New York, Boston, and Los Angeles to Dallas. 1

The company was renamed American Airlines in 1934, and Cyrus Rowlett Smith

became the president. Smith went on to run the company as CEO until 1968,

when he resigned to serve as United States Secretary of Commerce. 2

Within its first decade of operation, American Airlines flew its one-millionth

passenger, became the number one domestic carrier in the United States (byrevenue), and began trading on the New York Stock Exchange. The airline had

also collaborated with New York City Mayor Fiorello LaGuardia to develop

LaGuardia Airport. As a first-mover among airlines, and a critical player in the

development of the project, American was also granted extra hangar space and

real estate. AA opened the world’s first airline lounge, the Admirals Club, in

1939. 2

The 1940’s offered American myriad opportunities to expand into other areas of

the airline industry. In 1942, American launched the catering subsidiary

SkyChefs, which provides in-flight meals to American and other carriers. In 1944,

American, which had become the first commercial airline to fly the DC-3 eight

years earlier introduced a freight route making use of this line of aircraft. Though


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half of their fleet was turned over to the military during World War II, the

company launched American Overseas Airlines, (AOA), its first European service,

in 1945. 2 AOA was acquired by Pan American World Airways in 1950. 3

After the war, American Airlines quickly renewed its fleet to match growingdemand for air travel in the United States. By 1949, AA was the “fleet of the

future,” and the only airline with a ubiquitous use of pressurized, post-war

planes. 2 As the company expanded, American Airlines introduced programs to

make flying more affordable for families, and introduced coach service as an

economic alternative to first class.

The fifties brought further advances for the company in reservation and flight

tracking technology, as well as the implementation of transcontinental nonstopflights with the Douglas DC-7. By the end of the decade, American Airlines was

moving into the jet age, becoming the first airline to offer coast-to-coast jet

service on the Boeing 707. In the following two years, American Airlines also

pioneered turbofan and turboprop service on the Corvair 990 and Lockheed

Electra, respectively.

American Airlines spent the first half of the 1960’s working with IBM to create

SABRE, which at the time of its introduction in 1964 was the second largest and

most powerful electronic data processing system after the US government’s

mainframe. American Airlines’ iconic AA logo was designed in 1967. The sixties

also saw the introduction of the Boeing 727 and 747, with the freighter edition of

the latter debuting in 1974. As American added new planes to its fleet, it

expanded its route offerings through a 1970 merger with Trans Caribbean

Airways, and with the acquisition of routes in 1975 from Pan-America.

The Airline Deregulation Act of 1978, which removed government control over

routes in exchange for market allocation, prompted a massive campaign of route

expansion for American Airlines. At the same time, AA moved its corporate

headquarters to Dallas/Fort Worth, where it had already established training

facilities and reservations offices. By 1981, the Dallas/Forth Worth airport


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became the major hub of American’s worldwide hub-and-spoke system. The same

year, American Airlines launched its revolutionary AAdvantage Frequent Flyer

program, which remains a hallmark of the company and boasts an enrollment of

over 50 million members today. 4

In 1980, faced with rising fuel costs, AA retired the Boeing 707. These planes

were phased out as the newer more efficient 767 joined the fleet in 1982. The

same year, stockholders approved a plan to reorganize American Airlines. The

passenger and cargo businesses would operate as separate subsidiaries under the

holding company AMR Corporation. In 1984, AMR grew to incorporate the

American Eagle system, a regional carrier connecting passengers to American

Airlines. As AA expanded its hub-and-spoke system through the 1980’s, the

company added Chicago, Nashville and Miami as hubs, and made the SABRE

system accessible through a personal computer.

In 1990, American Airlines purchased TWA’s London-Heathrow assets,

establishing a hub in the United Kingdom. In the following years, American

Airlines tried to introduce their “Value Pricing” program with the hopes of

making flight fares more simple, understandable and cheap. Stiff price

competition, however, prevented the success of the modified fare structure,

leading AA to abandon the model shortly thereafter. The years 1993 and 1994

were marked by a comprehensive service agreement with Canadian Air, and the

formation of the SABRE technology group as a separate entity under the AMR

umbrella. In 1995, AMR announced the SABRE group would file for an IPO,

commencing a spinoff that would be completed by 2000.

In September of 1998, American Airlines announced the formation of a new

global alliance, oneworld, which would generate codesharing agreements amongmultiple international airlines. Founding members included Cathay Pacific,

Canadian Airlines, Quantas, and British Airways. 5 Today, oneworld members

serve nearly 700 destinations in over 130 countries and territories, and the

alliance has grown to include eleven major carriers. 6


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In early 2001, American Airlines completed the acquisition of the near bankrupt

Transworld Airlines, adding a hub in St. Louis. Unfortunately, American Airlines

flights were the target of the September 11, 2001 attacks. This event left the entire

airline industry struggling, but hit American Airlines especially hard because the

company was in the wake of a major acquisition.

Since 2001, AMR has posted annual losses in seven out of the past nine years,

accumulating to a net loss of almost $11 billion over the period. While it has

expanded non-stop service to include routes to Russia and China, the company is,

like other legacy carriers in the airline industry, struggling significantly. Rising

fuel costs over the past decade and recent economic downturn have raised

questions about the economic sustainability of American Airlines. 7


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Financial Analysis

American Airlines, like other hub-and-spoke airlines, has been struggling

financially since 2001. The first half of the decade presented rapidly rising fuel

costs as a major challenge, and the recent economic downturn has further

reduced demand. In the past five years, many of its hub-and-spoke competitors

turned to bankruptcy filings or protection and aircraft order deferrals to

reorganize and address costs. American, however, insists that fiscal discipline will

keep them attractive to investors as they weather the storm, and are going

forward with plans to renew nearly their entire fleet in the coming five years. The

company is proud of its status as the only U.S. airline which has weathered World

War II, deregulation, the Gulf War, the attacks of September 11th, periods ofincredible fuel price volatility and the recent major recession without being

acquired or going bankrupt.

American Airlines has cut costs significantly in the past nine years, but recorded

heavy losses in every year with the exceptions of 2006 and 2007. 8 While AMR is

betting heavily on resurgence in demand for commercial air travel as the

economy recovers, analysts expect annual losses through the end of 2011. The

current strategy of AMR emphasizes long-term success. It is questionable whether investors are patient enough to wait for these returns, and whether they

are as confident as management that AMR will thrive after the economic

recovery. Of equal importance is the consideration of whether AMR will have the

financial strength to continue through these difficult times, should resurgence in

demand take longer than expected.

Current Financial Position

In 2009, AMR recorded a net loss of $1.47 billion, compared with a 2008 net loss

of $2.1 billion. 9 This past year’s loss was driven by a decrease in air travel as a

result of the economic downturn, leading to significant reduction in passenger

revenue. Industry-wide fare discounting exacerbated such declines, further


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diminishing American’s passenger revenue per seat mile. Overall revenue fell

from $23.77 billion in 2008 to $19.92 in 2009. 10

In response to decreased demand, American Airlines continues to enact capacity

reductions, reducing mainline seating capacity by an additional 7.2% since 2008.This reduction in capacity, along with a year-over-year 33% decrease in fuel

prices, helped to soften the blow to the company’s finances. Jet fuel, the largest

single cost that the company faces, fell from a 2008 average of $3.03 to a 2009

average of $2.01, and constituted 35.1% and 26.5% of 2008 and 2009 operating

expenses, respectively. 11 AMR’s credit rating, due to the weakness of its balance

sheet and the state of the aviation industry, limits its ability to hedge fuel prices.

As such, volatility and/or disruptions in the supply of fuel, as well as escalating

costs may adversely impact AMR’s financial position. 12

The company’s guidance suggests it is in a stronger financial position than at the

beginning of 2009, although American increased its lease-adjusted total debt by

$831 million. The company will need to raise substantial additional funds to

maintain liquidity, and will face challenges doing so on acceptable terms. These

liquidity issues may be further worsened if American Airlines is required (by

potential new financial regulation) to maintain reserves to cover the credit card

processing agreements it has with multiple financial services companies. 13


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Industry Comparable Analysis

American Airlines recorded the second highest revenues in the airline industry

(after Delta) in 2009, but recorded the largest loss of its peers. As the recession

hit, American’s revenue fell sharply, dropping 16% in 2009 compared to 2008. While net margins improved, the company still maintains the lowest net margins

in the industry.

The reduction in demand for air travel put additional strain on American’s debt

load, and ability to raise funding in capital markets. American, along with United

and USAir, have liabilities that exceed their assets, as is indicated in their

negative debt/equity ratios, and debt ratios in excess of one. 14 The corporate debt

for each of these firms is rated B-, limiting the ability of the companies to enterinto fuel hedging agreements, as well as to sell debt at favorable rates. 15

Southwest is unique among airlines in that it has a significantly higher corporate

debt rating (BBB) which is considered investment grade. American and its peers

issue debt rated as B or lower, which is considered to be speculative grade.


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16

In addition to unfavorable indicators in terms of traditional financial measures of

debt, operations and leverage, American struggles on a number of industry

specific metrics as well (see appendix). In the third quarter of 2009, American

was in the top half of its peers in terms of operating expense and fuel cost per

available seat mile and was in the bottom half of the industry in terms of margins,

and revenue per average seat mile. 17


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Stock Performance

Last 12 Months: AMR, S&P 500 and XAL Airline Index 18

Last 12 Months: AMR, S&P 500 and XAL Airline Index19

Last 5 Years: AMR, S&P 500 and XAL Airline Index 20

Despite forecasting losses through 2011, analysts are bullish on AMR stock. Post-

earnings analyst reports in January 2010 indicated an “Overweight” or “Buy”


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rating from Morgan Stanley, Bank of America-Merrill Lynch, JPMorgan,

Barclays, and UBS, as well as a “Hold” rating from Citigroup. 21

Management and Analyst Outlook

As stated in management guidance from the 4Q 2009 press release, AMR plans

to increase its international capacity by 3.2%, while reducing domestic capacity

by 0.5%. This will produce a net increase in mainline capacity of 0.9% compared

with 2009. AMR is planning for an average system price of $2.36 per gallon

during the first quarter of 2010, with an average of $2.42 throughout the entire

year. 22

Management expects a 1.1% increase in average cost per seat mile, excluding fuel,

due to costs of bringing a new fleet of aircraft online. These new aircraft,

however, are 35% more efficient, and are expected to deliver a 2% increase in

mainline fuel efficiency in 2010. 23

Credit analysts expect 2010 revenues to improve by 9% but for fuel costs to rise

23%, well above management’s guidance. Although AMR will undergo extensive

capital expenditure as it renews its fleet, analysts expect attractive sale-leaseback

agreements to offset these costs. While AMR remains at the top of network

carriers in terms of liquidity and balance sheet health, the overall view on the

airline industry from credit analysts is “Cautious,” as rising fuel prices and worse-

than expected revenue recovery present significant risks to the financial health of

the industry. 24


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Competitive Analysis

The airline industry continues to face a challenging market environment. While

loss margins shrunk in comparison to 2008, IATA estimates that the globalairline industry lost $9.4B in 2009, slightly stronger returns than the $15.9B

estimated loss in 2008. 25

American Airlines provides scheduled transportation of passengers and high

priority cargo via aircraft between two airports, one of which is located in the

United States. With this definition of business, the North American Industrial

Classification System (NAICS) identification is “Scheduled Air Transportation”

(48111). American Airlines is significantly involved in two subcategories of thisclassification: “Scheduled Air Passenger Transportation” (481111) and “Scheduled

Air Freight Transportation” (481112). 26

While the markets and customers for passenger and freight transport may vary,

there is significant cross-elasticity of supply in providing both these services.

Many of American’s competitors also benefit from this economy of scope; like

American, they derive most of their revenue from passenger transportation.

American Airlines business faces competition from both legacy hub-and-spokecarriers like Alaska, Continential, Delta, Northwest, United and U.S. Air, as well

as point-to-point low cost carriers including JetBlue, Southwest and Airtran.

American Airlines also faces competition on international routes, especially from

AirFrance, Lufthansa, and British Airways.


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Five Forces Industry Analysis and Strategy

Force Strategic Significance

Internal Rivalry High

Supplier Power HighBuyer Power Medium

Entry and Exit Low

Substitutes & Complements Low

Internal Rivalry

American Airlines faces its most significant competition domestically, where

multiple carriers compete for the same customer base, commonly on identical

routes. In 1978, the Airline Deregulation Act established consumer market power

over air travel. This action greatly benefitted passengers by driving fares down,

but put immense competitive pressure on airlines. Because air travel is a largely

undifferentiated product between airlines, this competition principally takes

place in the price arena.

Two distinct carrier models dominate the market in which American Airlines

competes. The legacy carriers, including AA, use a hub-and-spoke model. This

model allows carriers to serve a vast network of airports with a smaller fleet size

compared to direct point-to-point service, and is necessary for the present

comprehensive domestic air transport system. American Airlines and other

network carriers employing this model, however, face stiff competition from

point-to-point low-cost carriers (LCCs).

The LCC model piggybacks on the existing network, typically flying only the “cash

cow” routes. In addition to cherry-picking profitable routes, LCCs often also

reduce their operating costs by flying to secondary airports in major regions,

offering no-frills service with “sardine-packed” seating. They also commonly only

use a single airplane type to simplify pilot training and maintenance inventory. 27

While such a model does not provide a comprehensive and sustainable air travel


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system, their ability to undercut the hub-and-spoke airline companies presents a

significant competitive threat to legacy carriers like American Airlines.

The competitive threat posed by LCCs has grown significantly in the past decade

with the proliferation of online ticketing, which has been growing steadily overthe last decade. This phenomenon has intensified cost competition as passengers

can compare prices across the industry before choosing a carrier. While

passengers have always been price sensitive, increased availability of pricing

information has greatly aided LCCs in stealing marketshare from the network

carriers.

Supplier Power

There are three key inputs to operations involved in the transportation of freight

and passengers by air: fuel, aircraft and labor. Supplier power in each of these

areas is significant.

Aviation fuel is the largest single expense in AMR’s budget. 28 American has

among the highest fuel costs per seat mile, and highest fuel costs as a percentage

of operating costs of any of its competitors. Despite the immense amount of fuel

consumed by the company, there is very little bargaining power in the purchase

of this commodity, which has a market rate determined externally by long-term

contracts, futures markets, and spot prices. As mentioned earlier, AMR is limited

in its ability to hedge fuel prices. The firm, like each of its competitors, is

enormously sensitive to fluctuations in the price of oil. 8

American Airlines faces supplier power when purchasing aircraft, as two giants,

Boeing and Airbus, dominate the supply for commercial airliners. At the end of

2009, AA’s fleet (not including American Eagle) consisted of 610 aircraft, 349 of which were owned. American Airlines’ fleet is split 60/40 between Boeing and

McDonnell Douglass, and Boeing planes represent 75% of their owned

equipment. AA is in the process of phasing out their McDonnell Douglass fleet for

additional Boeing planes. 29 The small number of firms in the aircraft

manufacturing industry gives a fair amount of bargaining power to the supplier.


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Labor is the third major input to operations in the airline industry. Labor in the

airline industry is highly unionized, and wages, salaries and benefits constitute

about a third of AA’s total operating expenses. While some of American Airlines’

competitors have achieved labor cost reductions through bankruptcy

proceedings, American continues to pay some of the highest labor costs in the

industry. 30 It is unclear whether this gap can be closed, as the bargaining power

lies with the unions. The labor costs of AA’s competitors are predicted to rise, and

possibly narrow this gap. Union pressure, however, along with the seniority of its

workforce, will likely continue to keep American Airlines’ labor costs higher than

those of its peers.

Buyer PowerDue to the proliferation of online ticketing, consumers have nearly perfect

knowledge of pricing in the industry. This factor, combined with the price

sensitivity arising from the undifferentiated nature of airline service, grants a

significant amount of buying power to the consumer. Furthermore, because

passengers have low switching costs, even within the same travel schedule (i.e.

multiple carriers for the same trip), buyer power is further amplified in the airline

industry. In general, this enhanced ability of consumers to act on price has

benefitted low-cost carriers, which can offer more attractive pricing on many of

the high-trafficked routes.

Entry and Exit

Significant barriers to entry favor the existing firms in the airline industry. In

terms of financial barriers, operating an airline is a capital intensive, high fixed-

cost endeavor. There are significant economics of scale that arise from marketing,

the capacity to spread fixed costs over many routes, and the ability to enter intocodesharing agreements.

In addition to economic difficulties, there are regulatory and logistical barriers as

well. The airline industry is still highly regulated, both in terms of route

scheduling and homeland security. In addition, “slots” at major airports are


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valuable commodities that are often locked into long-term contracts. For

example, it is impossible to add flights at New York’s three major airports

without acquiring the operating rights from another carrier. These three airports

are involved in 6 out of the 10 most trafficked routes in the US, and the

restriction on the supply side has made these operating rights quite expensive. 31

Exit from the airline industry is also a difficult process. In addition to the

liquidation of fleet, equipment, plant, property and operating rights, airlines are

obligated to honor the existing passenger reservations. In 2005, rather than

exiting the industry, five of the seven largest network carriers opted to enter

bankruptcy or bankruptcy protection agreements and reorganize. 32

Substitutes and Complements

Substitutions for commercial air travel include other forms of transportation and

other methods of accomplishing the tasks that motivate the need to travel. The

former encompasses both business and leisure travelers, while the latter is more

relevant to business customers.

In the United States, there are few viable substitutes for long distance air travel.

The US lacks a strong high-speed rail network, and even on shorter legs, trains

are slower, and often not significantly cheaper, than traveling by air. There is an

extensive interstate system and available low-fare bus transportation, but airlines

still seem to offer a better value proposition for long distance travel.

Over short distances, the advantages to trains and road travel are amplified,

especially in light of heightened security measures that extend the length of time

it takes to travel by plane. For distances under 250 miles, the door-to-door time

is often shorter when traveling by land. In many cases, land travel is lessexpensive as well.

For business and high net-worth customers, a viable substitute is private,

chartered or corporate jets. The growing popularity of fractional-ownership

programs and lessened pre-boarding hassle have made this substitute more


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attractive. This segment of the industry, however, is even more sensitive to

business cycles, and charter jet customers tend to downgrade to first or business

class on carriers like American during economic downturn.

The second substitute, most relevant to business customers, is the growth oftelecommunications, which has been greatly enhanced in the past decade by the

proliferation of fiber optic networks and high speed internet. With continued

improvement in video-conferencing technology, businesses may be able to

consider less travel to be essential to their own operations, reducing corporate

spending on commercial airliners. This is particularly problematic because on

many flights, business class financially supports coach class by paying higher

fares for a service that does not cost the airline significantly more to deliver. This

substitution will be more significant in economic downturns, as corporations cut

travel budgets further.

Travel by air is usually purpose motivated and non-experiential. Passengers see

the use of this service as a means to an end, namely to travel between two

destinations. As such, we posit two categories of complements when considering

air travel. The first category, unilateral complements, see an increase in demand

with increases in air travel, but their prices do not significantly increase air travel

itself. The second category, bilateral complements, can influence air travel with

changes in prices or desirability, as they motivate the demand for travel.

Unilateral complements to air travel include on-board wireless internet access, a

la carte items, in-flight shopping, and other amenities offered during the flight

experience. These serve primarily to enhance the traveling experience, and in

some cases to add revenue to the carrier, or edge out a competitor in terms of

offerings. American Airlines specifically has implemented wireless internet on all767-200 flights, select MD-80’s, and is working on installing the service on their

fleet of 737’s. 33 While these amenities can affect preference of one airline over

another, and subsequently patterns of demand between carriers, they are unlikely

to draw new customers to the industry.


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Bilateral complements include hotel stays, car rentals, and general goods and

services associated with business or leisure travel. A reduction in the cost, or

increase in the desirability, of reaching a destination will stimulate air travel and

increase demand on all carriers in the industry. Similarly, if air travel is very

inexpensive, there will be increased demand for these travel-related goods and

services. Undeniably, the airline industry is very pro-cyclical, and economic

activity tends to generate more demand for both business and leisure travel.


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SWOT Analysis

Strengths

• AAdvantage

o Enrollment of over 50 milliono Perennially recognized as one of the best customer loyalty programs

o Highest proportion of redeemable seating capacity among legacy

carriers• Reputation and Brand Strength

o One of the oldest, most established, carriers in the industry

o Only legacy carrier which hasn’t filed for bankruptcy• Strategic Airport Locations

o Hub positions in Dallas, Miami, Chicago

o Strong presence in major business hubs• Investor Confidence

o AA generates strong operating cashflowo Highly-rated

Weaknesses• Inability to compete on international flights

o Foreign carriers dominate market and offer higher quality service

o West coast weakness inhibits ability to reach Asian markets• Financial position

o Analysts forecasts losses through 2011

o Credit rating inhibits ability to enter fuel hedging contracts• Dependence on resurgence in demand• Labor and Union Issues


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Opportunities

• Flightplan 2020 34 o Management has laid out a plan of action for the next ten years

o Emphasis on investing wisely in fleet, earning loyalty,strengthening the global network, building workplace community

and flying profitably• Address labor costs

o Flight attendant union negotiations

o Maintenance outsourcing• Enhance international offerings

o Potential for growth in Asian markets

o Upgrade business class on long-haul flights

Threats

• LCC model edging out legacy carriers• Competitors have reduced costs through bankruptcy and consolidation• Fuel market volatility• Escalating militancy of labor unions

• Growth in videoconferencing and travel substitutes


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Strategic Recommendations

Address Labor Costs

American Airlines has some of the highest labor costs in the industry, as a result

of having a highly unionized workforce, but also in part due to the tenure and

seniority of their workforce. Competitors were able to slash union commitments

through bankruptcy and bankruptcy protection, but AA is constantly fighting

pressure from unions and driving labor costs upward.

At present, AA is fighting its flight attendants union, the Association of

Professional Flight Attendants (AFPA). In mid-March, the APFA appealed to the

National Mediation Board to declare that negotiations are at an impasse. In

addition, the APFA board of directors has indicated that it will distribute strike

ballots to its members in early April. 35 If the National Mediation Board declares

that talks have deadlocked, it can initiate a 30-day “cooling-off period” after

which union members can begin a strike. 36

AA should maintain its managerial discipline throughout flight attendant

contract negotiations. Though flight attendants unions are known to be militant,

it seems likely that many will cross the picket line if it comes to a strike. British

Airways flight attendants have received very little public support for their current

strike, despite the comparatively favorable public opinion of unions in the United

Kingdom versus the United States. 37 38 AA’s flight attendants are among the

highest paid in the industry, and the current national unemployment rate is over

10%, putting a lot of pressure on flight attendants to cave in. 39 Furthermore,

American Airlines’ management has lower levels of executive compensation than

its peers, giving the APFA little to point at in terms of demanding concessions. 40


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Flight Attendant Compensation by Carrier (2008) 41

Airline Salary Hours/Month Hours/Year Salary/HourPay rate

versus AA American $49,776 43.0 516 $96.47 100%

Continental $49,061 46.7 560.4 $87.55 90.8%

United $40.129 41.7 500.4 $80.21 83.2%

Southwest $53,027 63.1 757.2 $70.03 72.6%

US Air $39,716 47.5 570 $69.68 72.2%

Delta $36,409 48.6 582.7 $62.49 64.8%

Airtran $29,706 58.8 705.6 $42.10 43.6%

Jetblue $33,014 73.4 880.8 $37.48 38.9%Frontier $31,217 96.4 1156.8 $26.99 28.0%

Explore Maintenance Outsourcing

Another driver of AA’s escalated labor costs is their approach to maintenance.

American Airlines performs all of their heavy maintenance in-house at facilities

in Tulsa, Oklahoma and Kansas City, Missouri. 42 Though AA management

rationalizes this decision by emphasizing the control over their product, many oftheir competitors have been able to achieve significant cost savings by

outsourcing aspects of mechanical labor. Continental sends its 777s to HAECO in

Hong Kong for heavy maintenance; United Airlines sends 777’s and 747-400’s to

Ameco in Beijing for annual and heavy maintenance checks; US Air and JetBlue

have their A320 fleet serviced at AVEOS in El Salvador. 43 44 45 American

announced in October 2009 that they were phasing out their Kansas City

overhaul and maintenance base to adjust for capacity cuts. 46 Rather than

investing capital to expand the remaining Tulsa facility, American should explore

options abroad to see if their scheduled maintenance could be performed at a

lower price.


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Continue Fuel Efficiency Initiatives

As fuel prices escalated in the second half of the last decade, American Airlines

moved quickly in the implementation of fuel-efficient practices. In addition to

taking measures to lighten the load each plane is flying, other practices such asthe installation of blended winglets are estimated to have saved American

Airlines 111 millions gallons of fuel in 2008 alone. 47 They have been installed on

the owned 737-800s (77 in total) and should be extended to the remaining 31 that

are currently under operating lease agreements. This will not only improve fuel

efficiency, but mitigate the environmental impact of AA’s operations and reduce

its sensitivity to fuel price fluctuations. 48

Pursue Strategic Alliances

In early stages of analysis Vector Strategy Group favored recommendations for

American Airlines to partner with a low-cost carrier, and, as a separate endeavor,

to work to feed more international travel through John F. Kennedy Airport in

New York. We are pleased with the recent announcement of AA’s alliance with

JetBlue, and commend management for finding a way to simultaneously

implement these two strategies.

American will gain eight takeoff and landing slot pairs at JFK, and offer seamless

service to customers who fly JetBlue domestically to connect to American Airlines

international destinations. 49 Aviation analyst Robert Herbst estimates that the

agreement will add at least $14 million and $55 million to JetBlue and

American’s operating income, respectively. 50

Enhance International Offerings

American Airlines lags its international competitors in terms of in-flightamenities and domestic carriers with regards to connections to Asian markets.

AA can address these issues by upgrading its hardware, and opening new routes

to hubs in East Asia.


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AA is the only domestic carrier to guarantee a lie-flat seat in business class on

long-haul flights, but non-U.S. carriers are far ahead with flat bed seat

implementation. Furthermore, Delta, Continental and United are also moving

ahead with United guaranteeing flat bed seats through business class by the end

of 2010. 51 52 As American Airlines renews its fleet, it should pay attention to the

configuration that its competitors are offering and work to stay competitive.

American should begin building out its Asian presence with its existing fleet and

lay the groundwork for more routes to the region upon future delivery of the

787’s it has on order from Boeing. American should enter this region by initiating

service from Chicago-O’Hare to Hong Kong and from Dallas-Fort Worth to Seoul.

The former of these routes would connect two major oneworld hubs and build out

American’s connectivity to codesharing partner Cathay Pacific. Initiating service

to Seoul introduces American to a large local market, where AA is well-positioned

to steal U.S.-based Korean Air customers with its AAdvantage program.

American has 47 Boeing 777’s in its fleet, though its current route schedule only

requires 42 planes. While AA is obligated to keep a portion of its fleet reserved for

military contracts it is possible to add new Asian routes on a limited basis with

these extra 777’s. If this expansion is successful, they could add frequencies and

routes with the coming integration of the Boeing 787 into their fleet. 53

Exercise Political Power of Legacy Carriers

With American Airlines leading the pack, the legacy carriers in the United States

have a fair amount of political clout. 54 There is a political case that the hub-and-

spoke carriers can make regarding the market environment they function in and

the boon that a comprehensive airline network generates for the national

economy. While government regulation of the extent seen before 1978 seems

undesirable, the legacy carriers can make a case for an incentives-based program

that will preserve the viability of the network service they provide. A successful

lobby for tax credits could position the legacy carriers to compete with low-cost

carriers and return to sustainable profitability.


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The establishment of a tax credit that airlines could achieve by flying scheduled

routes through underserved areas would create a support system for the valuable

network that legacy carriers provide. The market would price the credit, with

each stipend going to the lowest bidding carrier that is willing to fly the route.

The advantages to such an incentive system are numerous. First, it would create a

subsidy for providing a public good (airline service to underserved markets)

without disrupting competition among carriers to fly that route most efficiently.

Second, it would put the legislative focus on serving an airport rather than

subsidizing a specific airline, mitigating the opportunity for favoritism. Third, it

would allow legacy carriers to more effectively compete with low-cost-carriers on

profitable routes, as they would no longer need to subsidize the lagging demand

on the less popular routes. This occurs on a very small scale at some regional and

local airports, and a national clearinghouse for tax credits would strongly

enhance the financial sustainability of a comprehensive air transport network.


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Appendix

Quarterly Operating Profit/Loss Margin 55

3Q 2009Rank

NetworkAirlines

3rdQuarter2008 (%)

4thQuarter2008 (%)

1stQuarter2009 (%)

2ndQuarter2009 (%)

3rdQuarter2009 (%)

3rd QuarterOperatingProfit/Loss$(Millions)

1 Alaska 7.2 4.1 1.0 4.2 16.8 1452 Northwest -5.7 -13.8 0.9 5.4 6.9 1983 United -8.4 -13.5 -3.7 4.3 2.9 1304 Delta 2.2 -1.2 -10.0 -3.5 1.4 675 Continental -4.2 -1.0 -3.1 -5.2 1.3 436 US Air -20.5 -12.5 -1.0 4.4 0.1 17 American -4.2 -3.9 -4.7 -5.3 -4.8 -246

7-Carrier -5.4 -6.7 -4.0 -0.5 1.4 338

3Q 2009Rank

Low-CostAirlines

3rdQuarter2008 (%)

4thQuarter2008 (%)

1stQuarter2009 (%)

2ndQuarter2009 (%)

3rdQuarter2009 (%)


1 Spirit -19.4 12.0 17.1 17.3 14.6 262 Allegiant 5.0 21.6 30.1 23.8 14.4 183 Frontier -2.6 0.0 8.4 9.5 10.3 314 JetBlue 1.6 5.3 9.1 7.9 7.7 675 AirTran -6.9 9.3 8.8 11.0 6.2 37

6 Virgin America -47.5 -24.0 -36.7 -8.4 3.2 5

7 Southwest 3.0 2.6 -2.1 4.7 0.8 237-Carrier -0.8 3.9 2.9 7.0 4.2 206

3Q 2009Rank

RegionalAirlines

3rdQuarter2008 (%)

4thQuarter2008 (%)

1stQuarter2009 (%)

2ndQuarter2009 (%)

3rdQuarter2009 (%)


1 Horizon 4.2 5.1 1.4 7.0 13.7 24

2 AmericanEagle 5.3 2.7 6.6 7.1 11.8 55

3 AtlanticSoutheast 6.0 7.6 4.0 7.7 10.7 22

4 SkyWest 6.5 6.5 6.8 8.7 9.2 415 Comair 9.0 7.1 7.9 16.2 3.8 96 ExpressJet -11.2 -5.0 -7.0 -6.1 -4.7 -87 Mesa** 0.2 7.1 0.9 4.3 N/A N/A

7-Carrier

Total 3.5 4.9 4.3 7.2 8.3 14


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Fuel Cost per Available Seat Mile (in cents) 56

3Q 2009Rank

NetworkAirlines

3rdQuarter

2004

3rdQuarter

2008

2ndQuarter

2009

3rdQuarter

2009

Pct.Change

3Q 2004-3Q 2009

PercentOf

OperatingCosts for

Fuel2004

1 Delta 2.04 5.33 3.85 3.61 77.0 15.82 American 2.18 5.87 3.13 3.41 56.4 20.03 United 2.11 7.02 2.11 3.31 56.9 18.44 Northwest 2.50 8.08 3.00 3.27 30.8 20.05 Continental 1.89 5.58 2.98 2.84 50.3 15.4

6 US Airways 1.86 5.70 2.39 2.83 52.2 13.3

7 Alaska 2.12 5.26 2.26 2.62 23.6 21.4

3Q 2009Rank

Low-CostAirlines

3rdQuarter

2004

3rdQuarter

2008

2ndQuarter

2009

3rdQuarter

2009

Pct.Change

3Q 2004-3Q 2009

PercentOf

OperatingCosts for

Fuel2004

1 Allegiant 2.06 6.25 2.92 3.34 62.1 24.82 Southwest 1.41 3.99 2.84 3.33 136.2 18.53 JetBlue 1.37 5.00 2.86 3.04 121.9 22.84 AirTran 2.08 5.78 2.60 3.00 44.2 24.15 Spirit 2.45 5.46 2.24 2.75 12.2 28.4

6 Frontier 1.93 5.52 2.31 2.74 42.0 20.97 Virgin America N/A 5.12 2.19 2.62 N/A N/A

3Q 2009Rank

RegionalAirlines

3rdQuarter

2004

3rdQuarter

2008

2ndQuarter

2009

3rdQuarter

2009

Pct.Change

3Q 2004-3Q 2009

PercentOf

OperatingCosts for

Fuel2004

1 Comair 3.52 9.35 2.58 6.47 83.8 28.8

2 AmericanEagle 3.55 8.98 4.87 5.21 46.8 25.0

3 Horizon 2.19 7.07 3.15 3.68 68.0 14.84 SkyWest 3.51 4.99 2.05 1.47 -58.1 26.55 ExpressJet 1.79 6.75 2.88 0.16 -91.1 14.5

6 AtlanticSoutheast 3.16 9.45 2.81 0.13 -95.9 25.8

7 Mesa** 2.86 4.99 2.05 N/A N/A 26.5


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American Airlines


Operating Cost per Seat Mile (in cents) 57

3Q 2009Rank

NetworkAirlines

3rdQuarter

2008

4thQuarter

2008

1stQuarter

2009

2ndQuarter

2009

3rdQuarter

2009

3rdQuarter

OperatingExpenses

$(Millions)1 US Airways 20.8 18.8 15.1 14.4 15.0 2,801

2 Delta 16.2 15.9 15.8 15.3 14.2 4,7293 American 15.9 14.6 13.4 13.3 13.9 5,3684 United 17.3 16.7 12.8 12.2 13.4 4,3055 Northwest 18.9 18.9 14.4 12.6 13.1 2,6766 Continental 16.3 15.2 13.2 13.4 12.8 3,2137 Alaska 13.9 12.5 11.7 12.3 11.7 714

7-CarrierTotal 17.1 16.2 13.9 13.5 13.7 23,80

3Q 2009Rank

Low-CostAirlines

3rdQuarter

2008

4thQuarter

2008

1stQuarter

2009

2ndQuarter

2009

3rdQuarter

2009

3rdQuarterOperatingExpenses$(Millions)

1 Southwest 10.9 10.2 9.9 9.7 10.7 2,6432 Frontier 12.1 11.2 9.2 9.1 9.9 2703 JetBlue 10.9 10.2 9.0 9.0 9.4 7894 AirTran 11.6 10.0 9.2 9.0 9.1 560

5 Virgin America

13.0 11.1 9.2 8.7 8.6 153

6 Allegiant 11.8 9.1 7.4 7.6 8.3 1097 Spirit 11.6 8.7 7.8 7.8 7.9 152

7-CarrierTotal 11.0 10.3 9.5 9.3 9.9 4,678

3Q 2009Rank

RegionalAirlines

3rdQuarter

2008

4thQuarter

2008

1stQuarter

2009

2ndQuarter

2009

3rdQuarter

2009

3rdQuarter

OperatingExpenses$(Millions)

1 Comair 22.0 20.4 19.9 16.8 21.0 2302 Horizon 20.7 19.8 18.4 17.7 18.0 154

3 AmericanEagle 20.0 18.6 17.2 16.5 16.2 412

4 SkyWest 13.7 12.3 11.4 10.9 9.9 399

5 Atlantic

Southeast19.4 16.1 14.1 12.7 9.1 176

6 ExpressJet 9.8 6.9 7.4 6.9 6.7 1867 Mesa** 16.2 13.5 12.8 12.2 N/A N/A

7-CarrierTotal 16.3 14.2 13.3 12.4 11.8 1,558


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Revenue per Seat Mile (cents per available seat mile) 58

3Q 2009

Rank

Network

Airlines

3rdQuarter

2008

4thQuarter

2008

1stQuarter

2009

2ndQuarter

2009

3rdQuarter

2009

3rdQuarter

OperatingRevenue

$(Millions)

1 US Airways 17.3 16.7 14.9 15.0 15.0 2,802

2 Delta 16.5 15.7 14.4 14.8 14.4 4,7963 Alaska 14.9 13.0 11.8 12.8 14.1 8594 Northwest 17.8 16.6 14.5 13.3 14.0 2,8745 United 16.0 14.7 12.3 12.7 13.8 4,4356 American 15.3 14.1 12.8 12.7 13.3 5,1227 Continental 15.6 15.1 12.8 12.7 13.0 3,256

7-CarrierTotal 16.2 15.2 13.4 13.4 13.9 24,144

3Q 2009Rank

Low-CostAirlines

3rdQuarter

2008

4thQuarter

2008

1stQuarter

2009

2ndQuarter

2009

3rdQuarter

2009

3rdQuarter

OperatingRevenue

$(Millions)1 Frontier 11.8 11.2 10.1 10.1 11.0 3012 Southwest 11.0 10.7 9.7 10.2 10.7 2,6663 JetBlue 11.1 10.8 9.9 9.8 10.2 8564 Allegiant 12.4 11.6 10.6 9.9 9.7 1275 AirTran 10.8 11.0 10.1 10.1 9.7 5976 Spirit 9.7 9.8 9.4 9.4 9.2 178

7 Virgin America 8.8 9.0 6.7 8.0 8.9 158

7-CarrierTotal 10.9 10.7 9.8 10.0 10.4 4,88

3Q 2009Rank

RegionalAirlines

3rdQuarter

2008

4thQuarter

2008

1stQuarter

2009

2ndQuarter

2009

3rdQuarter

2009

3rdQuarter

OperatingRevenue

$(Millions)1 Comair 24.2 22.0 21.6 20.1 21.8 2392 Horizon 21.6 20.8 18.6 19.1 20.8 178

3 AmericanEagle 21.1 19.1 18.5 17.8 18.4 467

4 SkyWest 14.6 13.2 12.3 11.9 10.9 4405 AtlanticSoutheast 20.7 17.5 14.7 13.7 10.2 198

6 ExpressJet 8.9 6.6 6.9 6.5 6.4 1787 Mesa** 16.2 14.5 12.9 12.7 N/A N/A

7-CarrierTotal 16.9 14.9 13.9 13.4 12.9 1,699


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References

1 http://www.aa.com/i18n/aboutUs/main.jsp&anchorEvent=false2 http://www.aa.com/i18n/amrcorp/corporateInformation/facts/history.jsp3 http://bulk.resource.org/courts.gov/c/F2/184/184.F2d.66.21727.21728_1.html4http://www.aa.com/AAdvantage/aadvantageHomeAccess.do?anchorLocation=DirectURL&title=aadvantage5 http://www.oneworld.com/ow/news/details?objectID=12716 http://www.oneworld.com/7 AMR 2009 Annual Report8 AMR 2009 Annual Report9 AMR 2009 Annual Report10

http://seekingalpha.com/article/183529-amr-corp-q4-2009-earnings-call-transcript11 AMR 2009 Annual Report12 AMR 2009 Annual Report13 AMR 2009 Annual Report14 2009 Annual Report & 10-K for DAL/UAUA/LUV/AMR/JBLU/CAL/LCC/ALK15 http://www.standardandpoors.com16 2009 Annual Report & 10-K for DAL/UAUA/LUV/AMR/JBLU/CAL/LCC/ALK17 http://www.bts.gov/press_releases/18 Google Finance19 Google Finance20 Google Finance21 January 21 st Brokerage Reports22 http://seekingalpha.com/article/183529-amr-corp-q4-2009-earnings-call-transcript23 http://seekingalpha.com/article/183529-amr-corp-q4-2009-earnings-call-transcript24

January 21st

Brokerage Reports25 http://www.iata.org/ps/intelligence_statistics/Pages/index.aspx26 http://www.naics.com/censusfiles/ND481111.HTM27 http://www.southwest.com/about_swa/press/factsheet.html#funFacts28 AMR 2009 Annual Report29 http://www.aa.com/i18n/amrcorp/corporateInformation/facts/fleet.jsp


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30 http://web.mit.edu/airlinedata/www/2008%209%20Month%20Documents/Employees%20and%20Productivity/Total/Total%20ASMs%20Produced%20per%20Dollar%20of%20Employee%20Compensation.htm31http://www.brookings.edu/~/media/Files/rc/reports/2009/1008_air_travel_tomer_puentes/1008_air_travel_appendix_3.pdf32 http://recession.org/library/list-of-bankrupt-airlines33http://www.aa.com/i18n/urls/gogo.jsp&anchorLocation=DirectURL&title=gogo?anchorLocation=DirectURL&title=wifi34 http://www.centreforaviation.com/news/2010/01/22/american-airlines-flightplan-2020/page135 http://www.apfa.org/content/category/9/17/46/36 http://www.star-telegram.com/2010/03/03/2012954/american-airlines-flight-attendants.html37 http://news.bbc.co.uk/2/hi/business/8597519.stm38 http://www.glgroup.com/News/After-Pointless-Strike-British-Airways-Is-Back-In-Business-47515.html39 http://aviationblog.dallasnews.com/archives/2010/03/the-flight-attendants-union-at.html40 http://seekingalpha.com/article/174816-trying-to-understand-airline-executive-compensation41 http://web.mit.edu/airlinedata/www/default.html42 http://www.aa-mro.com/43 http://www.haeco.com/44 http://www.ameco.com.cn/index-e.htm45 http://www.aeroman.com.sv/46http://www.tulsaworld.com/business/article.aspx?subjectid=45&articleid=20091028_45_0_hrimgs26681547 http://www.aa.com/content/images/jp/ta/pdf/UPDAATE_09Mar_en.pdf48 http://aviationblog.dallasnews.com/archives/2009/03/american-flies-boeing-767-300.html49 http://www.prnewswire.com/news-releases/american-airlines-and-jetblue-airways-sign-agreement-to-collaborate-at-key-east-coast-gateways-89588957.html50 http://www.centreforaviation.com/news/2010/04/06/new-american-airlines- jetblue-deal-expected-to-generate-usd69-million/page1


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51 http://www.flightglobal.com/articles/2010/01/25/337592/continental-cites-competitive-gains-with-lie-flat-seats.html52 http://asia.businesstraveller.com/asia-pacific/news/delta-airlines-joins-the-

full-flat-seat-club53 http://www.aa.com/i18n/amrcorp/corporateInformation/facts/fleet.jsp54 http://www.wsws.org/articles/2001/oct2001/air-o18.shtml55 http://www.bts.gov/press_releases/56 http://www.bts.gov/press_releases/57 http://www.bts.gov/press_releases/58 http://www.bts.gov/press_releases/