Despite Euphoria, American Airlines Faces Some Harsh Realities

CHARLOTTE, N.C. (TheStreet) -- Now that euphoria has set in around the US Airways/American (AAL) merger, it is probably time to question whether everything is quite so rosy as it looks.

This week, analysts were busily raising estimates after new American reported earnings on Tuesday. As a result, on Wednesday, every other major airline stock fell, but American gained 3%. Shares have gained 34% this year. Meanwhile, United (UAL) is up 23%, Delta (DAL) is up 11%, Southwest (LUV) is up 13% and the S&P 500 Index is down 3%. It is as if American flies in a parallel universe, where all news is good news.

The airline industry came to respect the America West management team because of what it did after taking over at US Airways in 2005. The team, led by CEO Doug Parker, took two weak airlines and made them into one strong airline. It took over three US Airways hubs in Charlotte, Philadelphia and Washington and made them all better. It benefited from closing its hub in Las Vegas and from continuing the Pittsburgh downsizing that previous management began. It also made the airplanes run on time.

But the America West team also benefited immensely from two unusual and concurrent phenomena. One was a peculiar seniority award that divided its pilots, who were trapped into maintaining two of the worst contracts in the airline industry for 10 years. That in turn delayed negotiations with the flight attendants, who didn't get a new contract either -- not until the America West team was ready to move on a merger with American.

Now US Airways' labor costs are expected to rise by $400 million annually, with cost per available seat mile rising 3% to 5% in the current quarter, Chief Financial Officer Derek Kerr said on Tuesday's earnings call.

The second phenomenon is equally unique: At the same time the America West team was doing everything right, most of the rest of the airline industry was also doing everything right. The industry consolidated successfully, developed capacity discipline and invented an auxiliary revenue stream. And the economy has improved steadily for four years.

Give Parker credit for triggering consolidation. Every legacy airline not only embraced capacity discipline, but also claimed to have thought of it first. As for an ancillary revenue strategy, United developed that one.

As the America West team faces its biggest challenge, it remains an insular group. On the American earnings call Tuesday, eight executives were identified as being available to speak. Of those, seven were most recently employed at US Airways, and six previously worked at America West. Just one, Bev Goulet, chief integration officer, came from American.

Success has its rewards, but the jury is out on whether a lack of inclusiveness is the best way to ensure that it continues.

Additionally, this time the problems are different, the competition is more intense and new American does not start with the strongest hand or even the second-strongest hand. Rather, new American has its New York hub in Philadelphia and its West Coast hub in Phoenix. Moreover, winning in the former US Airways hubs -- where US Airways dominated for years -- is not the same as winning in Chicago or Los Angeles or Asia.

Chicago is home to United. United remains a flawed airline and many say its last great CEO was Stephen Wolf, who left 20 years ago, and it is also true that the merger makes American the biggest carrier at Chicago O'Hare. But the America West team has never shared a hub with another legacy airline.

The team battled Southwest in Phoenix and held it to a draw, but Southwest competed on price, not on domestic or global connections. Is it possible that American is still competing with Southwest, adding seats to three aircraft types? Is that what corporate fliers want? At O'Hare, "there is going to be hard-fought, hammer and tongs battles for corporate contracts," said aviation consultant Bob Mann. "It will be fought contract by contract."

Los Angeles, which President Scott Kirby has said will eventually be American's gateway to Asia, is among the toughest operating environments in the U.S. Airport fees are high. All three majors compete. They cannot build big enough hubs, and on international routes they compete with foreign carriers who gather traffic in their home countries.

Delta has decided to build its Asia hub in Seattle, which lacks originating passengers but has just one competitor. Little Alaska  (ALK) is fighting the good fight, but from Delta's point of view who would you rather compete with, Alaska Airlines or the entire world?

Another concern is that the cost of the merger included divesting slots at Washington National, most of which were claimed on Thursday by JetBlue (JBLU) and Southwest. JetBlue will add 12 daily DCA departures while Southwest will add 27. They will very possibly bring fares down, reducing profits at what has long been US Airways' most profitable operation. Nearly all of the American slots at DCA went to competitors who may well charge less to key destinations. 

Mann said the biggest worry should be that the ongoing gradual economic expansion will cease, possibly as a result of an exogenous event. "Geopolitical events are the ones you can't plan for or effectively hedge or diversify from," he said. "All you need is one geopolitical event to screw things up." Higher oil prices are just one possibility.

Additionally, Mann said, "There are the usual integration challenges and execution risk. Delta and United aren't going to stand there and let their No. 1 and No. 2 network ranks be eroded. Also, we will have to see how long the honeymoon with labor lasts. Right now, I think labor shares the euphoria, but that can be short-lived."

Euphoria is nothing new for the America West team. In May 2006, eight months after the US Airways takeover, JPMorgan analyst Jamie Baker famously predicted that shares would double to $100.  

The shares got as high as $63.27 in November 2006, then fell back to the $2 range in mid-2009. Shares stood at $22.55 when seven years of trading in post-bankruptcy US Airways ceased in December.

Written by Ted Reed in Charlotte, N.C.

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