Are Legacy Costs Really AMR’s Biggest Problem?

Rubens writes:

“Can you give some specific advice to the big airlines on how they can cut costs and become profitable? I don’t think you really understand their situation. To compare the big airlines with the budget ones is like comparing a Ford and GM plant with a Toyota one. Ford and GM has massive legacy costs of high salaries and benefits, and so do the big airlines. American is one of the few (or is it the only one?) of the big airlines that hasn’t filed for Chapter 11 in recent years, which would have let them reduce costs and renegotiate legacy employee agreements.”

Thank you for the comment, Rubens.

Unfortunately, it simply isn’t true that legacy costs are the problem for American. In fact, Southwest actually spent more on wages, salaries, and benefits than American did in the first quarter.

As you can see from the Q1 summary below, American’s cost structure is higher than Southwest despite the fact that they spend less than Southwest on compensation expense. The difference in fuel costs is due to Southwest’s hedges (which tapers off over time) and it is too late to hedge those now.


However, AMR operating losses in Q1 amounted to 3.3% of sales, which just so happens to be the difference in “other” operating costs. So, if AMR could simply get their non-fuel cost structure in line with Southwest’s, they would have broken even in the first quarter.

UPDATE: I left off one statistic I meant to include. AMR employs 152% more people (85,500) than Southwest does (33,895) yet AMR only has 125% more in revenue. So staffing levels are another area they could cut to get their revenue per employee ratio down.

Full Disclosure: No positions in the companies mentioned at the time of writing

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6 Thoughts on “Are Legacy Costs Really AMR’s Biggest Problem?

  1. Alex on May 23, 2008 at 7:02 AM said:

    Spot On. Amr’s CEO recently said their fuel bill is 6 billion as compared to 4 billion a year ago. Their hedges were/are at $85/barrel. Crude has gone up substantially since then. But think about the extra 2 billion lost, and what they could have done with it

    -AlexG
    http://www.contrarianvalueinvesting.com

  2. David on May 23, 2008 at 9:50 AM said:

    I generally love your blog, but when you state that “Southwest and JetBlue have done wonderfully over the years” and imply that if AMR could just get to the efficiency level of Southwest, they would be just fine, I disagree for 2 reasons: 1) Regardless of where fuel prices are, the airline industry’s structure means that the airline business simply sucks, (a fact pointed out by Buffet and other superinvestors many times) and 2) AMR’s CEO is actually correct in saying that the airline industry is not built to withstand $120 oil. Let me elaborate on both points:

    1) When there’s only one operator in the business that has consistently made money, it’s not that the rest of the operators are bad – it’s that the one operator is good. Also, the last time Southwest actually earned double digit returns on capital and equity was in 2001 – that’s 7 years ago. Since then, their highest ROIC was 7.5% in 2003, when their ROE that year was 9.3%. If the best operator in the business can only earn such paltry ROEs, it means the business sucks. Lower fuel prices and more efficiency will not change this. What will? Consolidation will help, but even that will not do the entire trick. The incentives to price irrationally have got to go, which means capacity has got to be cut, which will only get done with the allowance of Chapter 7 bankruptcies (instead of Chapter 11), which will only happen if Airlines know that that’s where they’re going if they declare BK.

    2) AMR’s CEO’s statement is correct. Once Southwests’s fuel hedges run out, and IF oil stays where it is, even Southwest will be losing money. It may not have ever happened before (LUV losing money) but these are extraordinary times for the price of energy and past performance is no indication of future results.

    Also, a quick comment on JetBlue: JBLU IPO’d in April of ’02. Since then, total shareholder returns have been negative 66%, with the S&P500 up a positive 43% and the AMEX Airline Index down 74%. 8% outperformance against your peers over a 6 year period is statistically insignificant and 130% underperformance against the broad market is nothing to sneeze at. Also, their ROIC has been double digits once in the last 7 years. I wouldn’t say that JetBlue “has done wonderfully.” Maybe customers like JetBlue, but that doesn’t necessarily translate into making money, especially given the crappy industry dynamics.

  3. Chad Brand on May 23, 2008 at 10:26 AM said:

    David,

    Thanks for the insightful comments. Let me follow up with some responses to your points, if I may.

    1) I totally agree with you that the airline business is a bad one to be in. I have avoided airline stocks for that very reason. Even Southwest, the best operator and a personal favorite of mine from a traveler perspective, has been an overvalued stock for years in my view.

    When I state that LUV and JBLU have done wonderfully over the years, I am referring to their revenue, shareholders equity, market share etc, not their stock prices.

    2) Given that, in order for airline companies to prosper they need to be managed very well (i.e. LUV). Poor management with poor industry dynamics is a recipe for disaster, as we have seen over and over again.

    3) With oil where it is, AMR’s CEO is correct that the current revenue/expense structure is not profitable. I would argue, however, that there is an operating and efficiency level that an airline can make money even with $130+ oil.

    To get there would an airline have to shrink by eliminating unprofitable routes and cut staff levels? Absolutely, but those are the moves that need to be done to adapt to changing industry dynamics. Changing is the only way to survive.

    The point of my post was that their recently announced initiatives don’t appear to be the best options. Charging for checked bags is just going to reduce the revenue base they already have because even though it boosts fees in the short term, most likely they lose customers longer term because of it.

    4) Finally, re: JBLU’s stock price since their 2002 IPO. Simply looking at the share price doesn’t tell us very much. JBLU ended 2002 with tangible shareholder equity of $346 million. Since then, tangible equity has risen each and every year, and was over $1 billion on 12/31/07. That is a 193% increase in 5 years, so JBLU has created a ton of shareholder value since the IPO, unlike AMR and the other legacy carriers.

    Now you might say “nonsense” because the stock is down since the IPO, but that is because investors were paying a ridiculous valuation back then to “get in” on the concept. The stock is not down because management has done a poor job creating value. It is down because investors didn’t understand that what you pay for a stock is far more important than what stock you buy.

  4. David on May 23, 2008 at 10:45 AM said:

    Chad,

    All fair points. I especially agree with you that AMR’s recent moves are totally bone-headed.

    One more comment on JBLU – while the equity value per share has grown significantly (~14.5% coumponded annually since their IPO), it must be recognized that a key component of that growth in book value was levering up the company to achieve higher ROE’s at the expense of much lower ROICs. Indeed, long term debt has grown from $700M at IPO time to $2.6B as of the end of 2007. I understand that they’ve grown book value per share – but that’s come at the price of increased risk.

  5. Chad Brand on May 23, 2008 at 10:51 AM said:

    Very true.

    I only brought that up because it seems many people (the media mostly) focus on share price performance when evaluating management’s performance. Bob Nardelli was essentially forced out of Home Depot after he made millions as CEO while the stock got crushed. He actually grew the company very nicely… the P/E just corrected from 40-50x (insane) to 15x (more reasonable), which isn’t management’s fault. They can’t control the valuation when they take over.

    Anyway, thanks for taking the time to share your thoughts.

  6. David on May 23, 2008 at 11:24 AM said:

    Sorry. One last reply to your final point. If only everyone out there thought like you. Seriously. I was (and still am) an HD holder and loved Nardelli. It was not his fault that the stock was valued at 50x earnings when he came in. He increased margins and ROIC substantially in the years that he was there but was consistently faulted for the share price, which is ridiculous. I would argue that Jeff Imelt is suffering presently from a similar circumstance compounded by the fact that Jack Welch underreserved for insurance liabilities for years while he was CEO at GE. CEOs should be measured by economic value added as defined by ROIC over a complete cycle in excess of some benchmark return. Share price movements, even over five years, don’t necessarily reflect either mgmt aptitude or ineptitude. As John Hussman always says – the most important determinant of future returns is valuation.

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