During the past two years, American Airlines (AAL 1.76%) has faced significant pressure on its profitability. Initially, steep unit-revenue declines were the culprit. More recently, revenue per available seat mile (RASM) has been growing at a healthy clip -- but surging fuel prices and labor costs have become a recurring headache.
Last quarter, American Airlines managed to deliver a solid profit despite these headwinds, soaring past its fairly weak initial guidance. Earnings per share (EPS) returned to growth on a year-over-year basis. However, looking ahead to 2018, American Airlines' pre-tax income is likely to decline further, driven by higher fuel costs and rising competition from United Continental (UAL 1.10%).
Ending 2017 on a strong note
Back in October, American Airlines projected that its fourth-quarter pre-tax margin would fall to 4.5%-6.5% -- down from 7.9% a year earlier -- due to severe cost pressure. Indeed, unit costs rose 7.1% year over year during the quarter. Most of that increase was caused by a $0.34/gallon uptick in jet-fuel prices. However, non-fuel unit costs continued to increase at an elevated rate, as well.
Fortunately, American Airlines posted stellar unit-revenue growth last quarter. RASM surged 5.6% year over year, well ahead of management's initial forecast. As a result, American Airlines managed to report a 7% adjusted pre-tax margin for the fourth quarter.
Obviously, this was still down on a year-over-year basis. But the margin decline was partially offset by a strong 8.3% revenue increase. American Airlines' share-buyback program provided an additional boost to EPS. The net result was that American posted quarterly adjusted EPS of $0.95, up from $0.92 a year earlier. Analysts had expected EPS to remain flat, at $0.92.
The outlook is less pleasant
During 2018, unit-revenue comparisons will be tougher. Furthermore, while non-fuel unit cost pressure is subsiding, fuel costs have increased substantially in the past few months. This means that American Airlines is likely to experience further margin erosion this year.
Management projects that RASM will rise 2%-4% year over year in the first quarter. However, fuel costs could reach $2.07/gallon-$2.12/gallon, up from $1.70/gallon a year earlier, more than offsetting the expected revenue growth.
Non-fuel unit costs are also set to increase. The net result is that American Airlines expects its adjusted pre-tax margin to crash to a range of 2%-4% this quarter compared to 6.7% in the year-ago period.
American's projected first-quarter pre-tax margin is still better than that of United Continental, which expects a break-even performance. However, it's well below Delta Air Lines' guidance range of 6%-8%.
Can American Airlines fend off United?
American Airlines provided full-year EPS guidance on Thursday. It expects adjusted EPS to reach $5.50-$6.50 in 2018. This compares to $5.27 on an adjusted basis last year.
At first glance, this might look promising. However, American Airlines expects its book tax rate to fall from 38% to 24% due to tax reform. Including the impact of share repurchases, it appears that even American's best-case EPS projection contemplates another year-over-year margin decline this year.
Furthermore, the threat from United Continental's aggressive growth will increase during 2018 and beyond. United plans to increase capacity significantly in its mid-continent hubs (Chicago, Houston, and Denver) to capture more connecting traffic and boost unit revenue. Unfortunately, American Airlines also operates a sizable hub in Chicago, and its massive Dallas-Fort Worth hub competes for the same connecting traffic as United's Houston operation.
Thus, American Airlines could have more to lose from United's growth than any other airline. It may be forced to respond with its own capacity increases and fare cuts in certain markets to prevent United Continental from stealing its customers. As a result, there's no end in sight to American Airlines' margin compression.