It can't be fun to be American Airlines (NASDAQ:AAL) CEO Doug Parker right now. His company has experienced massive nonfuel cost increases over the past few years. Now that the carrier is finally reining in controllable costs, fuel prices have surged, creating a new headache. Meanwhile, American has the weakest balance sheet of any major U.S. airline.
At a major industry event last week, Parker reiterated his stance that industry capacity growth will slow and airfares will rise to offset the increase in fuel costs. However, he acknowledged that this process wasn't likely to play out right away.
Indeed, Parker's protege Scott Kirby -- now the president of United Continental (NASDAQ:UAL) -- is pushing ahead with an aggressive growth plan despite recent fuel price increases. The threat from United's growth will make it hard for American Airlines to fully offset its rising fuel bill.
United Continental changes course
For many years after the United Airlines-Continental Airlines merger, United was arguably the strongest proponent of "capacity discipline" in the U.S. airline industry. As fuel prices rocketed higher after the Great Recession, United Airlines maintained a very slow growth rate to ensure that it could pass its rising costs through to customers. Even when fuel prices plunged in 2014 and 2015, United continued to grow at a very modest rate.
Everything changed after United Airlines poached Kirby from American. Kirby believes that in the long run, United must regain its "natural" market share -- particularly in smaller cities, where airfares are high -- to improve its profitability and competitiveness.
As a result, United plans to increase its capacity by about 5% in 2018, with a similar growth rate in 2019 and 2020. That's more than three times United's growth rate for the 2015-2016 period. Much of this growth will be focused in the carrier's three main mid-continent hubs of Chicago, Houston, and Denver.
No good choices for American Airlines
Thus far, Kirby hasn't shown any inclination to scale back United's growth, even though the price of jet fuel has risen by more than $0.20 per gallon since he first revealed the carrier's aggressive growth plan in January. That's putting American Airlines in quite a bind.
On the one hand, American Airlines would probably like to cut capacity to help it push fares higher. After all, its adjusted pre-tax margin fell to 9.1% last year from 12.6% a year earlier and it is on track to post another substantial margin decline in 2018 due to rising fuel costs.
On the other hand, cutting capacity would play right into United's hands. American Airlines competes directly with United Airlines in Chicago, and its Dallas-Fort Worth hub competes for much of the same connecting traffic that United is targeting in Houston. Capacity cuts by American would help United Airlines gain market share and become a more formidable rival.
As a result, American Airlines has been forced to err on the side of leaving too much capacity in the market and absorbing the hit to its profit margin. This is probably the right move in the long run, but that doesn't make it any less painful.
American Airlines needs more flexibility
American's massive debt load could become a big problem if the competitive battle with United Airlines continues unabated through 2020. American Airlines frittered away billions of dollars on share buybacks over the past few years, causing its debt to swell to an unhealthy level.
As of the end of 2017, American Airlines had more than $25 billion of debt and capital lease obligations. Its pension plan was also underfunded by $7.5 billion. To make matters worse, nearly half of its debt matures by 2021.
Right now, the economy is booming. This has allowed American Airlines to remain decently profitable despite its woes. It has also had no trouble rolling over its debt this year.
However, if there is a recession in the next few years and United opts to keep growing, American would likely be forced to cede market share to its rival to protect its profitability and ensure that it can meet its debt and pension obligations. That's exactly the kind of trade-off that management has been trying to avoid. Unfortunately, the company's reckless capital allocation decisions of the past few years could put it in a bind during the next downturn.