In recent years, American Airlines (AAL 3.68%) CEO Doug Parker has been one of the most vocal advocates of the idea that industry consolidation has permanently transformed the U.S. airline business. Whereas airlines have historically lost huge sums of money during periodic industry busts, Parker has boasted that American Airlines will never lose money again.
Yet on the surface, management's optimistic outlook seems to clash with a trajectory of declining profits at American Airlines. If the company is struggling to maintain its profitability in a robust economy, one could reasonably wonder how it would do in an economic downturn. Indeed, American Airlines stock is down 38% year to date, so investors clearly are skeptical.
American Airlines Year-to-Date Stock Performance. Data by YCharts.
Let's take a look at what might happen to American Airlines if there is a recession in the next few years.
Pretax margin has been sinking
Over the past two years or so, American Airlines has experienced sharp margin erosion. In 2016, the company achieved a 12.6% adjusted pretax margin, but that fell to 9.1% in 2017.
In the first half of 2018, American Airlines' adjusted pretax margin fell by another 4 percentage points. It expects a similar margin decline in the third quarter, although the year-over-year profit pressure should hopefully start to ease in the fourth quarter.
American's management blames the margin declines on a combination of rising labor costs -- as it brought employees' wages up to industry-standard levels -- and the speedy run-up in fuel prices. However, in the medium term, American Airlines executives expect to recover fuel cost increases through higher fares. A variety of other revenue and cost initiatives should add to its prospects for a profit rebound.
How American Airlines plans to turn things around
Last September, American Airlines announced ambitious profit-improvement goals at its investor day conference. Management touted opportunities to improve annual profitability by $3.9 billion by 2021.
American Airlines has ambitious profit growth goals. Image source: American Airlines.
This figure should be taken with a grain of salt. After all, American Airlines expected to capture about $1.5 billion of the total $3.9 billion opportunity in 2018, yet profit is on track to decline significantly year over year. Nevertheless, if fuel price headwinds moderate next year, these revenue and cost initiatives should help the carrier stabilize its profitability. American Airlines also increased its baggage fees recently, which should boost ancillary revenue in 2019.
Route optimization should also provide a sizable near-term profit boost. American is eliminating a number of underperforming routes (and cutting capacity on others), including several routes between Chicago and Asia. This capacity will be redeployed into more promising markets, particularly in Europe.
Last -- and perhaps most significantly -- American Airlines will receive extra gates in Dallas-Fort Worth and Charlotte and larger gates at Washington, DC's Reagan National Airport over the next three years. This will allow the carrier to concentrate its growth in its three most profitable hubs, which will likely make them even more profitable. It will also make it easier for American Airlines to cut additional underperforming routes elsewhere in its network.
Economic disruption is still a risk
There's a wide range in the profitability of different routes and hubs across American Airlines' network, so the carrier has plenty of levers available to stabilize its profit margin if fuel prices continue to rise (i.e., it could make further cutbacks to lower-margin routes). This flexibility also offers some protection in the event of a recession that could cause unit revenue to fall.
That said, American Airlines could still be vulnerable, especially if rising oil prices and tariffs cause inflation to rise just as real GDP growth starts to stagnate. (Some prominent economists see this as a major risk, but others think it's unlikely to happen anytime soon.) A "stagflation" scenario would push costs even higher while making it hard to increase unit revenue.
American Airlines' high debt load makes it particularly ill prepared for a near-term recession. As of midyear, the company had about $24 billion of debt and capital leases. Furthermore, it expects to spend $5.6 billion on capex and pension contributions in 2019, which could cause its net debt to move even higher.
But the good news is that capex and pension contributions combined should total just $3.3 billion in 2020 and $2.7 billion in 2021. This will allow American Airlines to start reducing its debt burden in a meaningful way.
American Airlines has more than $7 billion of liquidity and enough unencumbered assets to raise another $2 billion of capital if necessary. While that should ensure its survival in any likely economic scenario, a recession would still be extremely painful if it hits in 2019. However, by 2020 or 2021, American should be much better prepared for a downturn, thanks to lower capex and pension costs and the benefits from its network changes and other revenue and cost initiatives.
