After briefly becoming one of the most profitable airlines in the world during 2015, American Airlines (NASDAQ:AAL) suffered severe margin erosion in the following years. A modest rebound in fuel costs drove some of this margin pressure, but rising nonfuel unit costs represented an even bigger headwind.
American Airlines' adjusted nonfuel unit costs came in at 9.4 cents in 2014. Based on American's 2018 cost performance and 2019 guidance, adjusted nonfuel unit costs will reach 11.5 cents this year. That would be up 22% compared to 2014, a compound annual growth rate of 4% over five years. (For comparison, most U.S. airlines try to limit annualized nonfuel unit cost growth to 2% or less.)
However, the Boeing (NYSE:BA) 737 MAX grounding has exacerbated American Airlines' unit cost inflation this year. The 737 MAX's return -- expected in early 2020 -- could spark a change for the better in American Airlines' unit cost trends over the next few years.
On a journey to simplify the fleet
Fleet simplification has been the centerpiece of American Airlines' cost-cutting plans in recent years. Following the US Airways merger, American Airlines was operating too many aircraft types. Additionally, in many cases, it operated multiple subfleets of a particular model, adding to the complexity.
In a presentation earlier this year, management noted that it had reduced the number of subfleets from 52 to 42 between 2016 and 2018. It also set a goal of having just 30 subfleets by the end of 2022. This should reduce maintenance costs, improve pilot productivity, and limit disruption in the event of last-minute aircraft switches.
American Airlines took one big step toward fleet simplification in 2019, as it retired the last of its MD-80s in early September. However, there is a lot more on the way over the next several years. American Airlines plans to retire all 20 of its high-cost Embraer E190s in 2020. It began phasing out its last 24 Boeing 767s earlier this year and will retire all of them by the end of 2021. Finally, the carrier's recent order for 50 Airbus A321XLRs will pave the way for it to retire the rest of its Boeing 757s by 2024. American will likely retire its Airbus A330-300 fleet around the same time.
All of these retiring aircraft types will be replaced with new jets that are part of larger subfleets -- reducing complexity -- and have lower unit costs than the planes they are replacing.
Why the Boeing 737 MAX's return is the key
While retiring smaller and older subfleets is one key part of the simplification drive at American Airlines, the carrier also wants to reduce the number of distinct configurations among the aircraft types that remain. Most notably, after having introduced the Boeing 737 MAX 8 with a 172-seat configuration, American Airlines intends to reconfigure all of its 737-800s in the same 172-seat layout. The airline also plans to outfit most of its previous-generation A321s (excluding its 102-seat transcontinental subfleet) with 190 seats.
These moves should help reduce unit costs. American Airlines will increase seating capacity on the 737-800s by 7.5% while having a minimal impact on trip costs. The seat count change will be smaller for the A321s, but those modifications will also significantly increase the number of first-class and extra-legroom seats. In total, nearly 500 aircraft will be reconfigured -- roughly half of American's mainline fleet.
Unfortunately, the Boeing 737 MAX grounding has forced American Airlines to cancel more than 100 flights a day since the spring. In order to limit the number of cancellations -- particularly during the spring and summer peak seasons -- the carrier halted all of its retrofit programs earlier this year and kept the aircraft previously scheduled for modifications in service. As a result, it has completed just a small proportion of the planned retrofits so far: about 72 aircraft.
American Airlines recently restarted the retrofit program, taking advantage of seasonally weaker demand in the fall. Assuming the 737 MAX is ready for service again in the first quarter of 2020, the airline should be able to step up the pace of aircraft reconfigurations next year.
Good things in store
During American Airlines' recent Q3 earnings call, CFO Derek Kerr said that adjusted nonfuel unit costs would likely be roughly flat in 2020, excluding the potential impact of new labor deals. The nonfuel unit cost outlook for 2021 and 2022 seems quite benign as well, thanks to the tailwinds from American's fleet simplification efforts and the addition of more seats to its 737-800s and A321s.
American Airlines' fleet initiatives should also drive big fuel efficiency gains. Between now and the end of 2021, it will add approximately 100 next-generation narrow-body jets to its active fleet (assuming the return of the Boeing 737 MAX). It will also more than double its fleet of 787-8 Dreamliners to 42 jets as it completes the replacement of its aging 767s. The 737-800 and A321 retrofits will have a meaningful positive impact on fuel efficiency, too. Fuel efficiency could improve by 3% to 4% between 2019 and 2021.
The combination of better fuel efficiency and flattish nonfuel unit costs -- along with the carrier's existing revenue initiatives -- should help American improve its profit margin relative to its largest peers over the next few years. That may be enough to get the stock moving higher, given its low valuation today. That said, American Airlines probably needs more fundamental change to become an airline industry leader in terms of profitability once again.