There is a tendency among many investors to fear wage increases as negatives to the bottom line, and the recent contract approved at American Airlines Group (NASDAQ:AAL) has grabbed a lot of attention.
While the wage increase percentage being reported looks high, it's necessary to dig deeper to understand what it really means for the airline.
A big raise... or is it?
The recently approved contract by American Airlines Group's pilots contains something many of us would like to see at our own jobs: a 23% raise followed by 3% raises each year afterward. A quick look at this makes it seem like the pilots are making out like bandits, but a complete picture requires more context.
To understand the position of the pilots, it's necessary to take a brief look back to a time before the American Airlines bankruptcy. Following the events of 9/11, the airline industry was in a tough position. United Airlines, now part of United Continental Holdings (NYSE:UAL), and US Airways both declared bankruptcy in 2002, and Delta Air Lines (NYSE:DAL) declared bankruptcy in 2005.
American Airlines managed to hang on through this rough period and got a major boost from its organized labor, including pilots, all of whom took a pay and benefit cut of around 35%. But as labor was giving up compensation to keep American flying, high-level management had quietly carved out a special retirement plan that would be separate from labor's and better protected in the event of bankruptcy. On top of that, high-level management took smaller pay cuts and approved millions in retention bonuses for themselves even as the airline was asking for labor to accept less.
Needless to say, this soured relations between labor and management, and after tensions rose as labor threatened to cancel its agreement to the pay cut, American's then-CEO was shown the door with a mere $12 million parting gift.
Disputes continued between management and labor for several years, and the inability to reach a consensus on labor terms has been seen as a major contributing factor to American's 2011 bankruptcy filing.
One of the biggest questions investors are asking is how American Airlines' new pilot contract stacks up against those of its rivals. Not surprisingly, management and labor each have their own perspectives on this issue.
According to Bloomberg, management highlights that the new contract has industry-leading base pay, claiming it to be 7% higher than that of Delta Air Lines. Labor counters by saying that total compensation is lower, since Delta's contract contains profit-sharing, a potentially lucrative source of income, while the American Airlines contract does not.
However, what is clear from both management's and labor's comments is that the new contract still allows American to compete using a similar cost structure as rivals.
Upside for American Airlines
With the record profits for the airline industry getting boosted even more by the fall in oil prices, major North American airlines are in a highly profitable position. While Delta and United will both see a boost to earnings overall, some of those extra profits will have to be paid to employees per the profit-sharing agreements in place. Without a profit-sharing agreement in place, American Airlines Group will get to keep even more of its profits, resulting in higher earnings for shareholders.
The new pilot contract also accomplishes another step in the American Airlines-US Airways merger. By creating a single contract for all of its pilots, the airline is now one step closer to fully integrating its workforce and being able to achieve the cost savings promised when the merger was announced.
Risks for American Airlines
In many ways, American is the risk-taker among major airlines. It carries a higher debt-to-equity ratio than Delta or United, it no longer hedges fuel, and it's ending profit-sharing in its latest contracts.
During good times, profit-sharing agreements can hurt the immediate bottom line since they require some of these profits to be paid to workers. But during bad times, profit-sharing agreements can help balance downturns since there are less, if any, profits to pay out -- and base pay is generally lower when accompanied by a profit-sharing agreement.
If the good times in the airline industry keep rolling, then American Airlines may be able to use its extra profits to reduce debt and acquire more fuel-efficient aircraft; however, American does remain a higher-risk airline if industry conditions were to rapidly worsen.
A good contract
Is the pilots contract perfect for both sides? No, but that's the nature of labor-management negotiations. All in all, it puts pilot compensation in a range similar to that of other airlines and keeps American's cost structure under control.
Despite the headline-making number of a 23% pay raise, pilots are not looting the company, nor is management getting big labor savings.
Alexander MacLennan owns shares of American Airlines Group and Delta Air Lines and has the following options: long January 2017 $25 calls on American Airlines Group and long January 2016 $60 calls on American Airlines Group.
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