American Airlines (NASDAQ:AAL) reported a record quarterly profit on October 23, with adjusted EPS up 67% year over year to $2.77. Yet after the stock rose in early trading that day, it gave up all of its gains during the subsequent earnings call.
During the earnings call, American's management team, for the second straight quarter, gave a very frank assessment of the competitive environment. This was the primary cause of investors' dismay. The big picture takeaway was that the carrier will continue to compete aggressively against discounters like Spirit Airlines (NYSE:SAVE).
Let's take a look at five specific points that American Airlines executives emphasized to see what this means in practice.
Air travel is a commodity to many
And we have many customers who are willing to fly [ultra-low cost carriers]. ... So 87% of our unique customers fly us one time per year or less, and they represent over 50% of our revenue.
-- American Airlines President Scott Kirby
One of the most important points made during the earnings call was that American Airlines has to treat its "Main Cabin" section as a commodity product. While the company makes a lot of money from loyal, high-fare customers, most of the people in the back of the plane are just looking for the cheapest fare.
Indeed, more than half of American's revenue comes from customers who fly the airline no more than once a year. American Airlines executives feel that if they don't match cheap fares from Spirit Airlines -- or anybody else, for that matter -- they won't capture these customers. This is too big a percentage of American's revenue for the company to walk away from this business.
Spirit is small, but disruptive
If you measure our overlap as our domestic ASMs that have nonstop competition from someone, 28% of our domestic ASMs have nonstop competition with Spirit. That is much larger than our domestic overlap with Delta (NYSE:DAL) and United.
-- Scott Kirby
Some analysts suggested that American Airlines could simply ignore Spirit, which has a little more than $2 billion in annual revenue, compared to more than $40 billion for American.
However, Spirit's small revenue base is deceptive. Unlike most airlines, Spirit operates one flight per day on most of its routes. So while it has far fewer flights than American Airlines, those flights are spread across many routes. And with one daily flight on a route, it can impact demand and pricing for the 10 daily flights that American might operate on that same route.
Counterintuitively, American Airlines actually has more routes overlapping with Spirit than with either of its big legacy carrier peers. That makes it all the more necessary to match Spirit's fares.
Price-matching can be refined, though
But we are going to go to a product that has different attributes ... if you buy ultra low-cost carrier competitive fare...
-- Scott Kirby
While American Airlines believes that it's necessary to match Spirit Airlines' fares to avoid losing customers in droves, it wants to minimize the impact of that strategy on its unit revenue. In 2016, it plans to introduce a new, separate fare type that is custom-designed for competing with ultra-low cost carriers.
The company didn't provide any details on what that would look like. However, Delta Air Lines has adopted a similar strategy in recent years with its "Basic Economy" fares. Delta offers these cheaper fares in markets where it competes with Spirit and other ULCCs. Unlike a typical coach fare, Basic Economy tickets don't include assigned seats (so you'll probably get stuck in a middle seat) and lack flexibility for flight changes or upgrades.
These "Spirit-match" fares allow Delta to keep price-sensitive customers in the fold. However, due to the onerous restrictions, 65% of customers presented with a "Basic Economy" fare choose to pay more for a fare that includes seat assignments, bolstering Delta's unit revenue. American Airlines will try to achieve the same effect with its new fare type.
Back to basics
We've done it to ourselves ... as we focused, really, on having a successful reservation systems integration. And now being able to turn our full attention in those groups to optimizing revenue, I believe, will lead to relative outperformance.
-- Scott Kirby
American Airlines doesn't have to wait for the rollout of this new ULCC-match fare type to start improving its results. President Scott Kirby noted that the carrier has also been held back this year by its focus on planning for a smooth reservation systems integration.
That process was successfully completed in mid-October. As a result, American's revenue managers can now devote their full attention to optimizing pricing. That may allow the carrier to reduce the impact that its price-matching policy is having on unit revenue.
Management is bullish
We know we have a lot of work to do, but we are very bullish on our future. That bullishness is evidenced in the fact that we repurchased $1.56 billion of common stock in the quarter, 38.4 million shares.
-- American Airlines CEO Doug Parker
American Airlines executives have previously projected that unit revenue could return to growth in the second half of 2016, but for now the downward trajectory remains firmly entrenched. To some extent, investors have to trust that the company's leaders are right.
American Airlines' management certainly sounds confident in its assessment of the competitive environment. CEO Doug Parker touted American's $1.56 billion in share repurchases during Q3, which enabled it to retire nearly 6% of its stock.
The company's board also authorized its third $2 billion share repurchase program of the year, with all buybacks to be completed by the end of 2016. If American succeeds in maintaining a high profit margin despite competing aggressively with the likes of Spirit Airlines, these buybacks will add a lot of value for shareholders, due to American Airlines' bargain valuation.
Adam Levine-Weinberg owns shares of Spirit Airlines and United Continental. He is also long November 2015 $40 calls on American Airlines Group, long March 2016 $40 calls on Spirit Airlines, long June 2016 $30 calls on Spirit Airlines, and long January 2017 $40 calls on Delta Air Lines, The Motley Fool is long January 2017 $35 calls on American Airlines Group. The Motley Fool recommends Spirit Airlines. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.