Things are going from bad to worse at American Airlines(NASDAQ: AAL). American has been facing steady margin erosion since 2016. However, a spike in fuel prices during 2018 combined with slowing momentum in unit revenue -- exacerbated by stiff competition from United Continental(NYSE: UAL) -- has the world's largest airline facing its biggest crisis since its 2013 merger with US Airways.
Last week, American Airlines reported dreadful results for the second quarter. Costs continue to rise much faster than revenue, leading the carrier to slash its 2018 guidance for the second time. While management claims that the worst will be over soon, it's hard for investors to have any confidence in this prediction, given the company's recent track record.
Another big profit decline
In the second quarter, revenue per available seat mile (RASM) rose 2.1% at American Airlines. Under normal conditions, this would be considered a solid result. However, United Airlines and Delta Air Lines both achieved stronger unit-revenue results last quarter. Moreover, this level of RASM growth wasn't nearly sufficient to offset American's rising costs.
First, adjusted nonfuel unit costs rose 2.4% year over year. Second, American Airlines paid an average of $2.24 per gallon for jet fuel, up from $1.63 per gallon a year earlier.
An American Airlines plane in flight, with mountains in the background
American Airlines' fuel costs surged last quarter. Image source: American Airlines.
The net result was that American's adjusted pre-tax margin plummeted to 8.6% from 14.2% a year earlier. Adjusted net income fell to $757 million from around $1 billion. And even though American Airlines benefited from a lower tax rate -- thanks to tax reform -- and reduced its share count nearly 6% year over year, adjusted EPS still plunged 20% to $1.63.
Guidance comes down again
American Airlines' outlook for the rest of 2018 is also fairly grim. On the plus side, nonfuel unit cost growth is set to slow, even though American has reduced its growth plans for the second half of the year.
Nevertheless, rising fuel prices and modest unit-revenue growth make for a bad combination. For the third quarter, American Airlines expects RASM to rise 1% to 3%, whereas its average fuel price is set to surge from $1.67 per gallon in Q3 2017 to a range of between $2.22 and $2.27 per gallon.
Even with nonfuel unit costs likely to rise just 1%, American Airlines expects its adjusted pre-tax margin to be just 5% to 7% this quarter. That's a dreadful result for what is traditionally one of the most profitable parts of the year for airlines. Last year, American's Q3 adjusted pre-tax margin was 10.2%; a year before that, it was 14%.
Lastly, American Airlines cut its full-year EPS guidance to a range of $4.50 to $5.00, from a prior range of $5.00 to $6.00 and an initial range of $5.50 to $6.50. Even if American reaches the high end of this updated guidance range, it would imply an adjusted pre-tax profit of about $3 billion: at the low end of the company's long-term guidance.
American is losing domestic market share
One of the most troubling aspects about American Airlines' recent performance is a slowdown in domestic unit-revenue growth. In fact, passenger revenue per available seat mile inched up just 0.3% in the domestic market last quarter.
A big portion of this unit-revenue pressure can probably be explained by United Continental's aggressive efforts to regain domestic market share. United expanded capacity in the domestic market by 7.4% last quarter and still posted a 1.7% increase in domestic unit revenue.
American Airlines and United Airlines have competing hubs in a number of key markets. As a result, United's recent resurgence has likely come at the expense of American, more than any other carrier. That's bad news, given that United Airlines plans to continue expanding rapidly in the domestic market for at least two more years.
A United Airlines plane
United Airlines' rapid domestic growth is hurting American Airlines' unit revenue. Image source: United Airlines.
Will management's turnaround plans be enough?
In the past few months, management has announced a number of moves designed to stabilize American Airlines' performance. The carrier is eliminating some underperforming international routes, while cutting capacity on others. American also plans to cut some domestic capacity in its less profitable hubs, while continuing to grow in Dallas-Fort Worth and Charlotte, its two largest and most profitable hubs.
In conjunction with its earnings report, American Airlines also announced that it will defer the deliveries of 22 A321neos from the 2019-2021 period to 2024. This will result in slower growth and lower capital expenditures. American will also modify its basic economy fares to allow those customers to bring carry-on bags. This will make the basic economy product more attractive, hopefully stemming some of its market-share losses.
These are all sensible moves; the risk for investors is that they're too little, too late. American Airlines has become a highly leveraged play on oil prices. If oil prices continue to rise, profit will probably continue to fall -- and American's massive debt load could lead to significant financial distress for the company.
Adam Levine-Weinberg owns shares of Delta Air Lines. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
