AMR Is Back in the Black
On Thursday, bankrupt American Airlines parent AMR reported record-setting results for Q2. Consolidated passenger revenue of $5.6 billion was the highest in the company's history. Moreover, AMR reported an adjusted profit of $357 million for the quarter, primarily on the back of an extremely profitable June.
AMR's solid Q2 earnings report suggests that its recent bankruptcy restructuring process has been a success. The company is relatively well-positioned for its impending merger with smaller rival US Airways . That said, AMR still has plenty of work to do if it wants to catch up to segment leader Delta Air Lines in terms of profitability.
Cost cuts coming through
The main driver of improvement at American Airlines was an aggressive bankruptcy cost-cutting program. Management targeted labor savings of more than $1 billion annually through a combination of slashing benefits and reducing the workforce through productivity improvements and outsourcing.
These moves helped AMR reduce unit costs excluding fuel and special items by 5.8%. Moreover, the company pointed to additional cost reduction opportunities, particularly relating to increased usage of large regional jets. Like its competitors, AMR wants to reduce its reliance on inefficient 50-seat regional jets, while adding 76 seat regional jets, which offer lower unit costs.
Margins grow, but still lag
AMR's adjusted operating profit nearly doubled compared to Q2 2012. This resulted in a healthy operating margin of 7.8%. However, while this is a respectable number and marks a substantial improvement for the company, AMR still lags Delta from a margin perspective. Delta has not reported Q2 results yet, but last month it projected a 10%-11% operating margin for Q2.
A difference in operating margin of 220-320 basis points may seem small, but over the course of a full year, the pre-tax impact would be $1 billion or more for Delta and the "new" post-merger American Airlines. That could be the difference between consistent profitability and financial instability.
Merger benefits are uncertain
As noted above, AMR hopes to continue rationalizing its costs in the next few years, but it also needs to invest tens of billions of dollars over the next 10 years to modernize its fleet. By contrast, Delta has much more modest fleet investment plans and is also in the midst of a $1 billion structural cost reduction program. In other words, American Airlines will need to drive significant further margin improvements if it wants to catch up to Delta.
Clearly, AMR has high hopes for its impending merger with US Airways; the two companies expect to generate more than $1 billion of merger synergies by 2015. According to a merger presentation, American Airlines now has non-fuel unit costs similar to Delta's, while US Airways has even lower costs. These synergies could therefore give American the lowest costs in the industry.
However, even AMR's management has admitted that there will be more than $1 billion of onetime costs related to the merger and that the synergies will be offset by higher labor costs (which was offered as a concession to seal labor's approval of the merger). In fact, the labor "dis-synergies" are estimated at $500 million from day one, rising to nearly $1 billion by the fourth year after the merger!
American Airlines reported strong results for Q2, but it's still clearly trailing Delta, which is the profit leader among major U.S. carriers. While the company hopes that its merger with US Airways will help it catch Delta, I'm fairly skeptical that this will happen. Most notably, the merger will lead to hundreds of millions of dollars in additional annual labor costs from the very beginning, while the "synergies" are more uncertain and could take longer than expected to develop.
If the history of airline mergers teaches us anything, it's that major transactions of this sort do not usually go as planned. AMR and US Airways do not offer particularly attractive risk-reward trade-offs for investors, given the potential for negative merger-related surprises.
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