Latest AMR financial results validate American Airline’s large narrow-body order

Earlier today, AMR corporation, the parent company of American Airlines, announced its financial results for the third quarter of 2011. Traditionally, the third quarter is the strongest financial quarter for US airlines. However, AMR posted a net loss of $162 million, $0.48 per diluted share. This stood in contrast to their $143 million net profit in the third quarter of 2010.

American showed singificant strength on the revenue front, with a 9.1% increase to US $6.4 billion. Seat-mile revenues were up by 8.7% as well, reflecting growing demand and broad capacity restraint in the US market. The carrier’s Latin American operations showed particular strength, with seat-mile revenues up 20% vs. 2010: 25% in South America alone.

And American looks poised to make continual incremental gains in revenue. The carrier plans to cut close to 3% of its capacity in the fourth quarter of 2011, and has stated that advance bookings are at similar levels to those of 2010. These capacity cuts will limit American’s year-over year capacity growth to just 1.2% on a consolidated basis.

But despite these positive indicators, American’s financial results were disappointing; primarily due to the sharp rise in fuel prices. In a narrative similar to the one given by Indian carriers to explain their results in Q1 of FY2012, American attributed a large portion of its loss to the increase in fuel prices. American’s fuel exepenses rose 39.8% year over year, by US $642 million.

Fuel represents close to 36% of American’s operating costs, and consequently AMR’s seat-mile costs jumped by 10.1%, more than wiping out the incremental revenue gains. American’s fleet of McDonnell Douglas MD-80 aircraft (and to an extent the fleet of Boeing 757-200s) is a severe disadvantage for the carrier. These aircraft are 25-30% less fuel efficient than current generation aircraft, and the potential fuel cost reductions of re-engined 737s and A320s can reach 40%.

Earlier this year, American Airlines announced a large order for 460 narrowbody aircraft, split equally between current and next generation aircraft. When news of the order broke, numerous airline analysts questioned the rationale behind the order, citing American’s financial troubles, and large debt load (net debt of $12.6 billion at the end of Q3). While there certainly is validity to the idea that limiting capital expense can be more important than improving fuel burn, American’s fleet is so inefficient that improving fuel burn should have a larger positive effect on their financial results than the negative effect of added capital expense.

To illustrate this point, just a 15% reduction in American’s overall fuel expenses (which a conversion of the entire MD-80 fleet to current generation narrowbodies could achieve) would have saved the carrier more than US $340 million this past quarter. And maintenance costs, which represennt roughly 5.44% of American’s operating expenses, would decrease as well (at least early in the life cycle of the new aircraft as well). aircraft rent represents just 2.6% of American’s operating costs, and thus even a 50% rise in rents would have a smaller overall effect on the bottom line than the reduction in fuel prices.

American’s latest quarterly loss illustrates the unique challenges faced by the carrier. Already locked into unproductive labor contracts, American’s fuel inefficient fleet of MD-80s is the largest restrictor on its overall profitability. While American’s recent order might increase capital expenses, their third quarter results illustrate that the fuel efficiency gains are likely too large to pass up.