Restructuring American Airlines

In November 2011, AMR Corporation, the owner of American Airlines and American Eagle, filed for bankruptcy, and within five months became the target of a takeover bid by US Airways. How this happened is a story of management error, labour intransigence and competitor opportunism.

AMR is one of the world’s largest airline companies, with a fleet of 900 aircraft operating 3,300 flights a day to 260 destinations in 50 countries. But it had incurred losses of $12 billion between 2001 and 2011.

These losses were due to high labour costs, an aging aircraft fleet, and too much debt. In 2011, AMR owed $11.6 billion with off-balance sheet leases of $7.1 billion, a pension fund deficit of $5.2 billion and retiree liabilities of $2.9 billion.

AMR’s competitive environment was also challenging, Apart from competition from low-cost carriers, AMR’s traditional airline competitors had mostly been through bankruptcy in recent years, which had enabled them to reduce costs and renegotiate labour contracts, giving them lower cost profiles. They had also achieved economies of scale through mergers, with Delta merging with Northwest and United merging with Continental.

Dated fleet

AMR has an aircraft fleet that is older and less fuel-efficient than its competitors’ fleets. Its fleet includes two hundred MD80s that are dated and fuel inefficient. AMR’s regional airline American Eagle flies 50-seat regional jets that have low operating efficiency.

AMR had tried to fix this problem and had announced in July 2011 that it had ordered 460 new Boeing 737s and Airbus A320s for delivery between 2013 and 2022 and had options to purchase another 465 aircraft. These cost of these aircraft would be $13 billion which would be financed with manufacturer leases. Introduction of new fuel-efficient aircraft was expected to reduce AMR’s fuel bill by between 15 percent and 35 percent.

Labour problems

AMR’s labour costs are reported to be the highest in the US airline industry. Its management claims that costs for its 78,000 personnel are $800 million higher than they would be under the labour contracts of competitors United Continental or Delta. Some analysts maintain that AMR pays $1.5 billion annually more than other airlines for the same employee output.

American Airlines had tried to resolve this issue for many years. It had negotiated since 2006 for changes to labour contracts with unions representing pilots, flight attendants, mechanics and baggage handlers. It argued that its labour costs were higher than those of competitors because its pilots flew fewer hours than competitors’ pilots, and had less flexible work rules. Its cost per seat mile was estimated to be 10 percent higher than Delta’s.

In the belief that the net result would be lower costs for the airline, American Airlines’ management had offered modest increases for current employees, and lesser increases for new hires, in return for changes to work rules and benefits, but no agreement could be reached. Although its pilots’ union had toned down extravagant demands for higher compensation, the union was still seeking substantial pay increases.

The last straw

In November 2011 the American Airlines pilots’ union rejected a management proposal by refusing to put it to a union member vote. AMR management then realised that the airline would not be able to reduce labour costs and narrow its competitive disadvantage by negotiating new labour contracts. The AMR board moved to declare bankruptcy which could be used to force unions to accept new contracts.

On 29 November 2011, AMR filed for bankruptcy under Chapter 11 of the US Bankruptcy Code. Its bankruptcy would not affect day to day operations, and its airlines would continue their regular flight schedules. Flights, ticket sales, overseas alliances, and frequent flyer programs would be unaffected. Employees would continue to be paid their remuneration and benefits.

At the date of the bankruptcy filing, AMR had assets of $24.7 billion and liabilities of $29.6 billion and was therefore technically insolvent. But its assets included cash of $4.1 billion that it could use to pay suppliers and ensure continued smooth operations.

Restructuring AMR

AMR’s bankruptcy was strategic and had the object of restructuring the group’s airlines and operations to become smaller with lower costs and less debt. Restructuring will be based on cuts to AMR’s route network, labour cost savings through new employment contracts, and reduction of group debt, pension deficit and retiree obligations. AMR claims that restructuring will create $3 billion in annual financial benefits by 2017, and to achieve this target AMR must reduce labour costs by $1.25 billion annually.

A main object of bankruptcy is to pressure unions. AMR is looking to utilize a bankruptcy rule that allows an employer to cancel union contracts if it can show a clear financial need, and if it can demonstrate that unions have unreasonably shunned attempts at consensual agreement. If this strategy works for AMR, it can impose temporary unilateral working terms while it continues to negotiate long-term labour arrangements. In March 2012, AMR applied to the bankruptcy court to cancel union contracts and cut 13,000 jobs, or eighteen percent of its labour force. It claimed that this would save the group annual labour costs of $1.25 billion.

Bankruptcy enables AMR to pursue an auction bargaining strategy to solicit the lowest financing costs from its secured lenders. So AMR can say that it does not require all its leased MD80s, and can then keep some of the aircraft based on the lowest financing bids from lenders. Lenders demanding more expensive finance charges will have their aircraft returned to them.

With one third of its fleet being leased, AMR has written to its aircraft lessors telling them that it cannot afford to maintain all of its leased aircraft at their current rentals, and that it intends to cancel some leases. AMR also has the option of reducing debt secured by equipment trust certificates by returning older aircraft to the certificate holders.

US Airways moves

As soon as AMR filed for bankruptcy, rumours began that a merger with another airline would follow. AMR’s management ruled out a merger, saying that it wanted AMR to remain independent.

US Airways was seen as the most likely partner for AMR, because it had tried unsuccessfully to merge with other airlines in the past. Its hostile bid in 2007 for Delta Air Lines Inc. had failed because of opposition from Delta’s pilots’ union.

Predictably, US Airways saw a merger with AMR as an opportunity that it could not pass up. In April 2012, US Airways proposed a merger with AMR. It predicted $1.5 billion in merger synergies, made up of $1 billion in additional revenues and $500 million in non-union cost savings. It then started discussions with AMR’s creditors seeking support for its merger proposal.

US Airways claimed that a merger would be benefit employees of both airlines by combining their hubs and aircraft to create a leading airline with the scale to compete effectively and profitably. It argued that while AMR’s independence strategy would cause 13,000 American Airlines employees to lose their jobs, a merged airline would provide competitive, industry-standard compensation and benefits, and improve job security and advancement opportunities for all of the combined airlines’ employees, and that 6,200 jobs would be saved. It promised AMR pilots a salary increase of 5.5 percent. It predicted that merger cost savings would come from cutting duplicated facilities, reducing management costs, combining IT systems, freezing pensions, reducing leased airport space, and reducing the costs of inputs through increased purchasing power.

Three unions representing 55,000 AMR workers then announced that they would support a merger with US Airways. US Airways signed agreements with the three unions, covering labour arrangements in the event of a merger.

But a merger would also need the approval of AMR’s creditors, management and board of directors. So US Airways approached creditors of AMR to build support for a merger. It tried to convince them that their recovery would be bigger under a merged group than from an independent AMR. US Airways also believed that gaining the support of a majority of creditor groups would enable it to mount a hostile takeover bid, if that became necessary.

US Airways has not however explained how a merger would be financed, or how the two workforces would be integrated. Airline mergers can generate new labour problems, as the airlines try to integrate employee groups, persuade pilots to agree on the make up of seniority lists, and persuade unions to agree to new contracts and face likely compensation cuts.

In the meantime AMR’s management has until September 2012 to resolve AMR’s issues without interference from outside parties. This means that it can fend off or ignore US Airways’ approach, at least in the short term.

Published in Airline Economics May-June 2012.