Industry Consolidation Leaves AMR Out in the Cold

During the last three years, consolidation has bolstered the prospects for U.S. airlines, as three large-scale mergers helped the industry reduce redundant routes, unnecessary overhead, and control capacity.

Although consolidation improved the health of the participating airlines--Northwest and  Delta (DAL),  United (UAL) and Continental,  Southwest (LUV) and AirTran--we believed the reduction in capacity would greatly benefit everyone by translating into higher ticket prices. Based on this assessment, we surmised that legacy carriers  US Airways  and  AMR  also would experience improved fortunes despite their lack of participation. While US Airways has benefited, legacy-laggard AMR has not.

As we commented in AMR's  second-quarter earnings report, we believed AMR implemented its last-ditch effort to return to profitability. It announced it would spin off its regional carrier and upgrade its decrepit, inefficient fleet. Although these two decisions will yield substantial savings, AMR has done nothing to improve its labor-cost disadvantage versus its peers. AMR has opted to wait to address labor costs, hoping that the cost disparity will shrink once the competition faces labor inflation.

Given the potential darkening of the global economy, however, we now believe that revenue improvement will not alleviate AMR's problem, and the growing cost disparity is foreshadowing further pain. Moreover, it appears AMR will not generate positive free cash flow for 2011, continuing its performance from 2010 when it burned through nearly $700 million.

Although AMR will end the third quarter with roughly $4.3 billion in unrestricted cash, we believe the firm may not be able to satisfy all of its future commitments on its current fiscal trajectory. We are placing AMR under review as we reassess the company's ability to remain solvent, and expect to factor some probability of financial distress.