What’s The Real Risk That American Airlines Files For Bankruptcy?

I wrote on Thursday that American Airlines could find itself in chapter 11 bankruptcy. It wasn’t a prediction that this would happen, or a claim that it’s somehow inevitable. Instead it was an explanation that it is now thinkable because of their vulnerable financial position combined with high fuel prices, increasing labor costs, and looming recession. If these stars misalign for them, they’re the most likely big airline to take that hit.

The post led to a number of misunderstandings that I would like to clear up.

  • American has liabilities greater than assets, that doesn’t mean it will enter bankruptcy. I do not think they are ‘bankrupt’ today. Instead I suggested that American has less margin for error than its competitors. It has plenty of cash and can pay its bills. It isn’t being forced into bankruptcy now, and bankruptcy is not inevitable. The argument was simply that they’re not in great financial shape, and the world could turn against them making their costs unsustainable.

  • They face a number of challenging potential conditions that could make their situation worse. Rising interest rates make rolling over their debt more expensive, and they have a lot more debt than competitors. New union contracts under negotiation will increase their costs as well (they’ve already publicly offered pilots a 17% raise, capitulated to mechanics at the start of the pandemic, and have an open contract with flight attendants). And these higher costs, for an airline with low margins to begin with, could pair with deteriorating revenue from recession. This is the mechanism that could create the conditions for a bankruptcy filing – in the way it’s simply not thinkable at Southwest or Delta.

    They aren’t in great financial shape, and macro conditions could substantially worsen. American is more vulnerable than other airlines, even more vulnerable than United.

  • Bankruptcy doesn’t mean ‘going out of business’ I had a couple of readers ask about their miles, and redemptions on partner airlines. A chapter 11 filing is a reorganization. American has done it before (and US Airways did it twice). United has done it before (and Continental did it twice). Delta has done it before (and Northwest did it too). They would likely continue to fly through bankruptcy without difficulty or significant interruption. It would largely mean shareholders and potentially some creditors taking a haircut, and also possibly renegotiation of union contracts (which is why unions were so supportive of government bailouts during the pandemic, hoping to avoid this).

I used the word bankruptcy and that scares people. It triggers an emotional response. And many people do not understand what chapter 11 bankruptcy even means.

Does Anyone Actually Disagree With This?

It’s really a simple argument, and despite vitriol in the comments there isn’t really disagreement that American is the most vulnerable large airline given its:

  • high costs
  • high levels of debt
  • low margin even in the current high fare environment
  • I haven’t seen anyone disagree that interest costs are rising (which disproportionately affects American), that labor costs are rising, and that we could be entering a recession. Those things could combine for a storm that presents real risk for the business.

    Instead the concerns are largely strawmen, that American isn’t bankrupt (now); that United has low margins too (they’ve been second-most at-risk throughout the pandemic) and that they are making money (today). But do they make enough so that when costs rise and revenue falls they’re still covering costs? They’ve already mortgaged most of what can easily be mortgaged. And in a recession with high interest rates taking on more debt creates further challenges.

    And even if an airline could go bankrupt that doesn’t mean it will in a given timeframe. American lasted as a ‘bankruptcy waiting to happen’ for many years as CEO Gerard Arpey simply refused to file as most other major carriers went to the courthouse. They’ve got the cash to forestall it for a long time even if it becomes in the strategic interest of the business.

    Watch The Price Of Credit Default Swaps

    If you want to understand what the market thinks about bankruptcy risk at any given time watch the price of credit default swaps. Before the second and third taxpayer bailout the market was pricing a virtual certainty of bankruptcy. (The absolute peak price of 5 year credit default swaps came in mid-May 2020, after the CARES Act but before the next two rounds of funding.)

    The injection of around $10 billion in government funds into the airline (plus a $5 billion subsidized loan) during the pandemic forestalled bankruptcy, but didn’t eliminate the possibility given the economic conditions we could be heading towards. In fact, the price of 5 year American Airlines CDSs has traded 4-6 times as high as pre-pandemic.

    In other words, the market believes there’s a meaningful but not currently existential risk that American defaults on its debt in the next five years. It’s not something likely to happen today, but that’s my point – they are in a position where near- and medium-term changes could push them into such a position.

    How To Turn Around Fortunes

    On a day that the airline triumphantly announced its highest revenue ever for a quarter, it’s worth noting that it would have been highly in these inflationary and high fuel cost times if that hadn’t happened. And their costs per seat mile grew just as much as their revenue did.

    American’s key problem is that its costs are too high to offer products like an ultra low cost carrier. It needs a product that will generate a revenue premium, that people want to fly and will pay more to do so. On-time reliability is a necessary but not sufficient condition for this. The experience has to be pleasant. That means comfortable cabins, it means friendly employees, and numerous small touches along the way that influence customer impressions. It’s everything the airline has underinvested in over the past 8 years.

    The current strategy has gotten them into their current position. Don’t blame the pandemic, other carriers have faced that too and taxpayers handed them $10 billion in cash and subsidized loans and the Federal Reserve subsidized their borrowing costs. ‘If you always do what you’ve always done, you’ll always get what you’ve always got.’

    Investments in a more premium or customer-friendly approach don’t guarantee success! And they can be especially tough sells heading into recession. But a low yield strategy fails when paired with American’s costs.

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