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Earnings Pressure Worsens at American Airlines: Rising Competition or a Blip on the Radar?

On Friday, American Airlines (NASDAQ: AAL) reported solid earnings results for the second quarter. By contrast, the company's third-quarter outlook was fairly dismal, although management claimed that it was not indicative of American's longer-term business trends.

It's possible that American Airlines' results will improve soon -- or that management was very conservative with its third-quarter outlook. However, it's also possible that United Continental's (NYSE: UAL) more aggressive posture is starting to weigh on results at its most direct rival.

American Airlines' second quarter in brief

Last quarter, American Airlines posted strong unit revenue results again. Back in April, the company projected that revenue per available seat mile (RASM) would increase 3%-5% in the quarter. However, it boosted its unit revenue guidance twice in the next three months. Ultimately, American Airlines reported that RASM rose 5.7% year over year, driven by strength in the domestic market and throughout most of Latin America.

American Airlines posted strong unit revenue growth last quarter. Image source: American Airlines.

On the flip side, cost inflation remained severe. Adjusted non-fuel unit costs increased 6.8% year over year. Fuel costs also rose, such that total unit costs (excluding special items) jumped 8.1%.

The net result was that American's adjusted pre-tax margin slipped to 13.5% from 15.4% a year earlier and net income fell to $944 million from $1.0 billion. Nevertheless, adjusted EPS rose to $1.92 from $1.77, because of a big reduction in American's share count -- most of which occurred during 2016. This beat the average analyst estimate of $1.87.

The third-quarter outlook doesn't look good at all

American Airlines' management expects unit revenue growth to slow dramatically in the third quarter. The company's initial Q3 unit revenue forecast calls for RASM growth of 0.5% to 2.5%.

Unit cost growth is also slowing, but not by as much. American Airlines expects non-fuel unit costs to rise about 4.5% year over year next quarter, while fuel costs are on track to be up by a slightly greater amount.

With costs rising significantly faster than revenue, margin contraction may accelerate this quarter. American Airlines currently projects that its adjusted pre-tax margin will fall to 10%-12% from 14% in Q3 2016. Furthermore, the company will get a smaller benefit from share buybacks. Based on American's current guidance, Q3 EPS is likely to wind up between $1.40 and $1.70, down from $1.76 in the prior-year quarter.

Is this cause for concern?

American Airlines CEO Doug Parker claims that investors shouldn't worry about the company's weak third-quarter forecast. Despite some volatility from quarter to quarter, he sees the industry as being fundamentally healthy, enabling American to earn a pre-tax profit of about $5 billion in a typical year.

Furthermore, the sharp drop-off in unit revenue growth from Q2 to Q3 is being driven by tougher comparisons. Looking back to 2016, RASM plunged 6.1% in the second quarter but fell just 2.2% in the third quarter. It's also worth noting that American's management has provided fairly conservative forecasts on average in recent quarters, so there may be some upside to its guidance.

That said, even a 12% pre-tax margin this quarter wouldn't be a good showing for American Airlines. To hit its $5 billion pre-tax profit target, American needs 12% pre-tax margins on average. Q3 is a seasonally strong period, fuel prices remain quite low, and the global economy is performing well. This is a time to be generating much higher profits.

Thus, it's reasonable to wonder whether competition is taking a toll on American Airlines. United Continental has made a big point recently of trying to regain its "fair share" of the domestic market. It has increased its domestic growth rate and added dozens of new routes. United Continental has also become quite aggressive in matching or even undercutting rivals' prices.

Competition between American Airlines and United Continental is heating up. Image source: Pixabay.

United's new strategy has probably had its biggest impact in Chicago, where both United and American have hubs. But the two carriers also have competing hubs in New York, Washington, D.C., and Los Angeles.

It's too early to be sure that United Continental's new posture is hurting American's profitability. Moreover, even if this vicious competition is hurting American Airlines right now, it could still bounce back in the future. Even so, investors should probably steer clear of American Airlines for now, in favor of airlines that are on more solid ground, such as Delta Air Lines.

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Adam Levine-Weinberg owns shares of Delta Air Lines. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.