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American Airlines Needs to Get Its Costs Under Control

Investors have spent much of the past year and a half panicking about American Airlines' (NASDAQ: AAL) unit revenue trajectory, amid rising competition from ultra-low-cost carriers.

What they really should be worried about is American Airlines' cost performance. Unit revenue is gradually starting to recover due to slowing industry capacity growth and improving conditions in Brazil -- although the impact of Brexit is still to be seen. By contrast, American Airlines increased its unit cost guidance for the second time this year on Wednesday, raising serious questions about its cost discipline.

Cost guidance rises once

At the beginning of 2016, American Airlines projected that its mainline adjusted unit costs (excluding fuel and special items) would rise a relatively modest 1%-3% this year. However, since then, the company's cost estimates have increased significantly.

American Airlines has increased its cost guidance twice this year. Image source: American Airlines.

American raised its cost outlook for the first time in April. At that point, it expected mainline adjusted cost per available seat mile to rise 3%-5% for the full year. There were two main reasons for the increased cost guidance.

First, American Airlines' dispatchers ratified a new contract agreement that month, locking in big raises that went into effect immediately. Second, American Airlines decided in late March to implement a 5% profit sharing plan beginning this year. Based on the company's 2015 adjusted pre-tax profit of $6.3 billion, a 5% profit sharing payout would have exceeded $300 million.

Cost guidance rises again

On Tuesday, American Airlines increased its cost guidance yet again. The company now expects mainline adjusted unit costs to rise 4%-6% for the full year, including a 6%-8% increase in Q3 and a 5%-7% increase in Q4.

There are likely two main reasons for this additional increase in American Airlines' cost profile. First, American has decided to reduce its capacity plans to better match demand. It now intends to increase its mainline capacity about 1% this year, compared to its initial plan to grow capacity by about 2%. Lower capacity means higher unit costs, as fixed expenses are spread over fewer passengers.

The second reason is related to the first. Due in part to lower growth projections for the next few years, American Airlines decided in May to accelerate the retirement of 37 jets to the 2017-2019 period. The company will likely need to report higher depreciation costs from now until those planes leave its fleet.

American Airlines needs to fix this soon

In the past few years, the legacy carriers have frequently stated that they want to keep non-fuel unit cost growth at or below the rate of inflation -- which they usually estimate at 2%. Clearly, American Airlines will be nowhere close in 2016.

This comes after mainline non-fuel unit costs rose 4.2% in 2015 (excluding special items). But at least 2015's cost inflation could be traced largely to a 23% pilot pay increase that went into effect that year. By contrast, the 2016 cost creep seems more broad-based.

American Airlines ought to be reaping cost synergies from the US Airways merger by now. Instead, mainline head count has risen by nearly 10% since the merger was completed, even though American's revenue is expected to be slightly lower in 2016 than it was during 2013.

In fact, American Airlines went on a hiring spree in 2015, as described by the Fort Worth Star-Telegram. Part of its head-count increase was meant to improve reliability. Other employees were hired to help smooth the transition to a new reservations system last October.

With most major integration activities now complete, American should be able to cut costs by reducing its head count, but this hasn't happened so far. Meanwhile, American's chief rival Delta Air Lines generates the same revenue -- with higher reliability -- despite having about 15% fewer mainline employees.

Particularly given its penchant for "upgauging" to larger jets within its fleet, American Airlines should be able to operate more capacity with less labor. Management needs to demonstrate a clear plan for doing so as soon as possible.

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Adam Levine-Weinberg is long January 2017 $30 calls on American Airlines Group and long January 2017 $40 calls on Delta Air Lines. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.