Working Through Adversity

In April 2003, Gerard J. Arpey succeeded Donald Carty as chief executive officer of AMR Corporation and American Airlines, Inc., and was elected a member of AMR’s Board of Directors.

Arpey joined American Airlines (AA) in 1982 as a financial analyst and became a corporate officer in 1989, when he was elected vice president of financial planning and analysis. He received a Bachelor of Business Administration Degree in 1980 and an MBA in 1982, both from the University of Texas at Austin. Arpey also is a multiengine- and instrument-rated private pilot.

On June 10, 2003, at the Merrill Lynch Transportation Conference in New York City, Arpey outlined American Airlines’ plans for the future with the following speech (edited by ALPC for space considerations):

While this is my first chance to formally brief the investment community as CEO, I am no stranger to the street. Through the 1990s, when I was chief financial officer of AMR, I spent a lot of time shuttling back and forth between Dallas and New York. And while I’m glad to be back, I wish it were under similar circumstances. When I handed the reins over to Tom Horton in early 2000, our stock price was over $60 and we had a solid balance sheet. Of course, the world has changed since that time, and the theme of this year’s conference—Working Through Adversity—illustrates that change. It also dovetails perfectly with what I’d like to cover tonight.

We are in a real period of adversity—but we are determined to work through it, and emerge from it as a stronger, leaner, more nimble, and ultimately successful competitor. As I’ve made the rounds these past few weeks, I’ve done my best to drive home the point that while we won’t be abandoning the values and strengths that have always defined American Airlines, my colleagues and I will be bringing new leadership, new thinking, and fresh approaches to the challenges confronting us. This dichotomy—of preserving those aspects of our business that work well, and bringing new approaches to bear on our challenges—is crystallized in the turnaround plan we announced last month.

The turnaround plan is the framework we’ve designed to give our employees, as well as the public at large, a crisp, easy to grasp picture of how we intend to work through the adversity were experiencing, and where we plan to lead American in the years to come.

The turnaround plan has four tenets:

1. Lower costs to compete;
2. Fly smart—give customers what they value;
3. Pull together, win together; and,
4. Build a financial foundation for our future.

Let me provide a little detail on these four tenets, starting with the first—Lower costs to compete. This is an area where we’ve already made a lot of progress. However, the fact that we now compete with low-cost carriers on about 86 percent of our domestic non-stop routes means we must continue to streamline, simplify, and remove costs from our operation wherever we can.

As you’re all aware, we have set out to remove $4 billion from our cost structure in the aftermath of 9/11. And while that’s an enormous challenge for a company our size, we are well on our way toward achieving that goal.

We began our cost-reduction program by finding ways to reduce our non-labor costs—in areas like fleet simplification, scheduling efficiency, streamlined customer interaction, distribution savings, and day-to-day operating adjustments. The initiatives we launched in these parts of the business will, once fully implemented, save us roughly $2 billion a year. That’s a great result, but unfortunately it was not enough.

So earlier this year, we turned to our employees, and after much negotiation and interaction we were ultimately able to reach agreements that will save us $1.8 billion annually in labor expenses. We are now in the process of implementing those agreements across all our work groups. Pay cuts went into effect May 1, and by July we will have nearly 35,000 fewer employees on our payroll than we did in 2001.

Finally, we reached agreements with many of our suppliers and aircraft lessors and lenders on concessions that have brought us close to $200 million in annual cost savings.

This reduction in our cost structure is strategically important, because lower costs will enable us to compete, rather than retreat, in lots of markets that are important to our customers, and where our position has been jeopardized by the entry of lower-cost competitors. Obviously, no airline can be price-competitive unless it is reasonably cost-competitive. We are determined to be both, so we are continuing to look for cost-reduction opportunities in every facet of our business.

Ever since deregulation 25 years ago, our success has depended on the ability to generate more revenue per unit of production than our competitors—thus compensating for our higher costs. This second tenet of our plan is all about capitalizing on our strengths, and sustaining the revenue premium we depend on—by giving customers what they truly want and are willing to pay for. It is about keeping our focus on the higher-yielding business passenger, but not losing sight of the need to attract at least our fair share of all customer segments.

To fly smart, we must optimize the breadth and efficiency of our network. We continue to believe our hub-and-spoke system is the most effective way to carry the most possible customers to the most possible places—and our regional partner, American Eagle, and our international alliances are key parts of this approach. Moreover, our powerful global network has become even more potent since we gained DOT approval to expand our alliance relationship with British Airways.

Of course, when it comes to networks, size and effectiveness are not the same thing. Flying smart sometimes means picking the right battles to fight. So to build the most effective network we must continuously fine-tune it. Moreover, given the decline in air travel demand, we must keep supply and demand reasonably in balance.

This summer, our peak capacity will be about seven percent smaller than last year, a number that reflects a 10-percent reduction in our domestic system and an increase in our international network of just over one percent. As for our fleet, by July we will have eliminated 57 aircraft compared to a year ago, and the plan we have in place will shrink the fleet another 57 units by next summer. Thus, in mid-2004, our fleet will be 21 percent smaller and our network capacity will be 15 percent less than it was in 2001. Our network structure will need to fit this new reality.

We are likewise examining all the attributes of our product offering. The AAdvantage Program, first and business class cabins, admirals clubs, and other amenities all contribute to our revenue premium. But again, we must pick our battles wisely and examine every aspect of what we offer in every market we serve. In the end, we cannot afford to provide more than our customers are willing to pay for.

When we launched the more room throughout coach campaign three years ago, airline yields were at historically high levels, and our business model was tightly focused on capturing share in what was a very strong business travel environment. We understood back then that removing seats would actually cost us revenue in some leisure-oriented markets, where loads tend to be very high, and fares tend to be lower. But our desire for a consistent product, combined with the benefits we expected from an increased share of business traffic, outweighed that concern.

As you know, the revenue picture today bears little resemblance to the year 2000, and business-travel demand no longer warrants offering fewer seats than our competitors in many higher demand markets. So to satisfy the demand for more low fares, and to match the product our competitors offer we will be adding seats in markets where price is more important than legroom. This change will affect our 757s and A300s, which are roughly 25 percent of our fleet.

We will start this project in the fall and will complete it early next year. We will retain more room throughout coach—and will promote it— in markets where it will help provide a revenue premium.

Adding seats to one-fourth of our fleet also contributes to the first turnaround objective—lowering costs to compete—by reducing the unit costs of the 757s and A300s. Moving forward, to compete on both the cost and revenue fronts, we will need to match what we offer with what our customers truly value—and are willing to pay for. As our efforts with respect to points one and two of our plan gain traction—as we continue to drive down costs and bolster our revenue premium—our performance relative to other airlines should improve.

The third tenet of our plan—Pull together, win together—is an explicit acknowledgment that the future of every member of our team is tied to the success of that transformation. Moreover, none of our other initiatives can fully succeed until we improve morale, and build trust and teamwork back into the fabric of our company.

But while the challenge is daunting, we cannot lose sight of the silver lining. We have a team of employees that knows how to execute, and which has tangibly and dramatically committed itself to our airline and its future. We’re listening to our people as we share our vision for the future. But “Pull together, win together” is about more than rebuilding trust and mutual respect. It’s also about making sure—through the use of stock options, profit sharing, and incentive plans—that each team member has a personal stake in the success we’re all working to create.

The fourth point of our plan—Build a financial foundation for our future—sums up the rest of the plan, because by lowering costs, flying smart, and pulling together we will lay the groundwork for the future. But this fourth tenet also acknowledges that we cannot build a bright future if we don’t generate enough earnings and cash flow to restore our balance sheet. We must—and we will—find ways to remove risk and build value for debt and equity stakeholders.

The good news is that while we still have a lot of hard work to do, we are at the same time a much different company than we were just two months ago. We’ve substantially lowered our cost structure, and as many of our initiatives reach steady-state in the months to come, we will become even more competitive. Strictly from a labor cost perspective, we reduced expenses by $200 million this quarter, and that number will double in the third quarter and hit $450 million by quarter four.

What’s more, as we head into the peak travel season, we are starting, finally, to generate some momentum on the revenue side of the ledger. While April results were nothing to write home about, there were signs of encouragement in our relative revenue performance. In terms of year-over-year change in unit revenue performance, American outperformed the industry by more than one and a half points.

Our good revenue performance has naturally been helped along by what I would describe as the most rational capacity environment we’ve seen in some time. Looking forward, we have reason to believe this will continue, with peak summer capacity for the majors currently seven percent lower than last year.

From a cash perspective, we still have some work to do. As we have said before, we will need some combination of improved revenues and additional funding in the near future, most likely through a combination of financings and asset sales, to meet our liquidity needs. However, we are feeling more optimistic today than we were just a couple months ago. At the end of the first quarter we had $1.8 billion in cash. April was a difficult month as we worked to iron out our labor agreements and the country battled the war in Iraq.

However, as we moved into May our cash outlook became a bit brighter. I’m sure you know that we received a $360 million reimbursement of security-related costs imposed by the Federal government. We also implemented new wage and benefit rates on May 1, and as I already mentioned, the revenue environment is showing some improvement. All told, we now have in excess of $2 billion in cash and we’re headed into the peak summer season.