American Airlines Expects to Catch Up to Delta With Its Basic Economy Strategy

Executives at American Airlines, the biggest airline in the world, had two stories to tell to investors on a call today, and both were about catching up to Delta Air Lines, broadly speaking.

American says it is finally achieving operational and revenue performances that are comparable to Delta’s. It also says that its plans for competing with low-cost carriers, which somewhat mimic Delta’s, are falling into place.

On the carrier’s second quarter earnings call Friday, American chairman and chief executive Doug Parker said, “We’re back in consideration for being one of the greatest airlines in the world.”

In the next couple of years, American, the largest U.S. airline by traffic, wants to get its margins closer to the high profits reported by Delta, the second-largest U.S. airline by traffic (and the rival most mentioned by American executives on today’s call).

Parker said that the gap between American’s profit margins and Delta’s can be entirely made up by boosting its revenue.

The company plans to steal some market share from rivals and get passengers to pay more for travel by copying some of the moves that have already been proven to work by Delta, such as adding basic economy fares to compete with low-cost carriers on price.

Basic Fare Bonanza

The media hasn’t given close attention to one aspect of American’s rollout of basic economy seats. The airline is aiming to play a subtle psychological and marketing trick on many of its passengers. By introducing products that, while cheaper, come with many restrictions, it aims to make their full-service products look more valuable and thus enable it to nudge up the prices for them.

CFO Derek Kerr says, “We expect business customers to pay a bit more for the product we offer today.”

Mirroring Delta’s experience, American expects business travelers, its most profitable segment, will stay away from the basic economy fares, which are non-refundable, don’t earn qualifying frequent flier miles, don’t allow for seat selection, and don’t allow an overhead bag.

Already some corporate customers that buy large volumes of tickets have told the airline they don’t want it to distribute the basic economy seats to them because they don’t see them as attractive.

Kerr also expects many leisure travelers who book in advance will also be turned off by basic economy fares because of the restrictions and be willing to pay more for standard tickets. “We think the carry-on bag restriction is quite critical for tapping into leisure customers’ willingness to pay,” he says.

Eventually, once all the ripple effects on pricing are tallied, the effect of adding basic economy domestically and premium economy on international flights (launching in April) will boost the company’s bottom line.

“We believe that basic and premium economy combined are worth more than $1 billion in incremental revenue,” says Kerr. Those gains will only start appearing with any significance in 2018 because it will take until then for the airline to roll out basic economy across its U.S. network.

As we’ve noted before, American believes its basic economy product will help it compete more effectively with low-cost carriers, such as Spirit and Frontier, by matching them on pricing for some routes.

Executives didn’t reveal at how much of a premium its existing “main cabin” seat product (which come with added legroom and other perks) will be priced relative to basic economy seats. Investment analysts will have to wait until basic economy pricing is revealed when seats go on sale in 10 markets in the U.S. in mid-February. (See our explainer for business travelers, “Comparing Basic Economy Fares Among American, Delta, and United.”)

Not everyone admires the strategy. Executives at Southwest Airlines say they won’t copy the basic economy fare model because they believe it would backfire given their carrier’s brand reputation for offering a consistent product.

Transatlantic Fare War

Besides cost-cutting and new product, other obvious steps have been taken by American to be more like Delta. Capacity growth on the passenger side was kept flat domestically year-over-year, avoiding a price war due to oversupply.

Like Delta, American’s one exception to keeping capacity in line with passenger demand was on routes over the Atlantic Ocean.

Low-cost carriers such as Norwegian and Wow entered into the transatlantic market recently, pressuring fares, with more discounting to come in 2017. Routes saw a drop of 7%, quarter-over-quarter, in revenue per passenger — about five points of that decline was related to Brexit-driven weakening of the value of the pound. But the company believes most of the drop was temporary.

Next winter American will cull some flights over the Atlantic that were “incredibly unprofitable”. But the company says it doesn’t intend to cede its market share across the Atlantic and that it will work with British Airways to compete with low-cost carriers via its premium economy product.

The bottom line for consumers? In the next year and a half, there will be continued fare discounting on transatlantic flights, as the airlines try to fight for share, executives acknowledge.

Meanwhile over the Pacific, American and Qantas plan to plead with U.S. authorities a month from now to create a joint venture, which would strengthen their alliance with more coordination on flights and cross-selling.

Operational Changes to Become More Like Delta

Looking broadly, a cost-cutting program that is similar to one instituted by Delta is bolstering American’s bottom line. Last year, for instance, the company combined the units’ reservation systems and loyalty programs.

American Airlines executives are happy to say that a closely-monitored industry metric for comparing airline performance improved for the first time in two years. Total revenue for a seat flown a mile was up 1.3 percent year-over-year, for the fourth quarter. That marks the first year-over-year increase since the fourth quarter 2014 — a better performance than other legacy network carriers have reported this month on that metric.

The company forecasts unit revenue to be positive, year-over-year, for every quarter of 2017, says president Robert Isom.

Overall, the company seems to be turning the corner. American has been plagued with some operational hiccups due to troubles in merging operations with US Airways.

Last year American mishandled almost double the luggage as comparably-sized Delta, says the U.S. Transportation Department. The airline canceled nearly three times as many flights as Delta, too.

But Kerr said American is getting better at operations. On baggage, it has recently debuted an integrated operations system across the merged airlines which it calls “state-of-the-art.” The company is also investing in automation to help customers reunite with lost bags more quickly.

Regarding flight delays, the company plans to optimize its schedule to be more realistic. It also expects flight delays to decline now that it has updated its fleet so that it has more planes that are “swappable” as back-up when an aircraft has mechanical problems. The company is also rolling out over the next year-and-a-half “a dynamic re-accommodation” system to let customers go online to rebook when a flight is canceled (instead of calling or queuing in line).

Also copying Delta, which has long had a profit-sharing progam, American’s 100,000 workers can take heart that they’ll soon enjoy the first profit-sharing reward from the company since 2000, thanks to a recently introduced program. Parker also said they are not as well compensated as some other airline workforces. He expects to hand out some raises as labor contracts are renegotiated.

The company plans to cut costs related to the merged operations from US Airways, with the savings appearing through 2018. The company has hired about 20,000 employees in recent years. The company says it intends to reduce its workforce through attrition and “early outs” rather than mass layoffs.

American is also hoping the U.S. government will more strongly enforce an aviation agreement to stop some foreign airlines, such as Qatar Airways and Emirates, from using foreign government subsidies to buy planes and fly them at discounted prices. The use of subsidies is against the agreement, they argue.

American is in synch with Delta about this, as it is about so many things these days.