American Airlines Begins Expanding at Its Biggest Hubs

Last week, American Airlines (NASDAQ: AAL) began new routes from its hub at Dallas-Fort Worth International Airport (DFW) to four small cities: Monterey, Burbank, and San Luis Obispo, California; and Flagstaff, Arizona. These new routes are particularly significant because they mark one of the first steps in a major expansion by American Airlines at its two largest hubs: DFW and Charlotte.

Indeed, American Airlines plans to operate 905 peak-day departures at DFW by July -- up from 809 a year earlier -- as it gains access to 15 additional gates. A smaller increase in departures is coming in Charlotte later this year. Management expects growth at the carrier's two largest and most profitable hubs to drive a much-needed turnaround at American Airlines.

Big hubs generate high margins

Large network carriers like American Airlines have higher costs than discount airlines. Their main competitive advantage is the ability to fly to small cities (where competition is limited and fares are high) and offer connecting service to destinations around the world. By clustering as many flights as possible in a single "bank" at a hub, network carriers can maximize the number of potential connecting itineraries, driving high unit revenue.

This provided the formula for strong profit growth at United Continental (NASDAQ: UAL) last year. United Airlines accelerated its capacity growth -- with a particular focus on small cities -- and "rebanked" several of its hubs to facilitate more connections. While many people doubted this strategy at first (including me), it worked wonders for United.

More evidence for the power of big hubs comes from American Airlines' own performance. Between mid-2017 and mid-2018, the carrier achieved a 13.1% pre-tax margin across its three most profitable hubs -- including both DFW and Charlotte, as well as Washington, D.C.'s Reagan National Airport -- compared to a 7.5% system average pre-tax margin.

In recent years, gate and slot constraints had prevented American Airlines from expanding much at these high-margin airports. However, that's about to change.

New routes and additional frequencies coming

American Airlines expects to gain access to its 15 extra gates at DFW this quarter, enabling it to begin new routes to numerous small cities, while also adding flights on existing routes.

The carrier's expansion at DFW Airport actually began last month, with new daily routes to Augusta, Georgia; Gainesville, Florida; Yuma, Arizona; and Bakersfield, California. The San Luis Obispo, Burbank, Monterey, and Flagstaff routes followed last week.

The growth spurt isn't over yet. Daily summer season flights to Myrtle Beach, South Carolina will start in May. And more than half a dozen additional routes will launch in June, connecting DFW to Kalispell, Montana; Harrisburg, Pennsylvania; Santa Rosa, California; Durango, Mexico; Santo Domingo, Dominican Republic; and San Pedro Sula and Tegucigalpa, Honduras. (Some of those routes will operate less than daily or seasonally.)

These new small-city routes will be complemented by additional frequencies to some cities that American Airlines already serves from DFW. This will lead to a big increase in connectivity. If United Airlines' 2018 results are any indication, this growth plan could drive strong margin expansion for American in the second half of 2019.

American Airlines will do the same thing on a smaller scale in Charlotte later this year, as it will get access to five additional gates there by year-end. This should unlock additional profit growth in 2020.

A much-needed catalyst

Right now, American Airlines is struggling. On Tuesday, the carrier said it expects to report unit revenue growth in the lower half of its original guidance range for the first quarter. As a result, American lowered its pre-tax margin forecast by 0.5 percentage points, to a new range of 2% to 4%. That would compare to an adjusted pre-tax margin of 4.5% in Q1 2018.

The government shutdown is partly to blame for this poor result. The recent grounding of the Boeing 737 MAX -- of which American Airlines has 24, with 40 expected by year-end -- and the temporary removal of 14 737-800s from the carrier's fleet because of problems with their interiors added to its woes.

Fortunately, the government shutdown impact will be limited to the first quarter, and all of the 737-800s should be back in the air by the end of April. The 737 MAX fleet will probably be out of service for several months, though, weighing on American Airlines' profitability.

In this context, increased small-city service from DFW Airport -- American's largest hub -- could provide a desperately needed earnings catalyst over the next couple of quarters. And if all goes well, profit growth could accelerate later this year and into 2020, as American Airlines expands in Charlotte (its No. 2 hub) and its 737 MAX fleet is cleared to fly again.

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Adam Levine-Weinberg is long January 2020 $20 calls on American Airlines Group. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.