Pilot Discontent Continues at American Airlines

Five years ago, support from American Airlines' (NASDAQ: AAL) top labor groups helped pave the way for US Airways to take over its larger competitor, rescuing it from bankruptcy. American's labor unions saw a merger as the best way to avoid pay cuts.

For a while, it seemed that the merger might have ended American Airlines' long-running history of labor discord. However, American's pilots have become increasingly militant in recent years, as pilots at rivals like Delta Air Lines (NYSE: DAL) have received bigger raises. It appears that management's decisions to voluntarily boost wage rates and to implement a profit-sharing program have not created any goodwill among the pilots.

Closing the nascent pay gap

In early 2015, American Airlines pilots ratified a five-year contract by a 2:1 margin. The new deal immediately raised wage rates by an average of 23%, with 3% annual raises in subsequent years. This put American's pilots at the top of the industry in terms of pay rates, in keeping with a promise made by CEO Doug Parker.

However, it didn't take long for American Airlines pilots to become dissatisfied with the contract they had signed. In 2015, airline industry profits surged due to low oil prices. As a result, profit-sharing payouts for Delta pilots soared to as much as 21% of their annual pay. Meanwhile, American Airlines' management had made a philosophical decision to offer higher base wages instead of profit sharing.

Faced with growing employee discontent, American Airlines announced that it would pay out 5% of its annual pre-tax profit as profit sharing beginning in 2016.

This decision built some goodwill, but it didn't last long. United Continental pilots negotiated big raises in early 2016, locking in base pay increases of at least 22% by 2018. Towards the end of the year, Delta's pilots approved a deal that will raise their base pay a total of 30% by 2019. Consequently, American Airlines pilots ended up at the back of the pack in terms of pay.

Management responded by offering pilots an 8% mid-contract pay increase last spring in order to get them back to parity with their peers at Delta and United. This move, along with a smaller 5% pay bump for American's flight attendants, will have an annual cost of $350 million. Parker (the American Airlines CEO) argued that the pay raises were necessary to keep employees engaged and providing good service to customers.

Pilots still aren't happy

Parker and the rest of American Airlines' management team have bent over backwards to keep the company's pilots happy. Given that the union had agreed to a contract running through early 2020, American would have been perfectly justified in deferring any pay changes until then.

Unfortunately, these gestures haven't won any credit with the pilot union. The union president has complained recently that American Airlines pilots are receiving much lower profit-sharing payouts than pilots at rivals like Delta Air Lines.

Indeed, Delta has a particularly generous profit-sharing program. It's also significantly more profitable than American Airlines. Delta pilots earned payouts equal to as much as 15% of their 2017 pay, compared to a measly 2% for American Airlines pilots.

This may seem unfair. But nearly half of the difference is the result of American Airlines' lower profitability relative to Delta. Furthermore, the current contract will end in early 2020, giving the union an opportunity to negotiate a better deal. Lastly, union leaders' claim that management still needs to "validate the trust" of employees doesn't stand up to scrutiny, given that American voluntarily gave the pilots raises totaling hundreds of millions of dollars in 2016 and 2017.

Did management make a mistake?

Back in April, I believed that American Airlines' management had made the right decision to boost pay rates for the carriers' pilots and flight attendants. While there was no obligation to renegotiate either deal before the end of 2019, it seemed better to incur higher costs in the short term -- recognizing that wages would have risen by 2020 in any case -- than to alienate a large part of the carrier's workforce.

Now, I'm not so sure. American Airlines' unit costs have skyrocketed in the past couple of years, contributing to a steep decline in its adjusted pre-tax margin, from 15.3% in 2015 to 9.1% last year. As of now, American seems likely to post another year-over-year earnings decrease in 2018.

In the meantime, management's goodwill gestures haven't done anything to appease the pilots (or at least the leaders of the pilot union). It appears that the pilots -- who are already very well compensated -- won't be content until they are the best-paid pilots in the industry at all times.

Management is now in an unenviable position. One option is to accede to the pilots' demands, now and forever, driving the company's pre-tax margin even further into single-digit territory. Alternatively, American will have to cope with both high costs and labor discord for the foreseeable future. This is one more reason for investors to steer clear of American Airlines.

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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.