Less than 20 months ago, American Airlines (AMR) was the largest airline in the world competing against five smaller and weaker US legacy carriers.

Following is a detailed summary of where the legacy/network carriers were, where they are, and where AirlineFinancials.com expects them to go.

In October 2008, Delta (DAL) and Northwest merged taking the #1 spot in the industry. By the end of this year, United (UAUA) and Continental (CAL) will merge pushing Delta/Northwest to the #2 position. American will soon become the 3^rd largest airline leaving US Airways as the only remaining smaller legacy competitor.

Some industry observers fail to accept airlines can be different and do not all have to become a “Southwest” type lower cost airline to be profitable. Consumers buy clothing at Walmart and Macy’s. Both stores are very different from each other and successful. The airline industry is made up of very different types of airlines. While all airlines sell “air travel”, large legacy/global carriers provide a different consumer product than the lower cost primarily domestic airlines.

One of the major differences between the legacy/network airlines and the lower cost domestic carriers is the connecting passenger “feed” that is required to support the legacy airline’s large international operations. In 2008, American had the largest route network connecting passengers from domestic cities to their major international hubs (see figure 1 for each airlines’ 2008 capacity breakdowns and annual revenue).

Figure 1

From the October 2008 merger of Delta and Northwest to the end of 2009, American went from the largest airline to being a much smaller competitor to Delta (see figure 2).

Figure 2

After many years of failing to find a partner, United found Continental in early 2010 willing to say yes. Subject to the expected DOT, DOJ, and stock-holder approval, United and Continental will merge by the end of this year. They will become the largest airline in the world topping the Delta-Northwest merger and move American to 3^rd place (see figure 3 for the 2010 revenue projections and reported capacity thru the first five months of 2010).

Figure 3

In a relatively short time period, American saw four smaller and arguably mostly weaker competitors join forces to become much larger and stronger.

The major challenges American must compete with are:

• Nearly every city American Airlines provides service to/from is also served by Delta and/or United-Continental. Further, due to their mergers, Delta and United will serve many more domestic and international destinations than American.

• Domestic passenger “feed” is the life blood to support the international operation of every large global network airline. United and Delta have much less restrictive labor contracts than American. Figure 3 above shows the advantage United and Delta garner over American from their regional/affiliate passenger “feed” to international routes.

• International traffic is where higher yields come from. The Delta and United mergers create much stronger competition for American’s international passengers. On the domestic side, lower cost carriers like Southwest (LUV), JetBlue (JBLU) and Air Tran (AAI) compete aggressively on nearly all of American’s domestic routes.

Approximately 50% of Delta and United-Continental’s mainline capacity is international compared to ~38% for American. As a result of labor contract restrictions, American receives less than 11% of their domestic capacity and passenger feed from regional/affiliates while United and Delta achieve approximately 23% (see figure 4).

Figure 4

Contrary to rumors and suggestions from many industry analysts and observers, it is the opinion of AirlineFinancials.com pursuing a merger with US Airways is –not– in the best long-term interest of American Airlines.

Furthermore, it is the opinion of AirlineFinancials.com that American’s plan to pursue stronger global alliances plus their announced “Cornerstone” focus is the best long-term strategy for American to compete against the new Delta and merging United-Continental.

In a federal securities filing last month, AMR said its Cornerstone focus on New York, Los Angeles, Chicago, Dallas/Fort Worth and Miami, plus its business alliances with foreign carriers, “will result in incremental revenues and cost savings of over $500 million per year.” The airline expects to see these savings in 2011.

If you have ever played the game of “RISK”, you have a realistic idea of what American’s “Cornerstone” focus looks like.

American, along with all the legacy carriers have no plans for adding any measurable capacity before year 2011.

This past April, American started changing their system schedule to build up each of their announced “Cornerstone” focus cities.

Figure 5 shows American’s rank and market share over the past 12 months in each of their “Cornerstone” airports –before– their announced buildup. Excluding LGA, which is primarily a domestic airport and EWR which is all but owned by Continental, American offers numerous international destinations to/from each of these focus cities. Additional destinations around the world are available through American’s alliance partners.

A recent agreement with JetBlue will allow American to provide up to 18 new connecting destinations from/to JFK and BOS.

The additional build-up in these focus cities should further solidify American’s already strong position as noted in figure 5.

AirlineFinancials.com believes Americans strong global network combined with the upcoming joint business venture with British Airways/Iberia and Japan Airlines will allow American to be competitive with Delta and the merged United-Continental.

Accepting the above, American Airline’s single largest obstacle to long-term success –profits and growth– is to find a solution which resolves their decades of contentious and ongoing battles between labor and management.

The airline industry is in the midst of making historical changes. History clearly shows those airlines that failed to adapt to industry changes, also failed to succeed.

Delta and United-Continental are adapting to industry changes. More importantly, both Delta and Continental management and their labor groups have a history of working together to find solutions to their problems.

For American Airlines, without a change from both management –and– labor to work together, it is unlikely they will be competitive with Delta and the new merged United-Continental. Note: Continental’s well respected management will be taking over the merged United and Continental.

In order to have a safe, efficient and financially solvent airline industry, politicians, the media, and consumers must accept the [airline] industry cannot –profitably– support too many airlines competing for the same customer.

In 2008, there were six legacy/network airlines all competing against each other for cash flow to survive as opposed to making profits and strengthening their weak balance sheets. The Delta-Northwest merger and the upcoming United-Continental merger will be a major step to improving the US Airline Industry.

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Disclosure- The above opinions and comments should not be used to determine the worth of any stock or investment. At the time of writing, the author and his family did not hold stock and/or derivative positions in any of the airlines covered in this article.

Sources of data include but are not limited to: AirlineFinancials.com, US Security and Exchange Commission, and Bureau of Transportation Statistics.

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Robert Herbst has been a commercial pilot since 1969. His aviation experience and financial background provides a unique analytical perspective into the airline industry. He is the founder of: AirlineFinancials.com which provides airline industry analysis and commentary for major US carriers.

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