Last Updated: April 30, 2008: 11:43 AM EDT
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American Airlines loses $3.3 million a day

How CEO Gerard Arpey runs a carrier that's losing money like airplanes burn fuel.

By Barney Gimbel, writer

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"There is no business," American's CEO Arpey said, "that can go on forever selling its product for less than the cost to produce it."
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Airliners burn too much fuel to make profits at current prices.
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Close Look - First Officer John Kotruch does a preflight check of an MD-80, one of the 300 that the FAA recently grounded.

(Fortune Magazine) -- Just as the Boeing 737 started its initial approach into Washington's Reagan National Airport, Gerard Arpey asked for my pen and pad. Arpey, the polished chief executive of American Airlines, was on his way from Dallas to brief FAA administrators about the maintenance issues that had recently grounded nearly half his fleet. But as the seatbelt sign went on, his mind turned to the industry's recent merger mania.

"While mergers may play a role in solving some of the fragmentation and capacity problems that plague the industry," he scribbled, "they are not the panacea for solving all the industry's problems and may create a few new ones." Then he looked at me, smiled, and said, "But that doesn't mean we aren't looking or don't have options."

Then, as if it had been timed, we hit a patch of turbulence.

That's a gentle word for what American's CEO has experienced of late. In the past month Arpey, 49, has dealt with picketing pilots calling for his resignation, FAA inspectors decertifying 300 aircraft, the merger of two large competitors, and $110-a-barrel oil that contributed to a $328 million loss for the first quarter. Since January, nearly every flight the airline has flown has lost money - analysts estimate it is losing $3.3 million a day.

Of course, red ink in the airline industry is about as novel as weather delays or lost luggage. What has changed for executives like Arpey is that there is not much left to cut. Thanks to bankruptcies or restructuring, airlines like American long ago chopped the low-hanging fruit and added extra fees wherever they could: Pilots make less, planes fly more, and passengers now routinely shell out for once-complimentary items like onboard food and checked luggage. The problem is that no airplane was ever designed to make a profit with jet fuel at these prices, and no carrier has figured out a way to charge enough to make up the difference.

Pity the airline CEO. He can't control his biggest costs. He can't really control the prices he charges. Already this year, record fuel prices have forced five carriers to file for bankruptcy. Analysts say more may be on the way - and some believe American is in danger. That's because as the only so-called legacy carrier to have avoided Chapter 11, American has significantly higher labor costs than many of its competitors and operates a largely aging fleet of gas-guzzling aircraft - two problems without easy fixes.

But give Arpey some credit: In 2002, the year before he became CEO, American lost $3.5 billion paying 76 cents a gallon for jet fuel. Since then the company has shed about $6 billion of costs and raised revenues 33%. And last year, with jet fuel soaring to a then-record $2.13 a gallon, American scratched out a $504 million profit. That should have earned him a plaque in the CEO hall of fame, right? And maybe Arpey would've been awarded one, except that the once-unthinkable $2.13 a gallon climbed to the completely unbelievable $2.74 a gallon. That means the airline's fuel cost to fly one seat one mile has increased 29% since last year.

Costs outpace fares

The problem? The market allowed fares to go up only 5%. "It's airline Darwinism," says Holly Hegeman, an analyst who runs PlaneBusiness.com. "Those unable to make a profit on their basic business will burn cash until they either figure it out or run out of cash and things to sell off, or oil prices significantly reduce."

So what's an airline executive to do? As in any industry that's in trouble, some think consolidation is the answer. Take the proposed merger of Delta Air Lines (DAL, Fortune 500) and Northwest Airlines (NWA, Fortune 500). Richard Anderson, Delta's chief, says the new carrier can better withstand high fuel costs by exploiting the combination of two complementary route networks. Northwest has a large Asian presence, and Delta has a large European one.

But many in the industry say that's exactly the wrong strategy, and that the value in such mergers lies in acquiring a competitor with similar routes and shutting some flights down. The terms Delta's executives propose will leave capacity largely unchanged and will increase their costs - they've agreed to give their pilots a raise - with limited potential to substantially increase revenue. "The appeal of consolidation is redundancy - the network overlap - that can be eliminated," J.P. Morgan analyst Jamie Baker wrote in a recent report. "The value creation comes in the form of shedding duplication."

Arpey agrees, adding that anything that can drive capacity out of the industry helps raise ticket prices. That brings up a rather basic question: Why haven't airlines been able to raise prices enough to offset their costs? Since deregulation in 1978, carriers have lost more money than they ever made as they battled for customers largely on price.

But the fare American needs to charge to make a profit is different from, say, that for Southwest Airlines (LUV, Fortune 500), which, thanks to prudent hedging in futures markets, is paying only $2.01 a gallon for its jet fuel. "They are without question the price leader," Arpey says. "And they've used that hedge position to in effect buy market share. And over the years, we've learned the hard way that we have to be competitive or we lose the business."

An effort by Delta to fight discount competitors, called SimpliFares, threw the airlines' pricing wars into a fresh kind of chaos. Delta rewrote its fare rule book in 2005 to price trips each way and eliminate the infamous Saturday-night stay requirement to get the cheapest ticket. The reason the Saturday-night requirement existed in the first place was so airlines could distinguish between their two primary customers: the price-sensitive leisure travelers and the deep-pocketed business ones. Folks traveling on business typically don't stay over Saturday nights. Other carriers had to match Delta's move to stay competitive and charge the same prices to all their customers. Overnight, the premium from business travel was lost.

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