It’s challenging to envision a large, significant business—currently or historically—that has been despised by investors more than American Airlines. At present, its stock is hovering at similarly dismal levels as when airlines were grounded during the peak of the COVID crisis. Since reaching its peak in early 2018, American’s shares have plummeted by approximately 90%, drastically reducing its market capitalization to a mere $7.1 billion as of October 27. This figure is so diminished that it ranks as America’s 478th most valuable public company. Simply put, investors and the financial markets hold an extremely bleak outlook on American’s future, a sentiment so pessimistic that it redefines the concept of “diminished expectations”.Thank you for reading this post, don't forget to subscribe!
Undeniably, investors are now considerably more pessimistic about the prospects of all major airlines compared to their outlook before COVID took its toll. The stocks of the Big Four—American, Delta, United and Southwest—experienced a robust recovery starting in March of this year, raising hopes of a sustained turnaround after three years of stagnation. The catalyst was a surge in travel demand during spring and summer, resulting in bookings exceeding the levels of 2019.
However, this rebound was short-lived. By July, share prices began a synchronized downturn that has shown little signs of relief. American and Southwest have been hit hardest in this recent decline, with both witnessing around a 38% drop since the beginning of July. Delta and United have experienced slightly lesser declines and are still trading more than 10% above their lows during the outbreak. Southwest, plagued by outdated systems impacting its traditional reliability, is trading even lower than its pandemic lows, trailing American. For all four major airlines, the current stock prices harken back to the levels of 2012 to 2013.
Analyzing the significant decline since July that derailed the budding recovery
According to Savi Syth of Raymond James, two factors account for the sudden reversal. The first is the 40% surge in jet fuel prices from June to September, a substantial increase considering that it already accounted for roughly one-fourth of operating costs. This sharp rise led to stock declines during a period when travel demand was still strong. Syth suggests that American and Southwest were somewhat disproportionately affected compared to Delta and United. American’s heavier focus on domestic and Latin American markets, in comparison to Delta and United’s extensive service to Europe and Asia, means that their flights cover shorter distances, resulting in higher fuel expenses per passenger due to a greater proportion of fuel consumption during takeoff. Additionally, Delta and United operate a larger number of wide body aircraft that are more fuel-efficient per passenger. (Southwest is the most exposed to fuel costs since its only international destinations are relatively nearby places in Central America and the Caribbean.)
The second factor is the slowdown in sales going into the fall. “Last year, the high demand for travel extended well into October,” explains Syth. “This year, it has returned to the traditional seasonal pattern, resulting in a slowdown compared to the exceptionally high levels of this time last year.” Delta and United are also benefiting more from global trends than American, as traffic to Europe and Asia remains strong while the U.S. market fades.
For all four major airlines, the significant drop in stock prices indicates a profound concern among investors regarding the prospects of these carriers earning substantially less in the coming years compared to when they were trading well above current levels during the recovery period from 2014 to 2019, or even in June of this year.
However, among the Big Four, American is valued the lowest by a wide margin, indicating that investors believe it will perform significantly worse than its struggling peers. The market capitalizations of United ($11.1 billion) and Southwest ($13.3 billion) exceed American’s $7.1 billion by 54% and 85% respectively, while Delta’s $20 billion is almost three times larger than American’s.
American’s underwhelming valuation is especially surprising considering that in terms of annual revenue, it is of a comparable size to Delta and United, generating around $50 billion, and collecting twice the fares of Southwest. Its meager standing is in stark contrast to its role as a leading player in global air travel, and even its current financial performance. American’s position as the world’s largest carrier, in terms of fleet size, daily flights, and passengers carried, is unquestionable.
While the COVID crisis had a substantial impact on American, the airline has rebounded sufficiently to generate profits well above the amount required to satisfy its creditors. Therefore, the likelihood of it filing for bankruptcy, as it did in 2011, appears minimal. In fact, following Q2 earnings, Fitch and S&P awarded American double upgrades, and Moody’s upgraded its status by one notch. All these agencies view American as being in recovery mode. Earlier this year, Fisk highlighted the prospects for “improved profitability” and a position of “solid liquidity.”
“It’s absurd that valuations for all four airlines have dropped to levels around the COVID period’s or even lower, in the cases of Southwest and American,” says Syth. “The markets are predicting that 2023 will represent peak earnings, and see a decline from that point.” And for investors, the most unsettling and unappealing prospect among the group is American, destined at best to struggle on with revenues barely surpassing expenses.
Considering that a quarter of U.S. travelers rely on this stalwart for their air travel, it is crucial to evaluate American’s current financial performance and determine whether its prospects of worsening significantly from here are as bleak as the market’s pessimistic judgment suggests.
American’s dual challenges: Weak cash generation and excessive debt
Since its merger with U.S. Airways in 2013 that created the world’s largest carrier, American has remained the least profitable of the four major airlines while accumulating the highest debt. This combination constrains its ability to reduce its substantial debt burden. A measure called cash operating return on assets (COROA) provides valuable insights into the returns American generates from its assets. COROA is a metric developed by Jack Ciesielski, a distinguished accountant, and it factors in cash from operations, adds back interest and taxes paid in cash, and compares it to the balance sheet assets. This metric shows how many dollars a company garners from every dollar invested in the business.
In 2022, American achieved an operating cash flow of $3.95 billion, pre-cash interest and taxes, on $85 billion in assets, resulting in a return of 4.7%. This is a decline from $5.7 billion and 8.5% in 2017, although it marks a significant improvement over the 2.7% margin in 2021. The fundamental issue is that American kept earning less on an expanding asset base. By contrast, Southwest registered a COROA of 7.6% last year, while both Delta and United achieved 8.7%, almost double the result of American, and significantly higher than their numbers from half a decade ago.
While the cash flow stagnated, American borrowed heavily for the dual purposes of share repurchases and aircraft acquisitions. Following the merger, the leadership perceived their newly-formed giant as highly undervalued and spent a staggering $12 billion on buybacks between 2014 and 2019, in anticipation of substantial operational improvements driving up the stock price. American also invested $30 billion in the same period to replace its aging fleet, adding over 300 narrow-body Boeing 737-800 Max, resulting in the youngest fleet among the big four. “The substantial spending while American was still integrating the two systems contrasted sharply with the more conservative approach at Delta,” explains Syth.
These substantial expenditures have encumbered American with a heavy debt load. In 2014, its net debt stood at $8.1 billion, and by the end of 2019, it had ballooned to almost $25 billion. Due to losses not covered by the significant federal aid package provided during the COVID crisis, American’s borrowings increased to $29 billion in Q1 of 2021. Subsequently, it has reduced this amount to $25.5 billion as of the September quarter this year. However, American’s debt load is approximately twice that of Delta and United, with Southwest holding no net debt. American also incurs an annual interest payment of around $1.5 billion, including the interest earned on its cash reserves, which is approximately double that of its two primary competitors.
This is where the nexus of subpar earnings and substantial debt diminishes American’s financial resilience. For the first nine months of this year, its interest payments absorbed a staggering 49% of operating income.
American’s cash flows are lagging, but it intends to vigorously pursue a revival
According to Syth, a primary reason for American’s operating margins trailing “around 3 points below Delta’s and United’s” is a lingering impact from the U.S. Airways merger. “The merger led to dis-synergies,” she explains. “It did not lead to cost improvements. American had to align the legacy U.S. costs with its own already elevated base.” Furthermore, American incurred significant losses on flights to Asia from both L.A. and Chicago, where it faced intense pricing pressure from Delta and United, both of which have a much larger presence in the region.
However, starting around 2018, American implemented a promising new strategy to concentrate capacity in its three dominant hubs in Dallas-Fort Worth, Charlotte, Miami, and Washington-Reagan. These sunbelt hubs serve cities that are among the top metros in the nation for job and population growth. “It’s a strategy based on the Delta model in Atlanta, where the more business you can generate in the same area, the more profitable it will be,” says Syth. “We were enthusiastic about the approach, and it appeared to be yielding positive results.” However, the pandemic disrupted this “doubling-down” strategy, forcing American to pause its plans and continue accumulating debt.
Now, American has resumed its efforts to expand in its most powerful and well-protected markets. “They are acquiring more gates in DFW and Charlotte,” explains Syth. “They are also expanding in Phoenix, [where they hold a 35% market share, tied for the highest with Southwest]. Phoenix proved to be a lucrative market for them during the pandemic and serves as their west coast connecting hub.” American has also formed strategic alliances in areas where it is weak, notably a partnership with Alaska Airlines in the Northwest. Alaska channels passengers from the west coast and Pacific Northwest into Seattle, from where they board American flights to major domestic hubs such as Dallas and Charlotte. (In May, a federal judge ordered the termination of a successful code-sharing venture between American and JetBlue, as part of the Justice Department’s efforts to block the proposed JetBlue-Spirit merger. The partners dissolved the alliance in July.)
The subdued outlook might indicate more trouble than anticipated
It is insightful to quantify the pessimistic outlook on American by the market. Let’s assume that because it’s a risky investment, investors would expect a 10% return, equating to 8% “real” gains plus 2% inflation. The 8% figure corresponds to a modest PE ratio of around 13. By attributing the current subdued valuation of $7.1 billion, investors anticipate American generating future net earnings of approximately $500 million annually (the $7.1 billion cap divided by 13), a “no-growth” figure that would simply keep pace with inflation. Essentially, the financial markets forecast that American will continue to teeter on the edge, generating insufficient returns to pay off debt, and risking default if economic conditions worsen.
However, American’s financial performance currently exceeds this pessimistic scenario. Syth predicts that the carrier will earn $1.6 billion this year—it is already on pace to surpass this through the first three quarters—dip slightly next year, but rise to $2.1 billion in 2025. It’s important to note that these amounts come after covering interest expenses.
The major risk is the onset of a recession that reduces demand and lowers revenues. Given the large portion of its cash flows being directed towards interest payments, American remains the most vulnerable of the big four. However, it appears that if American maintains its current course, it can withstand anything except an extremely severe, prolonged downturn. “In a recession, you face two risks,” explains Syth. “Cash flow dries up, and your spending requirements stay high. So, you need to raise high-cost debt or equity, which either further burdens the debt or dilutes the stock price significantly.” Alternatively, the airline may be in such dire straits that it cannot raise emergency financing and is compelled to file for bankruptcy.
Neither of these outcomes seems likely for American, according to Syth, and this sentiment is shared by this writer. Given its relatively new fleet, American’s future capital requirements are modest by industry standards. It also has a substantial cash reserve of $11.5 billion. “I don’t see them needing to raise new capital in a typical downturn, and downturns are not permanent. They usually persist for shorter periods than the pandemic did,” suggests Syth.
Perhaps the most compelling reason for American to persist is its leading market share on numerous routes with limited competition. The current airline model, where the four major players share the market and practice “disciplined” competition, should provide American not only with a path to survival but also with profitability that keeps the airline out of harm’s way.
This story was originally featured on Fortune.com