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I rate American Airlines (NASDAQ:AAL) shares a Hold at the current time. I’d generally want to wait until the shares got cheaper to consider investing, and would avoid them in favor of several other U.S. airlines given how massive the company’s debt burden is. While American is benefitting from the recovery in travel demand and has returned to profitability, it could and should focus primarily on reducing its debt load as it has less room to maneuver than its competitors if the recovery in the industry falters in the coming months.
Company and industry overview
American is one of the three U.S. “major” airlines which, along with Southwest Airlines, account for close to 80% of air traffic of the overall industry.
Like the industry overall, American had to take drastic measures to survive the COVID-19 pandemic. American came into 2020 with significantly more leverage and fewer unencumbered assets than other major airlines, which gave it relatively less flexibility in terms of antidilutive capital raising alternatives. However, they’ve availed themselves of every available option in order to make it through the worst of the crisis. Firstly, they raised over $13 billion in secured debt, much of which was sourced in the bond markets. Like Delta, United and others, they utilized their loyalty program for a sizable portion of that financing. They also utilized other assets, including certain slots, gates and routes and the company’s intellectual property as a source of funding, and received over $3 billion in unsecured debt from the government in addition to grants to cover employee salaries. Finally, they issued $1 billion of convertible bonds and some equity as well.
American recently operated at around 9% below 2019 capacity levels in the third quarter, and is seeing the same general trends of record revenue as its peers. They will continue to expand capacity in the coming months while being sensitive to how demand evolves in the coming months. They do trade at a slight discount to some other U.S. airlines, but this discount seems warranted in light of the company’s debt burden.
Financials and projections
American made a profit of $0.69 in the third quarter. International, particularly long-haul, continues to lag on the capacity front, which is relatively consistent with the industry overall. However, as the chart below shows, unit revenue performance has been strong, allowing the airline to achieve profitability with capacity still slightly below 2019 levels.
Source: American Airlines
Although they declined to provide guidance, it is not a massive stretch to see them potentially earning $2.00 – $2.50 per share next year, which would result in a forward P/E of approximately 6 times. They will continue to bring back capacity in the coming months if the travel demand is there to support it. However, there are several reasons to give pause when looking at American against Delta and United:
| AAL | DAL | UAL | |
| Operating margin (Q3 2022) | 7.2% | 10.4% | 11.3% |
| Non-passenger revenue as % of total (YTD 2022) | 9.3% | 21.0% | 11.4% |
| Debt / EBITDA (Q3 2022, annualized EBITDA) | 6.3 | 3.6 | 4.3 |
Source: Airline third-quarter earnings releases, author’s own calculations
American’s margins are materially lower and it is more dependent on the continued increase in passenger revenues than its competitors, which means that smaller changes in core airline performance will be more meaningful for it. While this can work in both directions, and American should greatly benefit from a continuation in the rebound in travel demand, it suggests that there is somewhat less of a margin of safety for them compared to Delta and United.
Risk factors
High leverage
American’s debt load is high and will continue to be even if the market strengthens further and performance exceeds expectations. Debt reduction is likely to remain a major theme for American for the foreseeable future. They ended the quarter with over $14 billion in liquidity and few major bullet maturities in the near term, which should insulate it well from any short-term vulnerability. Management has stated its goal of reducing total debt (including operating leases and pension) by $15 billion by the end of 2025.
However, American has contractual commitments to pay off over $17 billion in debt and finance leases alone (excluding interest payments) from 2023-25, plus billions in operating lease and other liabilities, which will almost surely see it needing to raise additional capital in one or more forms. Whether this is comprised of secured or unsecured debt, or equity, or some combination of the above, remains to be seen. They could also defer capital expenditures if they really needed to conserve cash. My forecast of year end debt / EBITDA for the business is below and shows that leverage will remain elevated even with the significant paydowns scheduled. While operating lease liabilities will be reduced, some of that reduction will likely be negated by operating leases or debt financing of new aircraft and engine deliveries and from extension or refinancing of expiring contracts. These reductions also mean that American will burn through most of its current liquidity cushion in the process, leaving it, per my estimates, with a cash and short-term investment balance of below 10% of estimated annual revenues, or around 10% when including the entire $3 billion in undrawn available credit that the company currently has.
| 2023 | 2024 | 2025 | |
| Gross Debt / EBITDA | 5.0 – 5.5 | 4.0 – 5.0 | 3.5 – 4.0 |
| Net Debt / EBITDA | 4.0 – 4.5 | 3.5 – 4.5 | 3.0 – 3.5 |
Source: Author’s own calculations; includes debt, finance leases and operating leases but excludes pensions
Pilot / labor shortage
American, like its peers, needs to hire additional pilots and other staff to continue to grow its operations beyond pre-COVID levels. The recently announced agreement that Delta has struck with its pilots provides for an over 30% increase in compensation over the next few years and reflects the inflationary pressures that will continue to exert themselves against airlines. Pilots in particular have a lot of leverage as they’ve been critical to allowing the industry to capture its record revenues and return to profitability. American’s lower operating margins give it less room to withstand such cost hikes as surely their unions are paying close attention to the outcome of the Delta contract talks.
Fuel costs
Fuel and labor have generally always been the most significant expenses for airlines. There is some chance that fuel prices remain high or even increase from recent levels. American has historically not hedged fuel costs at all, so while it benefitted most from the declines a few years back, it is more exposed to recent increases than some of their competitors. American and the industry at large have generally been able to withstand gradual increases in fuel costs and their revenue strength is a testament to that. American currently operates the youngest fleet of the major airlines and should continue to add new aircraft continue a significant quantity of next-generation aircraft will serve as somewhat of an implicit hedge, but does not change this relative exposure to fuel costs.
Interest rates
American does have some exposure to rising rates, with an estimated 25-35% of its existing debt being variable rate in nature, including multiple term loan facilities and certain equipment notes. American bought back over $300 million of its unsecured notes in the market and issued a EETC a little over a year ago that priced at attractive interest rates that would be well below market interest rates today. They have noted that they have $11 billion in pre-payable debt outstanding as an “opportunity”, though their ability to pay off that debt may be constrained by the factors mentioned above and relatively low amount of unencumbered assets remaining.
Conclusion
American trades at a very low multiple to forward earnings like most of the U.S. airlines do at the current time. It is discounted relative to some of its peers which I believe to be warranted despite the substantial measures they’ve taken to survive through COVID. Their substantial debt load and relative weakness compared to other U.S. majors exposes it to a wider range of outcomes economically, which give me pause. I would suggest investing in other airlines over it, as there are competitors priced almost as cheaply with better balance sheets and more of a margin for safety in what will likely continue to be a sustained but possibly fragile recovery for the sector.
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