When I sat down with American CEO Doug Parker recently, I was told the interview was limited to talking about Los Angeles, so that’s you heard in the podcast. After we finished on that topic, however, Doug and I kept talking for awhile about broader issues facing the airline. I took the pieces of that conversation that were on the record and combined it with comments he made in the airline’s earnings call last week. The end result is this post… a look at why Doug says Wall Street is wrong about American.
For those who don’t pay attention to the financial side of the business, I should explain exactly what it is that Wall Street thinks about the airline in the first place. Right now, it is not happy. Just take a look at the airline’s share price performance this year.
Its shares have suffered mightily. Just over six months ago, the stock was trading near $60 a share. Now it’s in the gutter, barely above $30. The airline’s market cap is now shy of $15 billion. United is at $23 billion while Delta is at $36 billion.
Some of the reason for this is crystal clear. Its financial performance has lagged its peers, and there’s this perception that things are stagnant at the carrier. You have Delta continuing to lead the industry as it has for years. On the other side, you have a rising United which, frankly, had to rise since it couldn’t get much lower. That leaves American in the middle. Its operations slumped last year, and some product moves — pulling out seatback televisions, for example, and adding even more seats to aircraft — have created this perception that American is the laggard.
So why is that not right? Is American really in a good spot? Here’s how Doug explains it.
Margins are Low, But Good Growth is Coming
Looking at third quarter margins, American lagged its two biggest competitors by far. Delta’s pre-tax margin led at 13.5 percent. United was next at 9.7 percent, and American picked up the rear at 6 percent.
American has several initiatives underway to further reduce costs and grow revenues, but that all sounds like corporate speak that may or may not pay off over time. It’s also not unique. Every company has programs to drive growth in revenues and cut costs. What is special is something that is actually fairly unique to American. While the airline isn’t expecting to grow much, it has a great opportunity to grow in all the right places.
In each of the next three years, American will be able to significantly grow its most profitable hubs, and that’s not something that happens often. In 2019, American gets 15 new gates at Dallas/Ft Worth. In 2020, it gets 7 gates in Charlotte. And in 2021, the new regional gates open at Washington/National allowing the airline to upgauge from 50-seaters to 76-seaters. These are American’s three most profitable hubs, so the growth should be a very material boost to the bottom line.
That sounds good, and it will help revenue, but there’s a bigger issue that’s been bugging Wall Street.
An Enormous Amount of Debt
Debt is good in moderation, but Wall Street doesn’t like what it sees at American. Take a look at this chart showing American’s short + long term debt levels compared to the others, and you’ll understand why.
That is a whole lot of debt, and it keeps going up. Why? Well, you have to go back to before the merger to understand that.
Before the American/US Airways merger, American’s previous management team placed a gigantic order for a hundreds of new airplanes. Sure American needed to get new metal after years of neglect, but these were mega-orders that others probably wouldn’t have found wise to place. The capital expenditure (capex) required to support these orders is… big. To really put this into perspective, look at this graph of how much American has been spending on capex compared to other airlines.
That is a whole lot of money. The good news for American, however, is that this number is finally starting to go down after next year. It should drop below $5 billion in 2019, but then it’ll be down to $3 billion in 2020 and $2 billion in 2021. Then American expects it to stay between $2 and $3 billion annually from there.
Spending less money will allow American to pay down its debt when it comes due, and that’s good because a nice chunk will need to be paid off or refinanced in the next few years. But remember that this debt has been taken on in good times at good rates, so American is in no hurry to repay it until it’s due. It’s not the crushing high interest rate loans taken out in desperation as airlines have done in the past during lean times. American has said it mostly plans on repaying these, not refinancing them, when due. So debt will start to dwindle.
In the meantime, there is risk. If things get ugly quickly, then American will have a lot of debt that earnings in theory might not support. Because of that, American has built a buffer. The airline has been keeping a whole bunch of cash on hand.
If things were to get ugly, then American can dip into its cash and still have plenty of reserves. But could things really get that ugly? Doug has famously said that the airline will never lose money again, earning about $3 billion in weak years, $5 billion in average years, and $7 billion in good years. If that’s the case, then the debt really isn’t an issue.
Right now, however, those earnings ranges sound like a long-shot. Adjusted for special items, American is at $2.1 billion in earnings today, so that would make this on the lighter side of a weak year. All we hear is how the economy is booming and the revenue environment is strong, so this doesn’t sound right.
I asked Doug if he was looking forward to a downturn, so he could prove his thesis. But in Doug’s eyes, the thesis is already being proven. Sure, revenues are strong and the economy is good, but have you noticed the cost of a barrel of oil?
Jet fuel prices have climbed more than a third in the last year. Revenues may be strong, but there is huge cost pressure. In the third quarter alone, American saw a negative impact on earnings of $750 million versus last year. Yet here American is still posting healthy profits, just not as healthy as the others.
Does this mean Doug is right and Wall Street is wrong? I do think Wall Street is likely overreacting, and that share price feels low. Doug certainly has several valid points when he’s making these arguments. But there’s only one way for American to fix that perception… it has to prove it can do better.