Behind the tailspin at American Airlines that has sent debt soaring, investors fleeing, and the stock plunging 90% to a level one analyst calls ‘bonkers’

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It’s hard to think of any big, important enterprise—now or ever—more reviled by investors than American Airlines. At present, its stock is languishing at around the same, super-depressed levels as when the world’s fleets sat grounded during the depths of the COVID crisis. Since peaking in early 2018, American’s shares have dropped roughly 90%, crushing its market capitalization to a puny $7.1 billion as of October 27, a figure so shrunken that this iconic name now sputters as only as America’s 478th most valuable public enterprise. Put simply, the funds and folks that drive the equity markets hold an incredibly grave view of American’s future, a take so dour that it gives new meaning to the term “diminished expectations.”

To be sure, investors are now far more pessimistic on the future for all the major airlines than before COVID lowered the hammer. Starting in March of this year, stocks of the Big Four—American, Delta, United and Southwest—staged a strong comeback, raising hopes that at long last, they’d durably break from their three year funk. The lever: A spring and summer surge in “revenge” travel swelled bookings to numbers even exceeding the excellent 2019 volumes.

The bounce proved short-lived. By July, share prices started a synchronized swoon that’s barely abated. Hardest hit in the recent downturn are American and Southwest. As of the market close on October 27, both have dropped around 38% since the start of July. Delta and United have suffered slightly lesser declines, and are still hovering more than 10% above their lows when the outbreak struck, while Southwest, hurt by outdated systems that undermined its traditional reliability, is selling even farther below its pandemic bottoms than American. For all of the Big Four, shares are now trading at 2012 to 2013 prices.

Assessing the big fall since July that killed budding comeback

Two negatives account for the sudden retreat, says Savi Syth of Raymond James. The first is the 40% June to September run-up in jet fuel, a line item that even before the jump accounted for around one-fourth of operating costs. The rise explains why stocks began dropping in the summer while traffic was still strong. That hit, says Syth, disproportionately penalizes American and Southwest somewhat versus Delta and especially compared to United. American tilts more towards the domestic market, as well as Latin America, than its two network rivals that offer more extensive service to Europe and Asia. Hence, its average flights are shorter, and the fewer miles covered, the higher the fuel expense per passenger, since such a high proportion of burn happens at takeoff. In addition, Delta and United are flying a greater mix of wide body aircraft that use less fuel per passenger. (Southwest has the greatest exposure to fuel costs since its only foreign destinations are relatively nearby places in Central America and the Caribbean.)

The second downer: softening sales going into the fall. “Last year, because of all the pent-up demand for travel, the vacation season lasted well into October,” explains Syth. “This year, it’s returned to the traditional seasonal pattern, so that we’ve seen a slowdown versus the extremely high levels at this time last year.” Delta and United are also benefiting more from global trends than American, as traffic to Europe and Asia remains robust while the U.S. fades.

For all four majors, the recent collapse in stock prices is flashing an extreme signal: Investors foresee the carriers’ earning a lot less in the years ahead than when they were selling at well above today’s levels as the recovery from the Great Financial Crisis gathered speed from 2014 to 2019, or even in June of this year.

But of the Big Four, American’s valuation is the lowest by a wide margin, meaning that investors wager that it will do far, far worse going forward than its beaten-down peers. The market caps for United ($11.1 billion) and Southwest ($13.3 billion) exceed American’s $7.1 billion by 54% and 85% respectively, and Delta’s $20 is almost three-fold bigger.

That American’s worth lags even the pummeled numbers for its rivals is especially shocking because measured in annual revenue, it’s about the same size as Delta and United in the low-$50 billion range, and collects twice the fares of Southwest. In fact, its lowly standing sits in stark contrast with its role as a centerpiece of global air travel—and even its current financial performance. The colossus of Fort Worth towers as the world’s largest carrier, measured in fleet size, daily flights, and passengers carried; last year, nearly two hundred million customers filled its seats.

Though the COVID crisis left its deepest scars on American, the airline’s rebounded sufficiently to generate well above the profit dollars needed to pay its creditors. Hence, the chance it will fall into bankruptcy, as it did in 2011, appear minimal. Indeed, following Q2 earnings, Fitch and S&P awarded American double upgrades and Moody’s raised its status one notch. All the agencies view American as motoring in recovery mode. In a note earlier this year, Fisk cited prospects for “improved profitability” and a position of “solid liquidity.”

“For all four airlines, that valuations have fallen to around the COVID period’s or even below in the cases of Southwest and American look bonkers,” says Syth. “The markets are forecasting that 2023 will represent peak earnings, and see a descent from there.” And for investors, the most ghoulish and repelling of the group, the “loser” destined to at best bump along as revenues barely exceed expenses, is American.

Given that U.S. travelers rely on the stalwart for around one-quarter of their air travel, it’s important to examine American’s current financial performance, and assess whether the odds that it will get much worse from here are really as high as the market’s dreariest of dreary judgment.

American’s twin problems: Weak cash generation, and excessive debt

Since its U.S. Airways tie-up that in 2013 created the world’s biggest carrier, American has been both the least lucrative of the four majors, and accumulated the most debt. And the combination limits its ability to reduce the big pile of borrowings. A metric called cash operating return on assets, or COROA, is an excellent yardstick for the returns American garners from marshaling its planes, gates, maintenance hubs and all other investments. COROA is the brainchild of Jack Ciesielski, one of America’s top accountants. To remove the effects of leverage and taxes, COROA starts with cash from operations and adds back interest and taxes paid in cash. That number is the numerator. The denominator is balance sheet assets plus accumulated depreciation and amortization. It represents all the capital parked in the business used to generate those cash flows. COROA displays how many dollars a company collects from all the dollars ever plowed into the business as it now exists, regardless of its debt load or tax burden.

In 2022, American achieved $3.95 billion in “operating cash flow,” pre cash interest and taxes, on $85 billion in assets, for a return of 4.7%. That’s down from $5.7 billion and 8.5% in 2017, though it’s a big improvement over the 2.7% margin of 2021. The basic issue: American kept earning less on a growing asset base. By contrast, Southwest recorded COROA of 7.6% last year, and both Delta and United hit 8.7%, almost twice American’s result and numbers exceeding those half-a-decade back.

While cash flow trickled, American borrowed heavily for two purposes, repurchasing shares and buying new planes. Following the merger, the leadership saw their newly-formed giant as extremely undervalued, and spent a staggering $12 billion on buybacks between 2014 and 2019 in anticipation that big operating improvements would drive its stock far higher. American also spent $30 billion in the same period replacing its aging roster of jets, adding over 300 of the narrow body Boeing 737-800 Max, a gambit that amassed the youngest fleet among the big four. “All the spending that was happening while American was still merging the two systems contrasted with the much more measured, conservative approach at Delta,” says Syth.

Those huge outlays imposed a mortgage on American’s future. In 2014, it owed $8.1 billion in net debt (defined as long-term borrowings plus capital leases, minus available cash). By the close of 2019, the burden had ballooned to almost $25 billion. Due to losses not covered by the huge federal aid package granted during the COVID meltdown, America’s borrowings expanded to $29 billion in Q1 of 2021. Since then, it’s wrestled the number to $25.5 billion as of this year’s September quarter. Still, American’s carrying about twice the approximately $13 billion loads at Delta and United. (Southwest has zero net debt.) American’s also paying around $1.5 billion in interest annually, including what it’s collecting on its cash horde. Once again, its overall interest bill is about twice that of its two biggest rivals.

Here’s where the intersection of sub-par earnings and heavy debt diminish American’s cushion for safety. 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 harbors a “doubling-down” plan for a liftoff

A major reason American’s operating margins trailed “around 3 points below Delta’s and United’s,” explains Syth, is a hangover from the U.S. Airways union. “The merger involved dis-synergies,” she says. “It didn’t result in cost improvements. American had to raise the legacy U.S. costs to the higher level of its own base, which were already elevated.” In addition, American booked big 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 much larger footprints in the region.

But starting around 2018, American launched a promising new strategy to concentrate capacity in the three hubs where it holds the dominant positions, Dallas-Fort Worth, Charlotte, Miami and Washington-Reagan. These sunbelt hubs serve cities that all rank among the nation’s top metros for job and population growth. “It’s a strategy based on the Delta model in Atlanta where the more business you can create in the same factory, the more money you’ll make,” says Syth. “We were excited about the approach, and it appeared to be working.” Then, the pandemic struck, forcing American to put the “doubling-down” game plan on hold, and keep piling on debt.

Now, American’s resumed its push to expand where it’s most powerful and best protected. “They’re getting more gates in DFW and Charlotte,” says Syth. “They’re also growing in Phoenix, [where it holds a 35% share, tied for tops with Southwest]. Phoenix proved a great destination market for them in the pandemic, and is their west coast connecting hub.” American wisely formed alliances where it’s weak, notably a partnership with Alaska Airlines in the Northwest; Alaska funnels passengers from the west coast and Pacific Northwest into Seattle, where they board American flights to such domestic hubs as Dallas and Charlotte. (In May, a federal judge issued an order to terminate a successful, three-year-old code-sharing venture linking American and JetBlue, as part of the Justice Department’s suit to block the proposed JetBlue-Spirit merger. The partners dissolved the alliance in July.)

The tiny expectations may point to more trouble than will happen

It’s illuminating to put numbers on the market’s dim view of American. Let’s assume that since it’s a risky play, investors would want a 10% return, meaning 8% “real” gains plus 2% inflation. The 8% figure equates to an extremely modest PE of around 13. So by awarding the meek current valuation of $7.1 billion, investors are expecting American to generate future net earnings of roughly $500 million a year, (the $7.1 billion cap divided by 13), a “no growth” number that would simply rise with inflation. In effect, the money crowd’s projecting that American will keep teetering on a narrow edge, making too little to pay down debt, and risking a fall into default if times turn tough.

But today, American’s making a lot more than that poor scenario envisages. Syth predicts that the carrier will earn $1.6 billion this year—it’s already exceeding that pace through the first three quarters—dipping next year, but rising to $2.1 billion in 2025. Keep in mind that those amounts come after covering interest expense.

The big danger: The onset of a recession that slashes demand and lowers revenues. American remains the most vulnerable of the big four due to the large portion of its cash flows going to interest. But it appears that if American simply maintains the current course, it can survive anything except maybe an extremely severe, long-lasting downturn. “In a recession, you have two risks,” says Syth. “Cash flow dries up and your spending requirements stay high. So you need to raise high cost debt or equity, which either makes the debt burden even more crushing, or pounds the stock price through huge dilution.” Or, the airline’s in such bad shape that it can’t raise emergency financing and files for bankruptcy.

Neither outcome appears likely for American reckons Syth, and this writer agrees. Because its fleet is so new, American’s Capex future requirements are modest by industry standards. It also holds a substantial cash trove of $11.5 billion. “I don’t see their having to raise new capital in a normal downturn, and downturns aren’t forever. They usually last a shorter time than did the pandemic,” says Syth.

The best reason, perhaps, that American should persevere: It boasts the top market share in hundreds of routes where it faces limited competition. The current airline model where a four main players divide the market and practice “disciplined” competition should be its ticket not just survival but at least profitability that keeps the carrier out of harms way.

This story was originally featured on Fortune.com

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