American Airlines Group Stock Is No Sure Thing

The new American Airlines Group (NASDAQ: AAL  ) took flight last week following the completion of its merger with US Airways. Eager investors bid up shares by more than 10% in the first few days after the merger closed, believing that the merger will be very successful and that integration risks are minimal. However, American Airlines stock is very far from being a safe bet.

American Airlines officially merged with US Airways last week (Photo: American Airlines)

While CEO Doug Parker has integration experience from the 2005 merger of America West and US Airways, bulls have probably overstated the value of this experience. Airlines are extremely complex organizations, and while executives have focused on avoiding some of the pitfalls of the America West-US Airways merger, other issues that they don't expect will undoubtedly arise.

That said, integration risks are not the biggest challenge facing Parker and his management team. The one big reason why American Airlines stock is too risky for me to recommend is that the company has enormous capital commitments. Whereas successful rivals like Delta Air Lines (NYSE: DAL  ) have tried to hold down capital spending, American Airlines is in the midst of a costly plane-buying spree that will tie its hands for years to come.

New planes galore
Prior to its bankruptcy filing in 2011, American Airlines announced plans for a grandiose fleet transformation to replace its aging narrow-body planes. The company ordered a total of 460 new Boeing (NYSE: BA  ) 737 series and Airbus A320 series jets, for delivery between 2013 and 2022. That order included 54 already-scheduled Boeing 737 deliveries as well as firm orders for 57 wide-body Boeing aircraft from the 777 and 787 aircraft families.

In other words, American Airlines plans to replace nearly its entire aircraft fleet within a span of about 10 years. (At the time the merger with US Airways was announced earlier this year, American's mainline fleet totaled just over 600 planes.)

This fleet renewal project will be a phenomenally expensive undertaking. As of the end of September, American had committed about $2 billion a year for aircraft purchases between now and 2017, and has more than $12 billion in commitments beyond 2017. US Airways had also committed about $4 billion for aircraft purchases between now and 2019.

That only covers a portion of the new American's fleet renewal costs. In order to keep its own capital expenditures to reasonable levels, American Airlines arranged lease financing for many of its new aircraft.

This will drive up American's aircraft rent costs dramatically over the next few years. Last year, American Airlines paid just $550 million in aircraft rent. By 2017, this cost will swell to $1.67 billion annually due to all of the shiny new leased aircraft the company is receiving.

A different direction
American's aggressive fleet renewal plans stand in stark contrast to the strategy adopted by Delta Air Lines. Back in the late 1990s, Delta went through a similar phase of rapid fleet renewal, and it got burned during the industry downturn after 9/11. With heavy capital commitments, Delta suffered several years of negative free cash flow, and lacked the flexibility to cut capacity in response to the weak travel environment.

Now, Delta's management has vowed, "Never again!" Instead, the company is committed to a program of gradually updating and replacing older planes with a combination of new and used aircraft, with a goal of keeping capex steady.

By contrast, American's heavy investment in new aircraft today should rapidly reduce its fuel and maintenance costs. However, as the planes age over the next decade, maintenance costs will creep up again. Furthermore, the fuel savings of American's new fleet will eventually be surpassed by even more fuel-efficient aircraft.

Meanwhile, with so much money invested in new "metal", capacity cuts -- one of the main tools used by Parker to improve results following the America West-US Airways merger -- won't be a viable option. In fact, the new American's fleet order basically forces it to grow.

The growth risk
This built-in growth is the most troubling part of American's fleet plan. As of Sept. 30, American Airlines (excluding US Airways) had firm orders for 488 new planes, but only 355 older-model planes ripe for retirement.

For the next few years, American has plenty of older planes that it can retire, allowing it to adjust capacity according to demand trends. However, with American taking more than 60 new planes a year on average for the next four years, it will soon run short of these older planes. At that point -- if not before -- American's new aircraft will have to be used for growth, rather than replacement.

Capacity discipline has been one of the driving forces behind the airline sector's recent upswing. However, American Airlines' fleet plan is predicated on long-term growth, and there is no way to know today whether the market will be able to absorb that growth. This is a big long-term risk that shareholders need to recognize.

Foolish bottom line
Many investors and airline analysts are very bullish on the new American Airlines, expecting a smooth merger integration process and speedy rise to the top of the industry. Indeed, there are good reasons to expect strong earnings in the next few years. A flood of new aircraft will allow American to cut fuel and maintenance expenses, while the combination of the complementary American and US Airways networks should create revenue synergies.

However, the combined company's massive aircraft orders will soak up much of American's cash flow over the next 10 years. Over time, those new planes will start to age, and maintenance expenses will eventually rebound.

Lastly, because American has significantly more firm aircraft orders than older aircraft ready for retirement, it will eventually need to grow capacity. This forced end of capacity discipline could rapidly undermine American's profitability, depending on future market conditions. Even if the merger appears to be successful in the next few years, the new American's massive capital commitments are a ticking time bomb that could bring the company down later on.

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Read/Post Comments (13) | Recommend This Article (9)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 16, 2013, at 11:37 AM, meched49 wrote:

    FUEL ECONOMY is going to save them BILLIONS

    that's why they are replacing the planes. Very smart move as fuel is their biggest expense. Stock is going to 36. It's way under valued now. Has the lowest PE of any airline. I could go on and on, your sour grapes for not buying at .50.

  • Report this Comment On December 16, 2013, at 11:39 AM, meched49 wrote:

    I am waiting for an entry to load the boat. JPM and the other big boys have targets of 31-37. See you in 2014 we'll see who is right.

  • Report this Comment On December 16, 2013, at 11:52 AM, snowday97 wrote:

    This article is a mere assumption. They plan to buy those new aircrafts in the future.

    It's NOT like they purchased whole planes at one time. I'm sure they have an agreement where they could adjust the deal or cancel in a case of hardship in an economic. (They're professional)

    GOOD with new planes: they would save oil expense; It would help to cover the expense of purchasing new planes.

    EXPERIENCE: both AAMRQ and LCC ( AAL, american airline's mergers) have previous experience in combining air lines.

    LCC was a merger in 2005, had gained 200% by the end of the year; In 2006, due to economic fall, all airlines fell, none of them could have avoided that. AAMRQ was a merger as well.

    They both have experience in this field. It would work out WELL, very well and precisely.

    That's why all experts are expecting a potential gain in AAL than any other airlines. Right now, it's so under valued. And did you know AAL has a less debt than DAL and UAL?

  • Report this Comment On December 16, 2013, at 11:56 AM, snowday97 wrote:

    You stated DAL as an example of bad case in merged deal where they bought new planes.

    They would have done BETTER if it was the economic fall, which started in 2006. If it wasn't , then DAL would have made a significant gain

  • Report this Comment On December 16, 2013, at 1:18 PM, TMFGemHunter wrote:

    @snowday97: I don't understand your second comment. As for your first comment, American has some level of flexibility to defer or accelerate aircraft under its purchase agreements, but if it had to cancel a significant portion of the order, it would likely face significant penalties. AA will certainly save some money on fuel expense to cover the cost of the new planes, but the company still has to put up an enormous amount of capital in the next 10 years to cover its purchase commitments. Whether the new planes pay off will depend a lot on where fuel prices and airline demand go.

    @meched49: Absolutely; I never disputed that the new aircraft will be more fuel efficient. By the end of the decade, AA may be able to boost fuel efficiency by 15% fleet-wide, saving around $2 billion annually at current fuel prices. But it will also be paying about $2 billion more in aircraft rent, depreciation, and interest expense. $2 billion is still $2 billion, regardless of whether you are spending it on fuel or planes.

    Saving fuel is great when you can do it in a way that minimizes CapEx. Spending tens of billions of dollars on new planes is a more risky proposition. It might work out, but it could also go horribly wrong in the end.

    Adam

  • Report this Comment On December 16, 2013, at 1:55 PM, ExitOnBir wrote:

    Meanwhile, air travel will grow significantly between now and 2020 (30-35% in aggregate perhaps more). Ticket prices will also increase and assuming there is some level of success integration, there will be savings. If you do the math, it actually looks like AAL is set to make some big bucks on the base case scenario.

    If renewing the fleet was such a bad idea, we would be all flying in turbo propellers made in 1956.

  • Report this Comment On December 16, 2013, at 2:26 PM, jwinske wrote:

    I think the "Fool" is way off on this one. AAL is going to be a huge hit with the market and those of us who took the risk a month ago or so will be greatly rewarded. First time I've seen the "Fool" so lost in his predictions.

  • Report this Comment On December 16, 2013, at 5:30 PM, TMFGemHunter wrote:

    @ExitOnBir: I didn't say that airlines should never replace planes. The best strategy is to gradually replace planes, at perhaps 4%-5% of the fleet each year. By contrast, replacing essentially the entire fleet in 10 years is hard to justify, when the useful life of a commercial jet is 25-30 years. It's a lot of capital that needs to be used productively not just next year, but in 20 years to be worth the investment.

    Air travel globally could potentially grow 30% by 2020, but U.S. air travel certainly won't grow that quickly. Delta and United have both stated that to properly match capacity to demand, they need to grow capacity at less than the rate of GDP growth. If GDP is growing 2%-3% annually for the next 7 years (on average), that means airline capacity should be up no more than 10%-15%, at least for the major carriers.

    Adam

  • Report this Comment On December 16, 2013, at 11:05 PM, justfun wrote:

    I do not care for AAL puchase airplane now or later...the only thing that happen to me is I puschased 55000 shares of AAMRQ at $1.23 and sold all of them at $12.45 I love this company.

  • Report this Comment On December 17, 2013, at 10:44 AM, maholder wrote:

    very much a stretch to turn this into some negative. The big issue with this article is that price matters. Show me a stock trading at 15x earnings and I'd be concerned about spending too much capital on planes... show me a stock trading half that value and I'm less concerned. AAL needs new planes....

  • Report this Comment On December 17, 2013, at 12:24 PM, TMFGemHunter wrote:

    Mark: are you looking at trailing earnings or forward earnings? AAL's pretax adjusted net income in the last 12 months is a little over $1.5 billion. That puts it at 13 times pretax earnings. I don't know if AAL will have a tax valuation allowance at the end of the year (American did, US Airways didn't), but without the valuation allowance, AAL is trading for 20 times after-tax earnings.

    Now, I think AAL is likely to make some progress on earnings next year. But it's still a double-digit forward multiple if the company is accruing a normal tax rate.

    I absolutely agree that price matters. But AAL, if not clearly overvalued, is at least borderline.

    Adam

  • Report this Comment On December 17, 2013, at 5:12 PM, TrendyHendy wrote:

    I think a lot of the commenters are missing the point. The "Fool" is not doubting this run can continue for 12 months, but is it sustainable for 12 years? Or will AAL be declaring bankrupcy again in 2020 because it can't get out of its 2+bn capital commitments just to new planes?

  • Report this Comment On December 17, 2013, at 5:25 PM, SkepikI wrote:

    If anyone expects these two airlines together to make more money than they have before, I hope their customer service and flight experiences have improved a whole heck of a lot in the past 3 years and will continue to improve....

    I never fly either one if I have a choice. I determined about a decade ago that these were the two WORST airlines in the business and have seen nothing to change my mind. Of course, since I quit flying on them except for the rare force, I wouldn't see it if they had.

    How about it you American and US Air flyers? I love a good turnaround story....

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