Last year marked a major event in commercial aviation history, as American Airlines Group (NASDAQ: AAL ) was formed by the merger of US Airways and AMR. There is clearly a lot of potential at the new airline, but what is attracting a lot of attention lately is the airline's $10 billion in cash.
Airlines are in a naturally volatile business, and any use of cash has to take into account the massive capital needs in the industry as well as the cyclical nature of earnings. That said, finding the right balance of saving for a rainy day and generating shareholder returns is the most beneficial strategy for airline shareholders. With $10 billion in cash, American Airlines Group will need to work on striking this balance.
Part of the rebuilding of American Airlines has been a massive fleet modernization initiative. With more than $40 billion in aircraft on order, American has committed a large amount of its capital to the latest aircraft technology. American will probably use a good portion of its cash for these new aircraft to prevent it from having to issue more debt than necessary.
Overall, this fleet modernization should benefit the airline in the long term through reduced fuel consumption and maintenance costs. Additionally, American is building its brand around having the youngest fleet of major U.S. airline. Although it may get in the way of short-term shareholder returns, fleet modernization can be considered a reinvestment in the core business and should still be considered a responsible use of cash.
With the large commitments American has already made to purchasing new aircraft, I tend to favor share buybacks over dividends at this airline. For share buybacks to be accretive for shareholders, they must be done at a reasonable valuation. American is currently trading at a single-digit forward price-to-earnings ratio implying that shares are fairly valued, if not undervalued.
The second part is whether the company is stable enough to execute a buyback without threatening its solvency. Since American has significant earnings power and can set the buyback amount at a level of its own choosing, the airline meets the requirement for the second point.
Buybacks also carry an advantage over dividends in that they can be turned on or off much easier. Buybacks typically run for a certain period of time and for a certain amount of money or shares. At that point, the company can reassess its financial situation and decide whether it makes sense to continue. In contrast, dividends are expected to be either held stable or constantly increased. If a company were to cut or eliminate its dividend, even if its the most financially responsible thing to do, shares would be punished because the market would see a red flag. Launching a share buyback at current levels would give American the ability to grow shareholder value while not committing to a long-term payout.
A similar buyback program was a core part of the capital return plan for Alaska Air Group (NYSE: ALK ) , which continued a share buyback program from long before it initiated a dividend in 2013. Quite likely, Alaska enjoyed the flexibility of a buyback program, especially as a growing airline looking for opportunities.
The place for dividends
Even as I prefer a share buyback over a dividend, I recognize there is an advantage to a dividend. Many funds have a mandate to only purchase dividend-paying stocks -- and paying a dividend, even a tiny one, makes a company's stock eligible to be purchased by these funds.
If American Airlines Group does decide to pay a dividend, expect it to be a small one -- possibly a yield less than 1% as seen at Alaska Air Group and longtime dividend-paying Southwest Airlines (NYSE: LUV ) . In the highly capital-intensive airline industry, large dividends are not something carriers like to commit to, especially considering the volatile nature of airline profits.
Ten billion dollars seems like a lot of money, but for an airline the size of American Airlines Group, this is far from free money to return to shareholders. Over the next several years, American will be taking delivery of hundreds of new aircraft while working to build the world's largest airline.
If American does decide to take additional steps to boost shareholder value, I would expect a share buyback to play a greater role than a dividend because of the current valuation of American Airlines shares and the flexibility available with a buyback. Investors must remember that the airline industry is still a capital-intensive one and that American will almost certainly continue to hold much of this $10 billion as cash.
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