Why You Should Be Terrified of the American Airlines Euphoria

Euphoria is the best word to describe what's happened to American Airlines (NASDAQ: AAL  ) stock since the company's merger with US Airways. In just three months, American Airlines shares have soared more than 50%, reaching a new high just short of $40 earlier this week.

AAL Chart

American Airlines Stock Chart, data by YCharts.

This came after the company's valuation had already risen more than 50% between when the merger was announced in early 2013 and when the merger closed near the end of the year. All in all, American's market value has grown from an estimate of $11 billion last February to $28 billion today.

While this has happened, analysts and investors have continually increased their expectations for the new American Airlines' earnings. This cycle of rising expectations and a rising stock price is unsustainable. American Airlines stock is likely to correct sharply lower later this year as reality sets in again.

Expecting a record profit
Last year, American Airlines reported a solid profit of $1.95 billion before special items. That was vastly higher than the company's 2012 adjusted profit of $407 million, primarily due to cost savings related to American's bankruptcy filing, as well as profit growth at US Airways. (All of these figures combine the results of American Airlines and US Airways.)

American Airlines earned a solid profit of nearly $2 billion last year. Photo: American Airlines.

American should be able to build on that profit in 2014 as it realizes additional cost savings from the bankruptcy process, replaces inefficient aircraft with better planes, and reaps early revenue synergies from its expanded network.

However, many analysts and investors are now looking for a lot more than "earnings growth." Analysts surveyed by Bloomberg projected on average that American Airlines will nearly double its profit this year to $3.5 billion! These bullish estimates seem out of control.

First signs of trouble
To some extent, the rapid rise in investor expectations was driven by the strong Q1 guidance that American provided in late January. At that time, the company projected a 6%-8% Q1 operating margin.

Earlier this week, American Airlines released its February traffic statistics, and the company noted that it had canceled 28,000 flights in the first two months of the year. American reiterated its unit revenue guidance but cautioned that costs would come in higher than expected. Despite this disclosure, the average analyst EPS estimate has barely budged, dropping just $0.01.

Four specific headwinds
Looking ahead, American Airlines faces four particular demand-side headwinds that will hit in the next year or two -- leaving aside the risk of integration problems. These all involve increased competition in markets where American is particularly strong.

1. A real competitor in London
First, since creating a joint venture with British Airways several years ago, the American Airlines/British Airways alliance has dominated travel between the U.S. and London's Heathrow Airport. Most notably, the two partners offer 17 daily nonstops between New York and London, including 12 nonstops on the JFK-Heathrow route. This is by far the most important international route for business travelers from the U.S.

Delta is boosting its presence on the New York-London route through a joint venture with Virgin Atlantic.

However, Delta Air Lines (NYSE: DAL  ) recently received antitrust approval for its joint venture with Virgin Atlantic. Later this month, the two carriers are implementing a coordinated schedule consisting of nine daily roundtrips between New York and London.

Delta still can't match the presence of American and British Airways on this route. However, its new joint venture makes Delta a lot more competitive. Combine this with Delta's brand-new terminal at JFK Airport and a leading position in the New York air travel market, and Delta is in a position to win market share among profitable business travelers.

2. A new threat in the transcontinental market
Second, American is the clear market leader on the busy transcontinental route from JFK Airport to Los Angeles, as well as a major player on the route from JFK to San Francisco. These routes have very high fares, and American is deploying its brand-new A321T aircraft on both routes. With 10 first class seats and 20 business class seats on these planes, American needs very high fares to be profitable.

However, JetBlue Airways (NASDAQ: JBLU  ) is upping its game in the transcontinental market beginning this summer. Not only is it boosting its economy class capacity by 33% from JFK to Los Angeles and by 59% from JFK to San Francisco, but it's also deploying flat-bed premium seats on those routes for the first time ever.

JetBlue plans to undercut American on price for flat-bed business class seats. Photo: JetBlue.

JetBlue and American will both be using the A321 aircraft on these routes, yet JetBlue outfits them with 159 seats, compared to just 102 seats for American. If rising premium cabin seat inventory on these routes cuts into premium fares, American Airlines could face margin pressure due to its focus on high-fare traffic for the transcontinental routes.

3. New competition in Dallas
American Airlines has also benefited from its dominant position in the Dallas-Fort Worth area ever since Delta closed its rival hub there in 2005. Southwest Airlines (NYSE: LUV  ) operates a focus city at Love Field in Dallas, but it has been banned from offering nonstop long-haul flights at Love Field. This limited its ability to compete with American's massive hub at Dallas-Fort Worth International Airport.

Southwest is adding lots of long-haul flights in Dallas this fall and in 2015. Photo: Southwest Airlines.

However, Southwest will be allowed to fly from Dallas to anywhere in the U.S. starting in October. Within the next year or so, Southwest will start service to 20 new cities from Love Field -- and if it gets access to additional gate space at Love Field, it will add 12 more new destinations.

American Airlines currently has the only nonstop service on many of these routes. It holds a dominant seat share on many of the others. New competing service on Southwest will drive down fares on many of these routes starting in Q4 and ramping up next year.

4. Low-cost carriers arrive in D.C.
Lastly, American will see margin pressure at its highly profitable Reagan Airport hub near Washington, D.C., starting later this year. US Airways has held a dominant share of Reagan Airport slots, and faced very little competition on most of its routes from the legacy carriers that held most of the other slots.

As part of the American Airlines-US Airways merger, the companies had to sell off dozens of Reagan Airport slots to low-cost carriers. JetBlue, Southwest, and Virgin America will all be expanding at Reagan Airport later this year, and most of their new flights will attack American Airlines-dominated routes. More competitors and more capacity will inevitably drive fares lower.

Foolish bottom line
I have great respect for American Airlines CEO Doug Parker and the rest of his leadership team. However, good management cannot change the fact that the airline business is ultra-competitive and has few barriers to entry.

Several artificial barriers to entry that have protected American Airlines are falling this year. Delta and Virgin Atlantic were given antitrust immunity to coordinate schedules, Southwest's base at Love Field in Dallas is opening to long-haul flights, and American was forced to divest slots at Reagan Airport to competitors.

Some of these three big changes -- as well as JetBlue's unrelated decision to introduce a premium cabin on transcontinental flights -- will start impacting American next quarter. However, the biggest impacts will come at the end of this year and through 2015. Investors should steer clear of American Airlines stock until the euphoria wears off and the market starts to rationally weigh the merger benefits against headwinds like these.

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Read/Post Comments (18) | Recommend This Article (4)

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 March 13, 2014, at 3:57 AM, Jakejory wrote:

    Uhmmm, you conveniently left out new Direct China routes out of DFW to Hong Kong, Shanghai and Beijing to destroy your argument and along with the newest most fuel efficient planes of any domestic airlines. Shame on you for ignoring these facts to make your argument.

  • Report this Comment On March 13, 2014, at 5:18 AM, snowday97 wrote:

    PEOPLE - LOOK

    One thing for certain, take a look at all Adam Levine-Weinberg 's articles,

    He always write articles and argues that would make AAL bad.

    BUT AAL has been better . : )

  • Report this Comment On March 13, 2014, at 8:40 AM, jpessin wrote:

    Shame on you your articles are never accurate and have no merit. You left out all the positives.

  • Report this Comment On March 13, 2014, at 8:57 AM, snowday97 wrote:

    I've seen few of his articles before. When he argues he left out all the positive sides. He dis_favor AAL. You can find all his articles and read about them. And you know what I mean.

    Such as....

    All airlines NEED and eventually NEED TO REPLACE old planes , or replace with fuel efficient planes for better.

    All airlines need planes, people, and sky to fly. He argued by purchasing new planes would put AAL under more debt and that could make AAL financially hard. Aren't all air lines needing new planes ? and eventually, they would need to replace old ones or with fuel-efficient ones, but he only picked AAL and wrote how bad they would impact the AAL. I laughed.

    This is fuel-efficient, so in a long term, they actually could reduce oil expense since oil prices are soaring and higher every day.

    (oil $ did drop , good news for all airlines. )

    But he never wrote any good side of it.

  • Report this Comment On March 13, 2014, at 9:17 AM, TMFGemHunter wrote:

    @snowday97: Of course airlines need to buy new planes. But some have already paid for the new planes. And others have figured out ways to limit how much they have to pay. American Airlines is spending tens of billions of dollars in the next ten years to replace its fleet. Obviously that will save fuel costs and some maintenance costs. I don't think AA has bad management. But to ignore the fact that your company has tens of billions of dollars of obligations on its books is not a good idea.

    @Jakejory: If the new routes from DFW to China were a slam dunk, American would have started flying them 10 years ago. These routes will probably lose quite a bit of money upon launch. Right now, the fares being offered barely cover the cost of fuel and the plane, let alone labor, maintenance, commissions, takeoff and landing fees, etc.

    Building the international route network is an important move to ensure long-term competitiveness. It is not a move that will generate profit in the short run.

    Adam

  • Report this Comment On March 13, 2014, at 10:07 AM, mwwestiii wrote:

    If Adam had bought LCC two years ago like I recommended instead of only writing negative articles about the company, Adam would be a wealthier man.

    I bought about 30,000 shares of LCC between $3-8 a share and am still holding the now converted AAL shares at $39. Do the math.

    I'm not terrified. I'm holding to $50+

    Don't listen to Adam.

  • Report this Comment On March 13, 2014, at 10:46 AM, snowday97 wrote:

    Adam, with all respect to you and giving us a nice analysis, well thanks to you.

    But PURPOSELY writing TO DOWNGRADE one stock, it is not worth to even look at it.

    I saw couple of your article regarding AAL, but you wrote it purposely to downgrade it.

    Thanks to your article again, because of your article, AAL is losing today while all airlines are moving forward. I can not think of other causes to drop AAL today;

    LCC & AAMRQ are the merged air lines; They have enough experience with merging two airlines and have done well in the past. I am sure they have experts to determined to purchased new planes with ways of finance to support the deal.

  • Report this Comment On March 13, 2014, at 10:47 AM, TMFGemHunter wrote:

    @mwwwestiii: FYI: I did buy LCC two years ago (actually it was a little more than two years ago) for less than $5/share. I sold the stock way too early: definitely a mistake, but it happens. (I thought about selling HP stock for $48 in early 2011 and didn't. It took me until recently to get back to breakeven on HP. I regret that one a lot more than selling LCC too early!)

    It's certainly possible that the momentum wave will continue and AAL will hit $50. But I don't for a minute believe that the company will be able to generate the long-term earnings necessary to sustain a stock price at that level.

    Adam

  • Report this Comment On March 13, 2014, at 10:52 AM, TMFGemHunter wrote:

    @snowday97: I seriously doubt that this article is having any impact on the market. I do not think that many of the hedge fund and institutional investors who have billions of dollars invested in AAL read articles here to make their buy/sell decisions. Anyway, of the airlines I track, about half are down today.

    I write my articles to give investors my perspective. The reason why most of my articles about AAL are negative or cautious in tone is simply because I think the stock has been overhyped. That's just my opinion; take it or leave it. I don't have any financial interest in what happens to AAL stock one way or the other.

    Adam

  • Report this Comment On March 13, 2014, at 11:29 AM, snowday97 wrote:

    @ADAM, no hard feeling against you. well, I'm sorry I think I was bit of zerg.

    Anyway, thanks for analysis, even though, I do not like it; but I can keep it as reference and would help to evaluate later.

    AAL dropped about 0.5% or more or less, I don't think there's the hedge fund or institutional investors move here, but individual investors are moved by your article.

    All airlines were up while AAL was only one in downside.

    As time goes by, all 3 major index dropped, seems investors are leaving some of their portfolio. And so did all airlines dropped too. But this morning, I can't think of any other cause

    .

    I do believe your article do and can influence other individual investors.

  • Report this Comment On March 13, 2014, at 12:19 PM, mwwestiii wrote:

    OK Adam, here's an exercise for you...

    Explain why AAL should not have a market cap equal to DAL and what the AAL stock price should be if it does.

    Please don't include any reference to the stupid refinery purchase made by DAL that they flushed $200 million down the toilet.

    One reason AAL is down today is because of the new stock distribution to bondholders.

  • Report this Comment On March 13, 2014, at 1:17 PM, GeoGecko wrote:

    I am totally confused! MF has very recently done nothing but blow their horn for AAL discussing how wonderful this merger is and how it has enlivened the airline stocks.

    Now, if I don't sell every share I own and heed the 'terror' around the bend I'm the fool.

    So which is it?

    Could this recent dip be due to very short term influences, e.g. stock distribution, oil, weather ?

    If I read your other articles correctly I should be just fine with AAL in the long term. Or is this really about over managing my account?

  • Report this Comment On March 13, 2014, at 3:06 PM, bridani wrote:

    Adam,

    Nice pictures, but horrible article. You left out many things and just tried to destroy AAL's image.

    Go back to school before you write an analysis again. Say that the airline industry has few berries to entry was not very clever.

  • Report this Comment On March 13, 2014, at 3:18 PM, TMFGemHunter wrote:

    @GeoGecko: We (as in Motley Fool writers) aren't told by the company to write. We are supposed to honestly provide our own analysis. I know that some of my colleagues are very bullish on AAL; obviously, I am not.

    You should take all of our articles into account when thinking about your investments and decide which ones you find the most convincing. You definitely should NOT be buying and selling based on any one article on Motley Fool. We are very much long-term oriented: thinking in terms of how stocks will perform over a period of many years not days or months.

    @mwwwestiii: That's a great question. If AAL had the same market cap as DAL, that would make the stock worth about $40 (I'm rounding here). But it isn't worth nearly as much as DAL in my opinion, and the reason is simple: free cash flow. FCF is the cash generated by the business in a given year, after taking into account capital expenditures.

    Over the next 5 years, I expect Delta to average at least $2-$3 billion in FCF annually, because it has very modest CapEx and is on pace for about $5 billion in operating cash flow annually. That's $10-$15 billion over 5 years. This money can be used for debt reduction, dividends, or share repurchases.

    Over the next 5 years, I expect AAL to produce zero free cash flow, plus or minus $5 billion. Here's why: while AAL may reach roughly the same amount of profitability as Delta, it needs massive CapEx to get there. Aircraft purchases alone average nearly $4 billion annually through 2018, and will remain high until at least 2020. (This is on p. 81 of the 10-K SEC form filed two weeks ago.)

    This, along with other routine capital expenditures, will soak up more or less all of American's operating cash flow. There may be some token dividend starting in a couple of years, but AAL simply won't have much extra cash at all. At some point after 2020, as the fleet renewal winds down, AAL could become a cash cow business. However, in the mean time, Delta will probably have returned something like $15 billion to shareholders.

    Adam

  • Report this Comment On March 14, 2014, at 12:03 PM, GeoGecko wrote:

    Adam,

    Based on your DAL FCF scenario, I suspect their advantage over AAL (and others) will be significantly lessened when you take into account DAL's announcement today concerning a huge aircraft order to replace a majority of their widebody fleet.

    The 747-400 and 767-300 fleets are their oldest.

    Thoughts?

  • Report this Comment On March 14, 2014, at 1:42 PM, 5eagles wrote:

    mwwestiii...I don't know where you got your information, but DL management doesn't "flush" anything down the toilet. Especially $200 million. The refinery is already profitable!

  • Report this Comment On March 15, 2014, at 11:24 AM, TMFGemHunter wrote:

    @GeoGecko: The reports I have seen on a potential Delta widebody order are very sketchy so far. I am skeptical that they are actively looking for a 747 replacement, although it is possible. Delta has 16 747s, of which 10 are really old and the other 6 were built between 1999 and 2002. I would expect those 6 newer ones to fly for at least another decade, while the 10 older ones are ripe for retirement. But Delta ordered 10 A330-300s last year, which arrive starting next spring. I was assuming (and still believe) that the A330s will replace the older 747s. They are about 20% smaller in terms of seating capacity, but Delta hasn't been very interested in jumbo-jets recently.

    As for the 767s, there are a lot of aircraft coming up for replacement in the next 10 years: maybe 50-60? (I think Delta could have some 767s flying until 2030 or thereabouts.) But Delta's total aircraft commitments at this point are $9.1 billion, which includes 18 787s scheduled for delivery after 2020. By contrast, American's aircraft purchase commitments are at $35.9 billion. You could add 60-70 widebodies to Delta's order book and it would still have half the CapEx of American. American is basically buying an entirely new aircraft fleet in the space of 10 years: that's going to soak up nearly all of its cash flow.

    Adam

  • Report this Comment On April 08, 2014, at 3:53 PM, THE wrote:

    LOL U forgot at every station the terminal realestate is $$$$$ expensive and a combinded airline they are going 2 need a lot less also less managment and employees at every station LESS + all the things everyone mentioned above so I think U are wrong

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