American Airlines Group, Inc. Is Not Invincible

Airline investors have been incredibly excited about the recent merger of American Airlines Group, Inc.  (NASDAQ: AAL  ) and US Airways. For the past year, a steady drumbeat of positive analyst commentary has driven their stock prices higher and higher.

It's true that consolidation is helping the whole airline industry become more profitable, and the American Airlines bankruptcy and merger have vastly improved its cost structure compared to the other legacy carriers. However, American is not invincible. This point may seem obvious, but it has been lost amid all the hype recently.

In other words, American Airlines is still subject to the vagaries of supply and demand, the risk of fuel price spikes, and weather-related disruptions. This week, it showed its first signs of vulnerability, cutting its Q1 earnings guidance. As more signs of fallibility creep in, the bubble in American Airlines stock could keep deflating.

Analysts are still too bullish
Last month, I argued that analysts' expectations for American Airlines had grown too lofty. At the time, I pointed out four discrete headwinds that the carrier faces. These headwinds will ramp up over the next several quarters and could offset much of American's merger synergies by early 2015.

American will face increasing competitive headwinds as 2014 progresses. Source: American Airlines.

Despite various warning signs, analysts have continued to offer unvarnished praise of American Airlines. Last week, one Wall Street analyst team took the time to create a list of "100 distinct reasons to be bullish on the stock." This week, another analyst team upgraded American and provided 10 reasons to buy.

Ultimately, most of the bullish cases are built on the theory that airline earnings multiples will expand over time to reach the market average. This certainly could happen, but it's far from guaranteed. Airlines face a lot different risks than the average industrial company, so it's reasonable for investors to demand a discount to invest in an airline.

Chinks in the armor
Weather is one of the significant risks faced by airlines. Like many other airlines, American was forced to cancel thousands of flights last quarter due to bad weather -- more than 34,000, in fact. In March, the company hinted that this extraordinary number of flight cancellations would weigh on Q1 profitability.

On Tuesday, the company quantified the impact of bad weather as a $115 million revenue loss and a $60 million reduction in operating profit. As a result, American had to reduce its operating margin guidance to 5%-7%, from an initial guidance range of 6%-8%. This will force analysts to reduce their Q1 earnings estimates.

Looking ahead
Even with the guidance reduction, American's ability to post any profit at all in the seasonally weak Q1 is a testament to the reform of the airline industry. In Q2, which is much stronger seasonally, American is likely to post a big profit.

However, analysts already expect a profit of more than $1 billion for this quarter. As a result, even if American Airlines provides a very strong guidance when it reports earnings later this month, it won't be a surprise. Analysts have already built a best-case scenario into their estimates.

Foolish wrap
American Airlines is well-positioned to see a significant improvement in profitability this year as it benefits from merger synergies and an historic low in competition. However, investors should keep their excitement in check. While American Airlines has a lot of things going for it today, it still faces plenty of risk.

Last quarter, bad weather disrupted American's operations and the result was a 1 percentage point reduction in its operating margin. While it's impossible to know what the next challenge will be for American Airlines, there will inevitably be something. That's just the nature of the airline industry.

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Read/Post Comments (7) | Recommend This Article (4)

Comments from our Foolish Readers

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  • Report this Comment On April 08, 2014, at 5:39 PM, Dagoldbaum wrote:

    C'on!! This article has to be one of the more useless pieces of.........literature I've ever seen come accross in The Motley Fool!!!

    AAL isn't invincible: Who is?

    Airline industry is very competitive:Which isn't?

    Weather is a risk factor in the airline industry.

    Wow!!!What else is new??

    Challenges are ahead:Isn't that the nature of any business venture?

    I'm sorry but to me the author is simply trying to put doubts to the fact that AAL has been so far a very

    successful business story after its recent merger.

    He attempts to do this,with out a single solid argument,using all sorts of generalities that could apply to any type of business segment whatsoever.

    Poor article with no depth!!!

  • Report this Comment On April 08, 2014, at 11:15 PM, classic216 wrote:

    Jim Cramer is betting his reputation on this stock.

    He has reiterated "buy American Airlines" more often than anything else.

  • Report this Comment On April 09, 2014, at 9:48 AM, TMFGemHunter wrote:

    @Dagoldbaum: Of course this SHOULD all be obvious. But there are a lot of Wall Street analysts who are getting paid the big bucks but are going to be blindsided in the next year or two by all of these obvious risks.

    Adam

  • Report this Comment On April 09, 2014, at 1:55 PM, Dagoldbaum wrote:

    Thanks Gemhunter,but if that's the point,then the article should have been addressing the whole airline industry,and not just AAL.

    Again,the article in question doesnt tell us anything we dont already know.

    It simply shows a negative bias against one particular airline.

    It just makes me wonder why.

  • Report this Comment On April 09, 2014, at 5:20 PM, TMFGemHunter wrote:

    @Dagoldbaum: People have accused me of having a negative bias against other airlines!

    Really, I don't have a dog in this fight. The reason why I'm targeting American Airlines specifically in this post is that Wall Street seems so outrageously bullish about AA right now. I think it's a fine company, but it's not a screaming buy.

    I'm focusing on the negatives to put the positives (which certainly do exist) into perspective. Read what bulls are saying about American Airlines, read what I've written here and in the other article I linked to, and decide for yourself.

    Adam

  • Report this Comment On April 09, 2014, at 5:34 PM, BillS wrote:

    While it might be a darling of many investors right now for a variety of reasons, in the longer term you also need to treat the customers well. Just yesterday, they made major, without-notice changes that hurt many of American's high-dollar frequent flyers (and other customers, too). Most of those customers realize that the frequent flyer points need to be less valuable given the management of inventory, the objection is that the changes were implemented without notice and without a summary of those changes. Customers need to really dig to find out what's changed.

    At some point, those customers will up-and-leave going to carriers that provide FAR better customer service, like Delta (which has garnered long-term value from treating customers well). Given Doug Parker's reputation and the reputation of US Airways (who's running the show), I fail to see that this company is being managed to treat the customers well in a commodity market.

    I am NOT buying for the long term.

  • Report this Comment On April 10, 2014, at 9:56 AM, Dagoldbaum wrote:

    BillS makes a good point when he states that air travel has become a commodity,specially when we are seeing that the bigger airlines all have occupancy rates over 80pct,people are complaining less ,and people keep on flying,even if service has not improved.Passengers are starting to assume mediocre service as a given in the airline industry.

    They simply want to go from point A to point B safely

    and on time ,as flying in todays world is no longer a pleasure but a necesity.No one expects to be pampered by an airline any more,people just want efficiency.

    Given these facts,the success in the airline business

    will also need to meet the following criteria:

    Size,and the ability to serve the most routes within

    their own network.

    Convenient departure times with prompt

    execution,specially for the growing business tavel market.

    All these factors point and favour airlines like DAL

    And specially AAL for stable and consistent growth.

    Once the synergies of the recently merged American and US Airways start to kick in,margins will definitively improve and this will derive in p/e expansion for the stock.

    With increasing seat demand,specially for the business travel segment,look for big airlines to do very well in this commoditized industry.

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