Airline investors have been incredibly excited about the recent merger of American Airlines Group, Inc. (AAL 0.94%) 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.
