Last Thursday, American Airlines (NASDAQ:AAL) reported strong earnings growth for the first quarter following its merger with US Airways. Adjusted earnings per share of $0.54 came in slightly ahead of expectations, and the company's adjusted pretax margin increased by 3.6 percentage points year over year to 4.1%.
While American is poised to post strong earnings growth for the full year, it is likely to face increasing headwinds beginning in the second half of 2014. Moreover, it has extremely high capital spending commitments for the next five years or so, which will depress its free cash flow. As a result, Delta Air Lines (NYSE:DAL) is a more attractive investment candidate among the legacy carriers.
Improving but not quite catching up
American Airlines definitely made a strong showing in its first full quarter since the US Airways merger. Q1 tends to be a seasonally weak period for airlines, and American's operations were further disrupted by severe winter weather, which forced it to cancel more than 34,000 flights during the quarter.
In this context, the company's 4.1% adjusted pretax margin was a great result. However, Delta did a little better, with a 5% pretax margin last quarter.
Looking ahead to Q2, Delta will retain its profitability edge and may even widen the gap. Delta has projected that its operating margin will reach 14%-16% in Q2, which would imply a pretax margin of roughly 12%-14%. By contrast, American Airlines is targeting a slightly lower 10%-12% pretax margin in Q2.
Upcoming earnings drivers
American is implementing two key initiatives to improve profitability starting this summer. First, it will retime flights in Miami, Chicago, and Dallas in defined "banks" rather than spread them throughout the day. Second, it will add seats to some of its planes in order to reduce unit costs. These changes could provide $400 million of incremental profit annually.
However, these positives will be offset by several negatives. Most importantly, American will see stepped-up competition later this year in key markets like Dallas and Washington, D.C., from competitors like Southwest Airlines (NYSE:LUV) and Virgin America.
This increase in competition can be attributed in part to the slot and gate divestitures mandated by the Justice Department as part of American's merger with US Airways. Separately, the opening up of Love Field in Dallas will allow Southwest and Virgin America to compete more effectively with American Airlines' megahub at Dallas-Fort Worth International Airport.
These positive and negative earnings drivers will largely offset each other, but I believe that on balance American's earnings growth is likely to come under pressure in late 2014 or early 2015. American Airlines (like its competitors) has seen better unit revenue trends in the U.S. than internationally due to industry capacity discipline here. As American experiences a big jump in domestic competitive capacity later this year, domestic unit revenue growth will decelerate.
Free cash flow is the key
The exact direction of American Airlines' earnings trajectory is impossible to predict. However, investors can be sure that its free cash flow will lag Delta Air Lines' by billions of dollars annually for at least the next five years. This is the biggest reason why Delta is likely to be a more rewarding investment than American.
American Airlines plans to replace nearly half of its mainline aircraft by the end of the decade. On the company's recent earnings call, management estimated that American will spend about $5.5 billion on aircraft each year for the next five years. (The company will also spend about $750 million annually on non-aircraft capital expenditures.)
By contrast, Delta is replacing older aircraft at a much more sedate pace. It plans to generate annual operating cash flow of more than $5 billion for the next few years while reinvesting about half of that in new aircraft, passenger amenities, and IT systems. This will provide at least $2.5 billion of annual free cash flow that can be used for shareholder-friendly dividends and buybacks. (Delta expects free cash flow to exceed $3 billion this year.)
With American Airlines planning to spend more than twice as much on capex as Delta for at least the next five years, it will produce little, if any, free cash flow over that time period, even if it catches up to Delta in terms of profitability. As a result, American will not be able to return nearly as much cash to shareholders until after 2020.
American Airlines and Delta Air Lines are both posting record profits, but Delta Air Lines is a better investment opportunity today even though it has a slightly higher market cap. American's heavy capital commitments over the next five years or so will use up most of its cash flow. The company will also face rising capacity from Southwest Airlines and Virgin America in some key markets later this year.
By contrast, Delta has continued to post industry-leading profit margins while keeping its capital spending at a modest level. This is about to produce a flood of free cash flow that will support higher dividends and a more significant share repurchase program. This makes it the most attractive investment opportunity among the legacy carriers.
Adam Levine-Weinberg has no position in any stocks mentioned, and neither does The Motley Fool. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.