American Airlines Earnings Fly Higher, but Delta Is a Better Buy

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.

American reported strong Q1 earnings despite severe winter weather. Source: American Airlines

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.

Southwest Airlines will be expanding in some key American Airlines markets later this year. Photo: The Motley Fool

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.)

By economizing on capital spending, Delta is producing billions of dollars of free cash flow. Photo: The Motley Fool

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.

Foolish wrap
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.

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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 April 29, 2014, at 10:50 AM, MaverickFlyer wrote:

    Adam,

    Greetings! Nice article (as usual), as enjoy reading your work product. Albeit DAL has a head start on AA from the merger standpoint and has had their IT systems and such in line for a period of time, strategy alignment and such - they definitely have made a turnaround and are a great competitor.

    From AA's standpoint - they are not the only one that has competition from WN and VX - and those market studies in the DFW area have concluded that any increased competition from Dallas Love Field, whether from WN or VX, will be nominal to AA's presence and market share in Metroplex. AA is much stronger now and has a new management style that 'competes' and does not 'retreat' as first course of action, point to be noted. I am not of the opinion that it will be 'difficult' for AA to compete with WN or VX, or other competitors for that matter. And for DAL's competition, how about WN in ATL, what are your comments there on how WN has taken market share from DL in ATL - really no difference there in ATL with DAL and WN, than DFW area - with AA and WN - just two different airports.

    AA has picked up a huge amount of volume with the merger as now being the #1 airline in Eastern US, #1 in Central and greatly strengthened presence on the West Coast - they would be foolish not to capitalize on increased revenue with this growth, Intl growth and other components that will bring them back to prominence in the industry.

    Maybe AA and DAL have taken two different paths, and has been noted that AA management is taking a page out of DAL's book in merger integration and such, especially since Doug Parker has much experience in this area.

    Definitely think DAL is a good buy, but also think that AA is a good buy too, and will be interesting to see the continued outcome of the legacies ahead.

    As usual, good article - thanks for sharing.

    Maverick

  • Report this Comment On April 29, 2014, at 12:24 PM, anindakumars wrote:

    As a customer, I try my best to avoid flying United, AA and US Air in order. So its a no-brainer for me whether to buy this stock or not. If I a direct customer is not satisfied with a business, why would I own a part of it. Foolish thought I suppose :)

  • Report this Comment On April 29, 2014, at 12:38 PM, mwwestiii wrote:

    Adam...have you ever written anything positive about LCC and AAL over the past five years? Your glass is perpetually half-empty while the stock has significantly outperformed DAL over the same time frame.

    And that's why you want people read your articles isn't it? To make money?

  • Report this Comment On April 29, 2014, at 4:12 PM, ferdiefor wrote:

    I hold a significant number of shares of AAL and I do appreciate getting the glass half full analysis because I can use the information to determine how much of it is relevant as we move forward.

    There is a lot of apprehension in AAL because UAL was looking very good after its merger until it wasn't looking so good anymore.

    I don't think the Dallas and DC competition will become a major threat to AAL but it is worth mentioning.

    I think the writer likes putting those impressive pictures of planes in his articles.

    I also own DAL and I overweight DAL 5 shares for every 4 shares of AAL.

  • Report this Comment On April 29, 2014, at 5:31 PM, mwwestiii wrote:

    Which is the better buy?

    For five years Adam has been consistently negative on LCC/AAL.

    Go look at the five year chart and ask yourself, which was the better buy? Which stock would you have rather owned?

    My bet is AAL will continue to outperform DAL for the next five as well.

  • Report this Comment On April 30, 2014, at 10:30 AM, TMFGemHunter wrote:

    @mwwwestiii: Yes, I have written positive things about LCC/AAL in the past. And since I purchased LCC stock less than 3 years ago, your statement is false on its face. In 2012, I sold that stock and rotated into Hawaiian Airlines and Delta. To be honest, all of those stocks have done incredibly well in the last 2 years. But I think that HA and DAL will do better in the long run. As I discussed in the article, American has too much deferred CapEx coming up in the next 5 years or so to make it an enticing investment for me.

    @Maverick: I am sure there will be opportunities for AAL going forward, and hopefully in May I will be able to write something about that. However, from AA's perspective, they are just trying to optimize what they are doing to make small improvements here and there.

    By contrast, Southwest has been unable to fly these competing routes due to regulatory reasons. So Southwest has a whole portfolio of new opportunities opening up to go head to head against American (and also United). American is almost by definition playing defense on these routes where it has never had serious direct competition before.

    Adam

  • Report this Comment On April 30, 2014, at 10:45 AM, TMFGemHunter wrote:

    @mwwwestiii: I just went back and looked, and I wrote an article saying to take profits in LCC in July 2012 when the stock was at $14. http://seekingalpha.com/article/707041-time-to-take-profits-....

    Obviously, the stock (and the business) has done much better than I expected since then. However, Delta has done even better than that -- it was around $10 at the time and has since gone to $36-$37. Even airlines that have major problems have had great stock performances in the last year and a half. That's just because investors have gone from hating the airline sector to loving it in a very short period of time.

    Adam

  • Report this Comment On April 30, 2014, at 11:00 AM, mwwestiii wrote:

    Adam, one of the reasons almost all analysts missed the move in airline stocks is they never actually worked in the airline business. I just viewed your profile and see your education was in Political Science.

    LCC was a client of mine back in the 1990s and our firm also did extensive business with American. We specialized in performance improvement programs for airline employees.

  • Report this Comment On April 30, 2014, at 11:17 AM, mwwestiii wrote:

    What I learned along the way was analysts tend to look backwards and focus on (superficial) things like route structures and competition, gates, etc., to write their recommendations.

    AAL CEO Doug Parker and his execs aren't managing their company like the analysts are following the company. Many are drawing conclusions from the wrong metrics because the industry has fundamentally changed.

    Adam...how many LCC/AAL earnings conference calls have you been on over the past three years?

  • Report this Comment On April 30, 2014, at 5:20 PM, MaverickFlyer wrote:

    Adam,

    To your response -

    "@Maverick: I am sure there will be opportunities for AAL going forward, and hopefully in May I will be able to write something about that. However, from AA's perspective, they are just trying to optimize what they are doing to make small improvements here and there.

    By contrast, Southwest has been unable to fly these competing routes due to regulatory reasons. So Southwest has a whole portfolio of new opportunities opening up to go head to head against American (and also United). American is almost by definition playing defense on these routes where it has never had serious direct competition before."

    I would give AA more credit than making just small adjustments here and there - as totally not the case, as they are a much different competitor now, with their merger, and post BK, than they were before - highlighted by a much more aggressive and proactive management team.

    And I don't think that AA will just sit by and let WN or anyone else just 'take' market share from them on any routes - as yes, may be new competitors on certain routes - but AA also has inputs and opportunities for countering competition and upping the game as well.

    Definitely think you need to be giving AA more credit than you are perceived in giving them, as indicated by the responses in this chain. WN is coming upon its own problems with labor negotiations, plane shortages for routes, WN/AirTran integration issues and more - as their customer service/on time numbers have gone down over the period of time, amongst other issues.

    Maverick

  • Report this Comment On May 01, 2014, at 12:58 PM, TMFGemHunter wrote:

    @Maverick: We'll just have to agree to disagree. I think you're giving AA too much credit -- things like competition are totally out of their control. It's not that they're doing anything wrong -- it's just that the market is changing around them.

    What inputs do you think AA has that would allow it to make more money on routes where it faces direct competition than it made without direct competition?

    From my perspective, AA has two main choices. 1) Add flights on the routes where it's getting new competition and drop prices. This would mitigate market share loss but lead to a huge drop in margins. 2) Cut flights on the routes where it's getting new competition and try to keep fares up. This would lead to a bigger drop in market share and a smaller drop in margin (but still a drop).

    If there's a third way, I don't see what it is.

    @mwwwestiii: I've listened to every single conference call. I've been following the airline industry intently for 10 years, and I think that's enough to have a reasoned opinion.

    In any case, you are conflating two completely different things: 1) how airlines perform; and 2) how airline stocks perform. Having a background in the airline industry might help a bit on part 1, but even then it's important to remember that the airline industry has changed dramatically in the last 5-10 years.

    In the short term, part 2 has very little to do with understanding airlines and a lot to do with understanding market psychology. United Airlines stock has more than doubled in the last 3 years even though its earnings have fallen and it has gone from near the top to near the bottom of the industry in terms of profitability.

    Adam

  • Report this Comment On May 01, 2014, at 1:00 PM, FrankoJames wrote:

    I wonder if DTV could purchase GOGO today just for fun... Fool on travelers...

  • Report this Comment On May 01, 2014, at 1:13 PM, MaverickFlyer wrote:

    Adam,

    Well, guess we will just agree to disagree. You seemingly (as others as well) seem to give WN all the accolades as the darling of the industry - and in fairness to all the other carriers, they are doing a lot more than WN in a lot of areas.

    Yes, market is changing around AA, but think they will be more aggressive now than the Horton days, and make proper adjustments in support of the market, market share, competition, etc. They are much (seemingly) proactive now than the pre-BK days. So, we will see.

    Yes, would like to see more articles from Motley Fool on positives from other airlines as well, and not just all the things that WN may be doing, or not.

    Give airlines credit where it is due!

    Thanks for the back and forth, on this subject - we will just agree to disagree.

    Good stuff! - Robert

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