For many years, investors viewed the airline industry as being extremely risky. One of the biggest risks is high operating leverage. This refers to the fact that small changes in revenue for an airline tend to drive big changes in earnings.
One important way to mitigate the risk from operating leverage is to be conservative about financial leverage -- or, to put it more simply, debt levels. A company with a strong balance sheet will have an easier time borrowing money in the event of an economic downturn than one that is already overloaded with debt.
Recognizing this, Delta Air Lines (NYSE:DAL) has worked hard over the past seven years to reduce its debt. By contrast, American Airlines (NASDAQ:AAL) has gone on a debt binge in recent years in order to finance heavy capital investments and share repurchases. That makes American Airlines a very risky investment going forward.
Debt falls at Delta but soars at American Airlines
At the end of 2009, Delta Air Lines had adjusted net debt of $17 billion as a result of years of accumulated losses. As its profitability improved in the next few years, it devoted much of its free cash flow to debt reduction. By the end of 2016, adjusted net debt had fallen to just $6.1 billion. Delta aims to reduce this to around $5 billion over the next few years.
American Airlines has produced much less free cash flow than Delta over the past few years, as it has implemented an aggressive fleet replacement plan. Meanwhile, it has returned more than $10 billion to shareholders over the past three years through share buybacks and dividends.
As a result, its debt burden has been rising precipitously. American's gross debt reached $24.3 billion at the end of 2016, up from less than $18 billion just two years earlier. Adjusted net debt -- measured in the same way that Delta measures its debt -- is even higher for American Airlines, at $26.4 billion.
American Airlines executives would argue that while their company has more debt, it also has higher-quality assets -- i.e., newer airplanes. But even with newer airplanes, American hasn't been able to match Delta in terms of profitability in recent years.
Breaking the cycle?
American Airlines' cavalier attitude toward debt probably stems from CEO Doug Parker's view that consolidation has fundamentally changed the airline industry. Last year, Parker stated, "We have gotten to the point where we, like other businesses, will have good years and bad years, but the bad years will not be cataclysmic. They will just be less good than the good years."
In other words, he thinks that the airline industry will be much less cyclical than it was in the past. With the top four airlines controlling more than 80% of the domestic market, each one has a strong incentive to carefully manage capacity to match demand. That could potentially blunt the impact of future economic downturns on airline profitability.
If that's the case, then operating leverage won't be as big a concern for airlines in the future as it has been in the past. This in turn would make American Airlines' aggressive use of debt seem a lot more reasonable.
The airline industry is certainly a lot healthier today than it was a decade ago. Nevertheless, it's dangerous to assume that American Airlines will remain consistently profitable even in bad times. Parker's optimism may be no more than the unrealistic cheerleading that is all too common among corporate executives.
First, while the U.S. airline industry is highly concentrated today, that could change over time. Indeed, the smaller airlines that collectively make up the "other" 15%-20% of the market are growing much faster than their larger rivals. Collectively, they are likely to at least double in size over the next decade. This will lead to more competition in the future -- and perhaps less capacity discipline.
Second, American Airlines is not in a good position to match supply to demand in a severe downturn. In fact, its fleet renewal efforts could backfire in this respect. Whereas Delta has lots of old planes that it could quickly and cheaply retire if necessary, American Airlines would have to park relatively young (and expensive) planes to achieve the same effect.
This year, American Airlines is facing unit cost pressure just from dialing back its annual capacity growth to 1%. Deep capacity cuts would drive unit costs up much further. This suggests that the carrier actually has limited flexibility to respond to a sharp drop in demand.
At the moment, American Airlines generates plenty of cash to support its high debt level. The carrier probably wouldn't have trouble responding to a small recession, either.
However, a bigger industry downturn -- along the lines of the post-9/11 drop in air travel or the Great Recession -- could create big problems for American Airlines. With a clean balance sheet, Delta Air Lines is ready for anything. By contrast, in a worst-case scenario for demand, American is likely to have trouble managing its massive debt burden.