Please ensure Javascript is enabled for purposes of website accessibility

American Airlines Investors Should Worry About Leverage

By Adam Levine-Weinberg – Feb 27, 2017 at 8:40AM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

American Airlines' management may be too optimistic about the company's future profitability -- and American is taking on too much debt for comfort.

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 (DAL 8.81%) has worked hard over the past seven years to reduce its debt. By contrast, American Airlines (AAL 8.64%) 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.

An American Airlines plane

American Airlines has a huge amount of debt. Image source: American Airlines.

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.

DAL Operating Margin (TTM) Chart

American Airlines vs. Delta Air Lines Operating Margin (TTM) data by YCharts.

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.

Wishful thinking

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.

A Delta Air Lines airplane

Delta has lots of old planes that it could retire if demand plummets. Image source: Delta Air Lines.

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.

Adam Levine-Weinberg owns shares of Delta Air Lines. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

American Airlines Group Inc. Stock Quote
American Airlines Group Inc.
AAL
$12.95 (8.64%) $1.03
Delta Air Lines, Inc. Stock Quote
Delta Air Lines, Inc.
DAL
$30.75 (8.81%) $2.49

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning analyst team.

Stock Advisor Returns
331%
 
S&P 500 Returns
106%

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 10/05/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.