American Airlines Group (NASDAQ:AAL) posted incredible profit growth in the first couple of years following its merger with U.S. Airways. Merger synergies helped a bit, but the bulk of the profit growth was driven by a sharp decline in oil prices -- along with management's savvy decision to avoid fuel hedging. In 2015, American's year-over-year fuel cost savings exceeded $5 billion.
American Airlines' profitability has receded quickly since then. The carrier posted a pre-tax margin of 15.3% in 2015, but it would be lucky to achieve a 9% full-year pre-tax margin this year.
Nevertheless, American's management is confident about the future. Many investors seem to agree with this bullish outlook, particularly because the carrier's revenue per available seat mile (RASM) returned to growth more than a year ago. However, I'm not convinced yet that American Airlines' recent pace of unit revenue growth is sustainable -- or that it will be sufficient to drive strong profit growth.
Management is bullish
American Airlines shares have been dead money over the past three years, because of the company's inability to sustain its 2015 margin performance. Apart from a brief Brexit-related swoon in mid-2016, the stock has been bouncing around in the $40-$50 range for years.
CEO Doug Parker and the rest of the American Airlines management team have urged investors to take a long-term perspective. At its investor day back in September, the company unveiled a variety of initiatives designed to boost annual earnings by $3.9 billion, with most of the increase coming in the next two years.
In fact, Parker believes so much in his company that he apparently bet a hedge fund analyst a bottle of wine that American Airlines stock will reach $60 by next November. That would represent a 23% return from the stock's Tuesday closing price of $48.65.
Less than meets the eye?
Given American Airlines' declining earnings power, there isn't much hard evidence to support management's bullishness. The only thing that stands out in a good way is the company's RASM performance. American has posted RASM growth for four consecutive quarters, outperforming the industry average, especially struggling rival United Continental (NYSE:UAL).
That said, much of American's recent RASM growth can be attributed to easy comparisons. Through the first three quarters of 2017, American Airlines posted RASM of 15.11 cents. That was up 3.3% year over year, but down nearly 7% from 16.20 cents in the first nine months of 2014.
For comparison, United Continental's RASM was 14.34 cents through the first nine months of 2017, down about 10% from 15.92 cents in the same period of 2014. The difference in the two carriers' performance is almost entirely tied to United's much larger footprint in the transpacific market, where unit revenue has been under pressure for several years.
In other words, looking at its revenue performance over a multiyear period, American Airlines is only doing slightly better than United Continental. That isn't saying much.
Is American's unit revenue growth sustainable -- and will it be enough?
Last quarter, American's RASM growth slowed to 1.1%. However, management blamed that on a particularly tough year-over-year comparison and repeatedly asserted that RASM growth would be stronger in the fourth quarter.
Sure enough, the company's Q4 forecast calls for a 2.5%-4.5% RASM increase, roughly in line with its year-to-date trend. However, repeating that performance in 2018 could be challenging. United's recent experience shows that the supposed gains from "commercial initiatives" often don't filter through to the bottom line. Meanwhile, American could face incremental pressure from United's aggressive price-matching campaigns in 2018.
In addition, American Airlines expects its non-fuel unit costs to rise by about 2% in 2018, while jet fuel prices are on pace to increase by about $0.25-$0.30 per gallon. In this scenario, the company would need a roughly 4% RASM increase just to keep its earnings flat next year.
If American Airlines does post RASM growth of 4% or more in 2018, it would be a promising sign that the company has enough pricing power to stabilize its profit margin and eventually return to profit growth. But for now, I'm going to stay firmly planted on the sidelines. There's a real chance that American Airlines' profit margin still hasn't bottomed out.