American Airlines (AAL 1.51%) has a very confident management team. CEO Doug Parker and President Robert Isom routinely tell investors that the whole airline industry has been radically transformed -- and that American will never again lose money. Parker even bet a hedge fund analyst a bottle of wine that American Airlines stock will hit $60 by next November.
However, this confidence is based on "faith" more than facts. Quite simply, management seems to be out of touch. That's a very good reason for investors to avoid American Airlines stock.
Playing the long game?
At American Airlines' investor day back in September, management talked a lot about playing the long game. This entails making significant investments in technology, aircraft upgrades, and ground facilities; paying employees best-in-class wages; and continuing to grow the carrier's route network to bolster its future competitiveness.
American Airlines' management believes the carrier has a bright future. Image source: American Airlines.
All of these plans seem entirely reasonable. Indeed, corporate CEOs should be focusing their energy on crafting a long-term strategy, rather than just trying to maximize short-term profits.
The problem in this case is that what American Airlines' management characterizes as short-term profitability issues may in fact be symptoms of deeper, long-term competitive challenges. If so, the company's strategy may not be appropriate to its circumstances.
A shaky record
One sign that American Airlines' management may not be on top of things is its poor forecasting track record. On American's Q3 2015 earnings call, Parker told analysts that industry profit margins might decline in 2016, due to fuel prices being roughly flat while unit revenue fell in response to the flood of capacity that entered the market during 2015. However, he predicted that margins would rebound in 2017 and eventually surpass 2015 levels.
Reality has been a lot different. American Airlines posted a strong adjusted pre-tax margin of 15.3% in 2015. Its average fuel price actually plunged by another $0.30/gallon in 2016, yet its adjusted pre-tax margin still slipped to 12.6%. Year to date, American's adjusted pre-tax margin has fallen by another 4.3 percentage points, putting it on track to end 2017 at 9% or less.
Parker has never really explained what went wrong with his forecast. As a result, it's hard to feel confident that his theory of how the airline industry has been "transformed" is accurate.
There's no reason for investors to trust management
One of the first slides from American's investor day presentation should have set off alarm bells for anyone who owns American Airlines stock. The slide described a "leap of faith" to believing that American Airlines and the industry as a whole "have been materially and permanently transformed."
This was effectively an admission that management doesn't have much evidence to support its view of the world. Investors are just expected to take it on faith. Yet there is no compelling reason anyone should put this kind of faith in American Airlines' current management team.
Leaving aside Parker's botched forecasts about American's likely 2016 and 2017 performance, the company's long-term earnings forecasts are troubling. American Airlines projects that its pre-tax profit will average $5 billion a year, with earnings as low as $3 billion in a bad year and as high as $7 billion in a great year.
However, American Airlines is on pace to end 2017 with a pre-tax profit of around $3.7 billion, and this could hardly be considered a bad year. Jet fuel prices are still well below historical averages, consumer confidence and business confidence are buoyant, and the economy has been growing nonstop for more than eight years. (To be fair, American identified specific initiatives at the investor day that could add billions of dollars to the bottom line going forward -- at least in theory.)
American's pre-tax profit will fall far below its $5 billion long-term target in 2017. Image source: American Airlines.
Additionally, the industry concentration that has boosted the legacy carriers' profitability may be a "long moment" rather than a permanent change. The top four U.S. carriers currently carry about 80% of domestic traffic. However, the smaller carriers that make up the other 20% of the industry are growing at a much faster rate.
For example, Frontier Airlines recently announced that it plans to triple in size over the next 10 years. Collectively, the smaller carriers will likely be at least twice as large as their current size a decade from now. That would boost their combined market share from around 20% today to roughly 30%. The increased competition will put pressure on the incumbents' margins.
Logic, the history of the airline industry, and recent trends all suggest that American Airlines' best days are probably behind it. For me to consider investing in American Airlines stock, management would need to back up its bullish outlook with facts, not faith.
