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Rising Costs Hit American Airlines Group, Inc. Again

By Adam Levine-Weinberg - May 2, 2018 at 8:20AM

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Profitability is still declining at American Airlines. That's bad news for shareholders -- even if the stock seems cheap at first glance.

For more than a year, American Airlines (AAL -3.48%) CEO Doug Parker has been touting his company's ability to earn a $5 billion pre-tax profit in a typical year. However, after hitting that earnings target in 2015 and 2016, American Airlines fell well short in 2017, posting an adjusted pre-tax profit of $3.8 billion.

With fuel costs rising, pre-tax profit is set to decline again in 2018, putting it even closer to the $3 billion mark that supposedly represents a worst-case scenario for American Airlines. Indeed, the company reported last week that pre-tax earnings fell sharply in the first quarter. At that time, it also cut its full-year earnings per share guidance. Considering this ongoing earnings pressure and the company's weak balance sheet, investors should avoid American Airlines stock.

Another weak quarter

After posting steep declines in revenue per available seat mile (RASM) in 2015 and early 2016, American Airlines has achieved consistent unit revenue growth since mid-2016. Nevertheless, its profitability has continued to sag thanks to big cost increases.

This trend continued last quarter. American Airlines posted a solid 3.5% RASM increase, driven by strong growth in cargo and other revenue, along with double-digit growth in passenger unit revenue on routes to Latin America. Yet that wasn't enough to offset a 2.8% rise in adjusted non-fuel unit costs and a 23.6% surge in the average fuel price American paid.

An American Airlines plane in flight, with mountains in the background

American Airlines' profit declined again in the first quarter. Image source: American Airlines.

As a result, American's adjusted pre-tax margin fell to 4.5% from 6.7% a year earlier. Adjusted pre-tax profit plunged nearly 30% to $468 million. And while a lower tax rate and share repurchases helped prop up EPS, American Airlines still reported that adjusted EPS slipped to $0.75 from $0.82 a year earlier.

Falling toward the back of the pack

In the first quarter, American Airlines remained ahead of perennial underperformer United Continental (UAL -3.49%) in terms of profitability. United posted a meager 2% adjusted pre-tax margin last quarter. However, American is set to fall to the back of the pack this quarter.

The two carriers were roughly evenly matched in the second quarter of 2017. American Airlines achieved a 13.5% adjusted pre-tax margin, compared to 13.2% for United Continental. For the second quarter of 2018, American Airlines expects RASM to rise by 1.5% to 3.5%: roughly similar to United's projected revenue performance. On the other hand, United's non-fuel unit costs will be roughly flat year over year in the second quarter, whereas American's guidance calls for a 3.5% increase.

As a result, American Airlines estimates that its adjusted pre-tax margin will be between 7.5% and 9.5% this quarter, compared to a 9% to 11% guidance range at United Continental.

Additionally, American Airlines cut its full-year EPS guidance range by $0.50. It now expects EPS of $5.00 to $6.00 in 2018. By contrast, United recently raised the low end of its full-year guidance and now expects to achieve EPS of $7.00 to $8.50 this year. American is still likely to record a higher adjusted pre-tax margin for the full year -- but only by a sliver.

American Airlines stock still doesn't look like a bargain

Shares of American Airlines plunged more than 6% after the earnings release last Thursday. The stock currently trades for about eight times the midpoint of the company's updated EPS guidance range.

Nevertheless, American Airlines stock is hardly a bargain. While management believes profitability will recover once fuel prices stabilize, there's no guarantee that will happen, given the intensity of competition in the airline industry. Meanwhile, American has loaded itself up with $25 billion of debt, nearly $12 billion of which is due between now and the end of 2021. To make matters worse, American's pension payments are set to spike next year.

This means the company could find itself in hot water if oil prices continue to surge, interest rates spike, and/or the economy tilts into recession. Even if American Airlines manages to avoid further profit declines, its substantial debt, pension, and capex obligations will prevent it from continuing the massive share buyback programs it has used to juice EPS growth in recent years. Thus, American Airlines stock carries way too much risk for the potential reward.

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Stocks Mentioned

American Airlines Group Inc. Stock Quote
American Airlines Group Inc.
AAL
$13.03 (-3.48%) $0.47
United Airlines Holdings, Inc. Stock Quote
United Airlines Holdings, Inc.
UAL
$35.68 (-3.49%) $-1.29

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