For the past several years, American Airlines (AAL 0.67%) CEO Doug Parker has been one of the most prominent proponents of the idea that the airline industry has been permanently transformed and will produce big profits going forward. In the past year, he has doubled down on this argument, saying that in the new environment, airline managers don't have to worry much about short-term profitability and can focus on making long-term investments.
If Parker is right, you wouldn't know it from his company's financial results. American Airlines' profitability has been plunging ever since oil prices began to recover from a 2014-2016 slump. Furthermore, American Airlines cut its 2018 earnings per share (EPS) guidance last month due to rising fuel prices.
The rally in oil prices has continued in the month following American's Q1 earnings report. This could cause the company's earnings to fall even further behind management's original forecast.
Profit comes under pressure
American Airlines' adjusted pre-tax margin peaked at 15.3% in 2015. While a 41% drop in the carrier's average fuel cost played a big role in that strong result, airline industry earnings had already started to rise in 2013 and 2014, before the oil price collapse. Thus, investors had some reason to hope that American could sustain a double-digit adjusted pre-tax margin regardless of where fuel prices went in the future.
However, American Airlines' adjusted pre-tax margin slipped to 12.6% in 2016 despite a further decline in fuel prices and plunged to 9.1% last year, when fuel costs started to rise again.
In conjunction with its first-quarter earnings report, American Airlines reduced its 2018 adjusted EPS guidance range from $5.50-$6.50 to $5.00-$6.00. This change in its earnings forecast was entirely driven by a higher fuel price assumption. Based on this updated guidance range, American expects to post an adjusted pre-tax margin of roughly 7% to 8% this year.
The oil price rally hasn't ended
Unfortunately, oil prices have continued to rise since American Airlines revised its forecast. On April 20 -- the day that the carrier updated its fuel price assumption -- the price of Gulf Coast jet fuel was $2.07 per gallon. Gulf Coast jet fuel reached $2.21/gallon as of Monday.
American Airlines uses about 4.4 million gallons of jet fuel each year. Thus, on an annualized basis, a $0.14-per-gallon increase in the price of jet fuel would add more than $600 million to its fuel bill. The cost headwind for the remainder of 2018 could be close to $400 million if jet fuel prices stabilize near current levels.
Unless American Airlines can push through bigger fare increases -- which would be tough in the current ultra-competitive environment -- this cost headwind will drive almost 1 percentage point of incremental margin pressure in 2018.
Cash flow is becoming a concern
Even with the recent spike in fuel costs, American Airlines is likely to earn an adjusted pre-tax profit of roughly $3 billion this year. This might make it seem like shareholders have nothing to worry about. However, the company needs a higher level of earnings to support its substantial capex commitments and its weak balance sheet.
Operating cash flow has fallen steadily since the beginning of 2017. Over the past 12 months, American Airlines has generated just $4.3 billion in cash from operations. That figure could move even lower during the next few quarters as higher fuel costs pinch profits.
On the other side of the ledger, American Airlines plans to spend $3.7 billion on capital expenditures (capex) in 2018, including $1.9 billion for new aircraft. This means that free cash flow will be close to zero.
Last month, management projected that aircraft capex would rise to $2.5 billion in 2019 before receding to $1.7 billion in 2020. Since then, American has ordered 30 additional regional jets, 29 of which will be delivered next year. This could increase 2019 capex (including non-aircraft spending) to nearly $5 billion, potentially pushing free cash flow into negative territory.
The balance sheet is a mess
During the past four years, American Airlines has dealt with weak free cash flow by borrowing heavily to finance new aircraft. This allowed it to return about $12 billion to shareholders, mainly through an aggressive share repurchase program.
American Airlines can continue to finance most of its new aircraft purchases to reduce its cash outflows. However, the bill for its previous financing activity is starting to come due. American has about $2 billion of debt maturing in the last three quarters of 2018. It also has nearly $10 billion maturing between 2019 and 2021.
With cash flow falling and interest rates rising, American Airlines will face some unpleasant choices as its debts come due over the next few years. As a result, while American Airlines stock has fallen more than 20% since March, investors should still stay away from this looming train wreck.