Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...
Buy American Airlines Group (NASDAQ:AAL), sell Southwest Airlines (NYSE:LUV)? That kind of advice cuts against the grain of Wall Street's usual theory that "legacy airlines are bad, discount airlines are good." And yet, this is the advice that analysts at Imperial Capital are dishing out today, as they raise their rating on American Airlines stock to outperform but cut Southwest stock to "in-line."
Here's what you need to know.
Upgrading American Airlines
Let's start off with the good news. This morning, analysts at Imperial Capital announced they're upgrading American Airlines and assigning the shares a $49 price target, which is 12.5% higher than where they trade today.
Their theory: Rising oil prices (and jet fuel prices) have taken a toll on American Airlines' pre-tax profits -- so much so that the airline is finally going to be forced to respond.
Mind you, American Airlines isn't losing money yet. Earnings may have fallen steeply from 2015's banner year of $7.6 billion in profit, with adjusted pre-tax profit margins declining steadily from 15.3% in 2015 to 12.6% in 2016 to 9.1% in 2017. They're currently expected to ring in a measly 7% or 8% this year. But still, this is the company that famously boasted it isn't "ever going to lose money again" last year.
So far, American Airlines is holding true to that promise, but with margins marching ever closer to zero, the time has come to act. Imperial believes that when American reports earnings in July, it will announce a reduction in "capacity" (i.e., it will fly fewer planes) in order to cram more passengers aboard the planes it does fly, and thus maximize the fuel efficiency of its fleet, as the analyst explains in a note covered on StreetInsider.com (requires subscription).
This move, argues Imperial, will "improve AAL's pricing power" (by cutting supply in the face of strong demand). It will also help American Airlines management achieve their profitability target and trigger their management bonuses -- a big incentive that could in this instance work to investors' benefit.
Now for the bad news: As much as Imperial Capital likes American Airlines' prospects, its view dims when it comes to Southwest Airlines stock.
In a second note out today, Imperial argues that while American is making the right moves on plane capacity, Southwest is headed in the wrong direction, and will grow the capacity of its fleet by not the 5% expected previously, but by as much as 5.5%. That seems a small sliver of a difference, but in Imperial's view, it's too great an increase relative to the 1% increase in revenue per available seat mile (RASM) that Imperial believes Southwest will enjoy this year. With airplane fuel getting more costly, and Southwest losing pricing power relative to American, Imperial predicts Southwest will earn only $4.35 per share in 2018 (down $0.05 from its previous estimate). The analyst thinks 2019 profits will be only $5.10 per share -- an improvement, but much less than the $5.60 that Imperial previously thought Southwest might earn.
That all translates into not just a downgrade for Southwest Airlines stock, but a much-reduced price target of only $54 a share that leaves investors hoping for less than 6% upside from current prices.
A third view
Is Imperial Capital right to take such a dim view of Southwest stock relative to American Airlines? I have to say that I have my doubts.
On the one hand, according to our data on Motley Fool CAPS, where we've been tracking the performance of Imperial Capital's stock picks for more than six years now, Imperial hasn't been a particularly successful stock picker historically. Only about 39% of its recommendations have outperformed the S&P 500 in the past -- and its average stock pick is underperforming the market by nearly 2 percentage points.
On the same hand, Imperial's favoring American Airlines stock over Southwest just doesn't make a lot of sense to me. Although technically profitable as GAAP accounts for such things, American Airlines hasn't generated positive free cash flow in over a year, according to data from S&P Global Market Intelligence. Over the past 12 months, for example, American Airlines has burned through $743 million in free cash flow.
Sure, cutting capacity might help American Airlines improve that number. Still, judging from where things stand today, American Airlines just isn't doing as good a job as Southwest -- which has been both GAAP-profitable and generated positive free cash flow for the past nine straight years, and churned out nearly $1.1 billion in cash profits over the past 12 months.
Now, even $1.1 billion isn't a lot of cash relative to Southwest's $3.6 billion in reported profit. With Southwest stock tipping the scales at nearly $30 billion in market capitalization today, I cannot honestly recommend its stock either -- not while its free cash flow looks so weak. But choosing to downgrade poor-performing Southwest to only hold, and upgrade the even worse-performing American to buy, looks to me like a great way to lose money on both stocks.