Over the past few weeks, COVID-19 has turned into a global pandemic, upending daily life worldwide. In the business world, no industry has been hit harder than aviation. With public health authorities vehemently urging people to avoid all non-essential travel, U.S. airlines have experienced a rapid decline in booking activity over the past few weeks, accompanied by a surge in cancellations.

The threat to airlines is so grave that industry trade group Airlines for America recently requested over $50 billion in government aid for U.S. passenger airlines. On the other hand, most airline stocks have lost more than half of their value over the past month -- and some have experienced even deeper declines. Many investors may be wondering whether these share price declines make it a good time to buy airline stocks.

AAL Chart

Airline stock performance data by YCharts.

The answer is that it depends. Airlines with solid businesses and strong balance sheets are definitely worth a look. On the other hand, those with weaker cash flow and poor balance sheets are in grave danger. Let's see how American Airlines (NASDAQ:AAL), Delta Air Lines (NYSE:DAL), and Alaska Air (NYSE:ALK) stack up.

Air travel demand has virtually evaporated

The collapse in air travel demand over the past few weeks has been truly unprecedented, forcing airline executives to rapidly adjust their plans.

In a presentation on March 10, American Airlines CEO Doug Parker observed that load factors (the percentage of seats filled with paying customers) had declined in the first week of March, but that there were still plenty of people traveling. In response, he said that American planned to reduce domestic capacity by 7.5% in April and cut international flying by at least 10% through the summer.

However, in a series of recent updates, American Airlines' management has acknowledged that conditions have deteriorated much further, requiring bolder action. On Thursday, American said it has cut its domestic schedule by 30% and its international flying by 75% in April, with deeper reductions likely in May. It will also temporarily park about 130 of its 150 widebody aircraft and 320 of its nearly 800 narrow-bodies.

As aggressive as these actions are, they pale in comparison with what Delta recently announced. Back on March 10, at the same investor conference, Delta was planning a 15% capacity cut. Now it intends to slash flying by 70% until demand recovers, while parking at least half of its fleet.

A Delta Air Lines jet taking off

Delta is cutting capacity by 70% until demand starts to rebound. Image source: Delta Air Lines.

Even Alaska, which had initially planned minimal schedule changes, said last Monday that it will cut capacity by at least 10% in April and 15% in May. Given how quickly the situation has been evolving, it would not be surprising to see additional flight cancellations announced over the next week or two.

Staying alive

One piece of good news for airlines is that fuel prices have plunged by more than half since the beginning of 2020. In addition, American, Delta, and Alaska are slashing discretionary spending and urging employees to consider voluntary leaves or early retirement programs. Nevertheless, with revenue evaporating, it is inevitable that all of these airlines and their peers will incur big losses this year.

In the short term, the key question for investors considering investing in airline stocks is whether each company has the balance sheet strength to absorb these losses without exiting 2020 with a paralyzing debt load. (While the federal government is likely to provide loans or loan guarantees to prevent mass bankruptcies in the sector, it won't just give away cash.) Government-backed loans may allow airlines with weak balance sheets to survive, but they will still have to figure out a way to repay that debt over time.

From this perspective, Alaska is in the best position among these three airlines, while American is clearly the worst. Here are the relevant balance sheet amounts for American Airlines, Delta Air Lines, and Alaska Air as of the end of 2019.

Airline

American Airlines

Delta Air Lines

Alaska Air Group

Cash and investments

$3.8 billion

$2.9 billion

$1.5 billion

Debt and finance leases

$24.3 billion

$11.2 billion

$1.5 billion

Operating lease liabilities

$9.1 billion

$6.1 billion

$1.7 billion

Adjusted net debt

$29.6 billion

$14.4 billion

$1.7 billion

Adjusted net debt as a percentage of 2019 revenue

65%

31%

19%

Data sources: American Airlines, Delta Air Lines, and Alaska Air Q4 2019 Earnings Reports. 

All three airlines have hurried to shore up their liquidity this month, giving them plenty of cash and borrowing capacity to make it through the next few months. But American Airlines entered 2020 with a huge debt load, and it can ill afford to pile more debt onto its balance sheet. By contrast, Delta and Alaska began the year with solid balance sheets: particularly the latter. Even after absorbing massive losses in 2020, their balance sheets will probably be better at year-end than American's was to start the year.

Who can repay the debt fastest?

From a longer-term perspective, a big question is which airlines will be able to repay debt fastest once the pandemic gets under control and the industry returns to profitability.

Investors shouldn't assume that airlines will all recover at the same rate from the COVID-19 demand shock. In particular, domestic demand may rebound a little faster than international demand, and traffic levels are likely to recover well before average fares return to previous levels. Both factors would suggest that domestic-focused low-fare airlines like Alaska Airlines could return to profitability a little sooner than global network carriers like American and Delta.

However, projections like these are inherently speculative. To get a good baseline estimate of which airlines have the most potential to generate free cash flow in the years ahead, it's useful to look at how they have performed in this respect over the past few years.

AAL Free Cash Flow (% of Annual Revenues) Chart

American Airlines, Delta Air Lines, and Alaska Air free cash flow to revenue data by YCharts.

As this chart shows, Alaska Air and Delta Air Lines both have good track records of generating strong free cash flow margins, with Alaska typically outperforming its larger rival. By contrast, American Airlines has been lucky to post breakeven free cash flow in recent years.

To be fair, American Airlines has already been planning for much lower capex in 2020 and beyond, supporting stronger free cash flow. Nevertheless, it is unlikely to match either Alaska or Delta in this respect.

A clear winner

Following the massive sell-off in airline stocks, Alaska Air shares trade for about four times the company's 2019 earnings. On the same basis, Delta and American trade for three times earnings and two times earnings, respectively.

However, while Alaska Air carries a slightly higher valuation than the other two airline stocks, it is well worth the premium. With a lower debt burden entering 2020, it can best afford the extra debt that it will have to take on this year. It also has the strongest track record of producing free cash flow, which will be necessary to pay down debt over the next few years. This makes Alaska Air stock worth consideration for long-term investors at its current bargain price. (Of course, it's still a risky bet, as nobody knows for sure when the COVID-19 pandemic will recede.)

Delta Air Lines is also a decent option based on its balance sheet and track record for producing free cash flow, but it is noticeably worse than Alaska across both metrics. American Airlines is in the worst shape by far. Its massive debt load makes it a highly speculative stock only suitable for the most risk-tolerant investors in the current environment.