American Airlines (NASDAQ:AAL) was a huge beneficiary of the "dash for trash" that began about a month ago. Speculators snapped up American Airlines stock along with other stocks that had been crushed by the COVID-19 pandemic, with no regard for business fundamentals or the companies' recovery prospects.
The surge in speculation has tangibly helped American Airlines: Increased interest in the stock enabled the company to bolster its balance sheet with an equity and convertible debt offering this week. That said, sentiment alone can't fix what's wrong with the full-service airline right now. Investors are starting to realize just how challenging a turnaround will be, causing the bubble in American Airlines stock to deflate.
Indeed, while raising equity and convertible debt was the right move, it will significantly dilute existing shareholders. Meanwhile, American Airlines' balance sheet will remain weak, driving up financing costs and limiting the company's future flexibility.
Shareholder dilution begins
In recent months, American Airlines has borrowed money to fund near-term cash burn. However, while this tactic worked in the short term, American Airlines entered 2020 with the worst balance sheet of any U.S. airline. As a result, it is already running low on collateral to support future debt issuances but still has significantly less liquidity than peers.
Considering that the number of confirmed COVID-19 cases has started rising again in many parts of the U.S., airlines can't count on a rapid recovery in air travel demand. That made it important to capitalize on the rebound in American Airlines' stock price to raise cash in a way that doesn't require collateral.
On Tuesday morning, American Airlines confirmed that it had priced an offering of 74.1 million shares at $13.50 per share. It also sold $1 billion of convertible notes due in 2025. The notes carry a 6.5% interest rate and can be converted to stock for approximately $16.20/share. The underwriters for the stock and convertible debt offerings have options to purchase an additional 15% of the offering amount to cover potential overallotments.
Assuming full exercise of those overallotment options and conversion of the convertible debt, the company would end up issuing approximately 156.2 million shares of American Airlines stock. For comparison, the company had about 423 million shares outstanding as of the end of March. Thus, American Airlines shareholders could have their interests in the company diluted by up to 27%.
The balance sheet is still terrible
This dilution means that even if American's financial results fully recover over the next few years, earnings per share would remain well below previous levels. Yet that pain will buy only modest balance-sheet relief.
Even accounting for recent improvements in American Airlines' daily cash burn, the airline is on pace to burn through about $6 billion in the second quarter. A little over $2 billion will be covered by the grant portion of American's CARES Act payroll support funds, but that still leaves $4 billion of "true" cash burn. Assuming the underwriters exercise all of their overallotment options, American Airlines will net just over $2.2 billion from the stock and convertible debt offerings after fees, covering barely more than half of this amount.
Entering 2020, American Airlines had $29.6 billion of debt and lease liabilities, net of unrestricted cash and investments. By year-end, that figure will likely exceed $35 billion. Digging out of this hole may well be impossible, depending on how quickly air travel demand recovers from the pandemic.
The cost of a weak balance sheet
Over the past five years, American Airlines has returned a massive amount of cash to shareholders while also spending heavily on capex. Management's willingness to operate with a weak balance sheet enabled the company to avoid choosing between investing in the business and rewarding shareholders.
American Airlines shareholders are paying the price now. Aside from the dilution discussed above, rising debt service costs will erode profits in the years ahead. The convertible debt alone will add $65 million of annual interest expense ($75 million if all overallotment options are exercised). American is also preparing to issue $2 billion of secured debt at double-digit yields, according to Bloomberg.
Fortunately for holders of American Airlines stock, most of the company's new borrowings this year will be low-interest government loans. Even so, annual interest expense is set to rise by hundreds of millions of dollars this year. Interest expense could continue rising in the years ahead if American has to pay significantly higher interest rates to refinance its debt maturities.
In short, American Airlines' weak balance sheet is creating even more barriers to an earnings recovery. As such, investors would be wise to steer clear of American Airlines stock.