The COVID-19 pandemic has dealt a huge blow to the U.S. airline industry over the past year. Fortunately, most U.S. airlines entered 2020 with solid balance sheets, thanks to strong industry profitability over the previous decade.
Among major airlines, American Airlines (AAL 1.42%) was an exception to this rule. The airline giant squandered billions of dollars on share buybacks in recent years, even as it spent heavily to upgrade its fleet. That put it in a weak position compared to peers like Delta Air Lines (DAL 0.62%). However, American just bought itself time by lining up $10 billion of new financing.
Facing a potential cash crunch
Like its peers, American Airlines borrowed lots of money during 2020 to cover its cash burn. By year-end, it had $32.6 billion of debt and finance leases on its balance sheet: up from $24.3 billion a year earlier.
American entered 2021 with $6.9 billion of unrestricted cash and investments, plus $7.4 billion of additional borrowing capacity (mainly from a government loan commitment). Having $14.3 billion of liquidity might seem like a lot. However, American is still burning lots of cash. It expects average daily cash burn of $30 million in Q1 -- equivalent to $2.7 billion over the course of the quarter.
Of course, cash burn should improve rapidly over the next few quarters as air travel demand returns. That said, the company has $21.7 billion of debt maturing between 2021 and 2025. It won't generate nearly enough free cash flow to repay all of those maturities. And while American Airlines should be able to refinance much of that debt, it might not be able to do so on favorable terms -- particularly for debt that is unsecured or backed by subpar collateral.
Contrast this with Delta's financial position. Delta Air Lines ended 2020 with $14.1 billion of unrestricted cash and investments on its balance sheet. It also had $2.6 billion of borrowing capacity on its revolving credit lines. Furthermore, Delta has been burning less cash than American, and it has only $15.7 billion of debt maturing over the next five years.
Tapping into the loyalty program
To address its near-term cash needs, American Airlines decided to follow its biggest rivals by carving out its loyalty program as a new subsidiary and using it as collateral. The desirability of this collateral enabled it to score a rating just two notches below investment-grade status from Moody's. That was an impressive achievement, considering the weak state of the carrier's balance sheet.
American Airlines ultimately raised an industry-record $10 billion backed by the AAdvantage program, up from its initial plan to raise $7.5 billion. The weighted average interest rate came to 5.575%, modestly higher than the 4.75% blended rate that Delta achieved when it issued $9 billion of debt backed by its loyalty program last September.
This $10 billion deal increases American's liquidity by $2.5 billion, net of the termination of its federal secured loan participation. This gives the company more breathing room to cover its near-term cash burn and debt maturities, reducing the likelihood of a cash crunch.
Fundamental problems remain
The new financing package buys time for American Airlines. (It also allows the airline to avoid unfavorable terms associated with the federal loans available under the CARES Act.) However, that doesn't mean the company is out of the woods.
First, American Airlines recorded mediocre adjusted pre-tax margins of 6.3% in both 2018 and 2019. Margins could be even worse going forward. First, net interest expense will be approximately $2 billion a year following this week's debt issuance -- up from $1 billion in 2019. That alone would reduce future pre-tax margins by more than 2 percentage points. Lower business travel demand and a tougher competitive environment could also weigh on profitability for the foreseeable future, offsetting the benefit of cost cuts.
Second, American had over $40 billion of net debt (including pension and lease liabilities) at the end of 2020, far too much relative to its earnings power. Its new debt package reduces the risk of near-term liquidity problems but doesn't address the underlying problem of excessive leverage.
To be sure, lining up additional long-term financing is an important step in American Airlines' efforts to recover from the COVID-19 pandemic. However, with American's market cap having already surpassed its pre-pandemic level, this may be a good opportunity for shareholders to head for the exits.