Shares of American Airlines Group, (NASDAQ:AAL) have soared since the company exited bankruptcy and merged with US Airways in late 2013. Investors are enthusiastic about the new management team (brought over from US Airways) and the potential to generate merger synergies.
So far, the rise in American Airlines' stock price has been matched by strong earnings growth. Like many of its competitors, American Airlines is on pace to produce record earnings this year. Are further gains possible? Here are three reasons why American Airlines stock could have more room to run.
Rapid fuel efficiency gains
Fuel consumption is one area where American Airlines will generate significant savings in the next few years. In 2011, American ordered 460 narrowbody jets to renew its dated domestic fleet. (A few of these orders were eventually converted to options.) The new planes are in some cases 35% more fuel-efficient than the models they are replacing.
American Airlines is also updating its widebody fleet with more fuel-efficient aircraft. Since late 2012, the carrier has added more than a dozen Boeing 777-300ERs -- the largest twin-engine planes in production today -- to its fleet. American will also receive the first of its 42 Boeing 787 Dreamliner orders later this year.
Adding new, fuel-efficient aircraft will reduce American's costs in the long-run. However, doing so requires massive up-front investments -- the carrier expects to spend about $5 billion per year on capital expenditures for the next few years. Thus, it is also important for American Airlines to make the most of the planes it already has.
American Airlines is doing just that by adding rows to all of its more than 200 Boeing 737-800 aircraft in order to squeeze more seats in. American is also gradually expanding the seating capacity of its Boeing 777-200s from 247 to 289. These projects will reduce unit costs, allowing American Airlines to make more money with lower average fares.
Merger revenue synergies
On the revenue side, American Airlines has a big opportunity to improve results by leveraging the combined strengths of the "old" American Airlines and US Airways. For example, US Airways has historically been very weak in the Midwest and the Great Plains states. However, it has been strong in the Southeast due to its big hub in Charlotte.
By contrast, American has had a strong position in the Midwest and Great Plains states thanks to its hubs in Chicago and Dallas. On the other hand, it has had a small footprint in the Southeast, as its Miami hub is inconvenient for domestic connections.
Merging American and US Airways is creating opportunities to grow based on the combined strengths of the two merger partners. The company has added numerous flights from Charlotte to the Midwest and Great Plains states this year, thus providing new city-pair connections.
Another area where the merger may drive revenue gains is in the New York corporate travel market. US Airways operates the highly profitable "shuttle" routes between New York, Boston, and Washington, D.C. However, it doesn't operate international flights from New York -- its main transatlantic hub is in Philadelphia.
American Airlines does operate transatlantic flights in New York, though. In fact, in conjunction with joint venture partner British Airways, it dominates the New York-London route -- the top international route for U.S. business travelers. Combining the two carriers' strengths in New York will help American gain lucrative corporate market share.
Returning cash to shareholders
The third factor that could send American Airlines shares higher over time is the company's plan to return cash to shareholders. In July, the company announced plans to start a regular dividend for the first time since 1980. American also plans to buy back $1 billion of stock by the end of 2015.
Just as importantly, American is using excess cash to pay down expensive debt. American's heavy capital commitments will limit the amount of cash that it can return to shareholders for the next five years or so. However, by the end of the decade, American could be producing massive free cash flow, allowing it to reward long-term investors with even bigger payouts.
Foolish bottom line
American Airlines clearly made the most of its trip through bankruptcy. Thanks to its merger with US Airways and a favorable industry environment, earnings have already rebounded to record levels. This is allowing American Airlines to return cash to shareholders through its dividend and share repurchase program.
The impact of American's fleet renewal initiative will continue to build during the next several years. The carrier also has numerous opportunities to exploit the combined strengths of the American Airlines and US Airways networks to generate revenue synergies.
That said, there are some potential headwinds ahead. Southwest Airlines is on the verge of a major expansion in Dallas, which is also home to American's largest hub. Increased competition there could put pressure on unit revenue over the next year. Additionally, merger integrations are always risky.
Lastly, American's valuation already incorporates a lot of the potential synergy gains. American Airlines does have plenty of upside for long-term investors. But that upside comes with risk, and it will be quite a while before the company has the means to match the industry leaders in terms of shareholder returns.
Adam Levine-Weinberg has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.