American Airlines Group (NASDAQ:AAL) has taken investors on a roller-coaster ride since it emerged from bankruptcy and merged with US Airways late last year. Shares stood near $25 at the time of the merger and soared as high as $44.88 this summer. However, since mid-July, American Airlines' stock has tanked by more than 20%.
The company's shares still do not look as appealing as those of rival Delta Air Lines. But the recent pullback seems like a massive overreaction, considering that American Airlines has posted strong results this year and has more merger-related benefits ahead. Thus, this definitely could be a good time to buy American Airlines stock.
American Airlines posted the best results in company history during the first half of 2014. In the first quarter -- typically a seasonally weak period -- the airline delivered an adjusted profit of $402 million. The company followed this up with a stellar $1.5 billion adjusted profit in the second quarter, powered by a 5.9% rise in passenger revenue per available seat mile, or PRASM.
The second half of the year doesn't look quite as rosy. In July, American projected that third-quarter PRASM would rise 1%-3%, leading to a 10.5%-12.5% pre-tax margin. However, by early September, the outlook had weakened: American now projects unit revenue will be up 0%-2%, and that pre-tax margin will be 10%-12% (compared to 12.8% in the second quarter).
American's unit revenue is also likely to come under pressure in the fourth quarter. International capacity growth has run ahead of demand recently, and American is about to get a boatload of new competition in Dallas and a few other key markets. Despite those issues, analysts expect American Airlines to post record earnings per share of $5.37 this year and $6.81 next year.
Extremely low valuation
Based on these analyst estimates, American is trading at about 6.4 times 2014 earnings and five times 2015 earnings. To be fair, these estimates exclude taxes, which American will start to accrue in the next year or two (though it will not owe cash tax payments for many years due to various credits).
Even adjusting for potential taxes, American Airlines trades for just eight times forward earnings. That makes it one of the cheapest stocks on the market. By contrast, Delta Air Lines stock trades for about nine times forward earnings (including taxes), and United Continental stock trades for about 12 times forward earnings (adjusting for taxes).
One reason for American's low valuation is its heavy capital expenditure burden. The airline plans to spend about $5.5 billion annually for the next five years in order to replace nearly half of its mainline aircraft fleet.
As a result, free cash flow will lag book earnings dramatically in coming years. Even if American Airlines looks extremely cheap based on its earnings multiple, it might actually be fairly expensive when measured by its free cash flow.
If American Airlines is a good stock, Delta is a great one
Despite American Airlines' low free cash flow, the stock still looks like a good deal following its recent pullback. The ongoing fleet replacement will significantly boost fuel efficiency over time, providing a long-term earnings tailwind. Moreover, as the pace of aircraft purchases slows after 2020, free cash flow should soar.
That said, Delta could be an even better bet. Delta's earnings multiple is only slightly higher than that of American, and Delta is producing billions of dollars of free cash flow annually. This will allow Delta to devote much more cash to shareholder-friendly activities such as dividends, buybacks, and debt reduction.
On the other hand, if you prefer American Airlines -- or already own Delta stock and want to diversify your airline stock holdings -- this looks like a good time to buy American Airlines stock. Barring any major integration blunders, American Airlines seems well positioned to continue earning big profits.
Adam Levine-Weinberg is short shares of United Continental Holdings. 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.