Shares of American Airlines Group (NASDAQ:AAL) rallied more than 110% last year and have already posted modest gains to start off 2015. While it would have been considered a radical idea early last year, a host of factors have analysts raising price targets, with some nearing $100 per share. Is this a realistic outlook? Let's assess the possibility.
Fuel savings winner
With fuel prices down about 50% from before the collapse, a major component of airline costs has plunged. Based on American Airlines Group's 10-K form, fuel comprised 35.3% of total operating expenses for 2013, making this a major area where the airline could see savings.
While other airlines tend to have fuel expenses as a similar percentage of total operating costs, American Airlines Group is in a unique position since it didn't hedge its fuel costs at higher levels.
Compared with Delta Air Lines (NYSE:DAL), which took a $1.2 billion writedown on its fuel hedges in its most recent quarter, and United Continental Holdings (NASDAQ:UAL), which took an $85 million charge, American Airlines is in a prime position to capture the full savings of cheap fuel.
Collapsing fuel prices have been a major reason for surging earnings estimates at American Airlines Group. Estimates for 2014 full-year earnings have held fairly stable in the past 90 days. Since most of the cheaper fuel costs are expected to be realized in 2015, though, analyst estimates have been reflecting a better 2015. The following data from Yahoo! Finance shows a surge in estimates in the past 90 days, as fuel prices have severely declined.
|Timeframe||Estimated 2015 EPS|
|7 days ago||$9.92|
|30 days ago||$8.65|
|60 days ago||$7.39|
|90 days ago||$7.19|
Based on these estimates, American Airlines Group trades at only 5.5 times next year's earnings, well below both the industry and market averages.
Of course, a lot of this rise has to do with falling oil prices. If oil prices were to surge higher, the airline would be negatively affected and EPS estimates would probably fall again. However, if oil prices stay near current levels, American Airlines Group is one of the best positioned airlines in the industry.
Higher price targets
As analysts have raised their earnings estimates, they've raised price targets as well. Yahoo! Finance doesn't keep track of previous price targets, but 4-Traders does, and its data shows that the average price target has increased about 25% in the past 90 days to currently sit at $68.90.
While none of the targets currently crack $100 per share, the highest one I found is from Bob McAdoo at Imperial Capital. He cites jet fuel prices as a major factor, along with airline industry fundamentals and merger synergies from the combination of American Airlines and US Airways.
With a $92 price target, McAdoo's position is near the triple-digit mark, but not quite there. In developing his target, he estimates 2015 earnings of $13.05 per share, still above the 2015 average but potentially obtainable under optimal conditions.
How high can shares go?
From a simple price-to-earnings perspective, the path to $100 per share seems pretty easy. Next year's estimates call for $10.10 in earnings per share, and a modest 10 times ratio brings a target of $101 per share.
Furthermore, using McAdoo's EPS estimate with the same 10-times multiple gives a target of $130.50 per share, but there are other factors that may prevent this goal from happening, or at least make it less likely.
Everyone's favorite topics: Taxes and debt|
From previous years of losses, American Airlines Group has net operating losses, or NOLs, amounting to around $10 billion that can be used against earnings, effectively making them free of corporate taxes. But the tax-free party runs out when the NOLs are exhausted, and a solid 2015 of profits would significantly reduce, if not eliminate, NOLs remaining for future years.
Since valuations tend to be based on what the market sees as sustainable earnings, the fact that some of the 2015 earnings will occur because of a temporary tax break is likely to result in the market's assigning a lower multiple to the stock.
While debt isn't always a bad thing, having significantly larger amounts of debt than one's peers can mean that a company is seen as higher risk and thus receives a lower valuation than its less indebted peers. American Airlines Group appears less favorably on this front, with a debt-to-equity ratio of 3.4, compared with United Continental at 2.9 and Delta Air Lines at 1.1. Despite this higher debt-to-equity ratio, American Airlines Group remains a healthy company; however, this factor may make shares of the airline appear riskier than those of its peers and keep American's valuation below the industry average.
Merger integration risk
The merger between American Airlines and US Airways that formed American Airlines Group is generally seen as a positive for the industry, but that doesn't mean everything's smooth sailing. American Airlines Group still needs to finish the task of integrating the operations of two major airlines. Doing so will involve overcoming technical and logistical challenges, as well as reaching new labor agreements with affected workers.
So far, the integration has been going fairly well, but large-scale mergers always present potential risks. As higher levels of risk tend to negatively affect valuations, the integration risk at American Airlines Group could be another factor that keeps shares at a below-average valuation.
Is it a $100 stock?
From a simplistic valuation standpoint, American Airlines Group could easily see a triple-digit share price; however, there are other factors that need to be accounted for. The temporary benefits of NOLs, merger integration risk, and the above-average debt-to-equity ratio at the airline could make it more difficult for this carrier to rise to an average industry valuation.
But time may be on the airline's side here. In 2015, the airline expects to combine its frequent flyer programs, obtain a single operating certificate, and merge its reservations systems, three of the largest steps left in combining the carriers. The higher debt levels can be dealt with through using part of the earnings from fuel savings to pay down outstanding debt. Doing so would have the positive effect of lowering the airline's overall risk and making a higher valuation easier to attain.
In all, I can see American Airlines Group shares as being able to hit the $100 mark, although it may take another couple of years for the airline to earn the necessary valuation. To make it possible, the airline needs to successfully integrate American Airlines and US Airways while directing some of its fuel savings to bringing down its debt levels.
Alexander MacLennan owns shares of American Airlines Group and Delta Air Lines and has options on American Airlines Group. 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 don't 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.