Stock buybacks have now become a theme among major airlines and American Airlines Group (NASDAQ:AAL) doesn't want to disappoint.
Alongside its latest earnings announcement, the airline announced a new $2 billion stock buyback. I'll take a look at what this means for the airline and whether this was the best move.
Airline buybacks take off
As profits among major airlines have surged, all major carriers have initiated a stock buyback in one form or another. Delta Air Lines (NYSE:DAL) and Southwest Airlines (NYSE:LUV) were among the first to do it but they were later followed by announcements from American Airlines Group and United Continental Holdings (NASDAQ:UAL).
Last summer, American Airlines Group launched a $1 billion buyback and in its latest earnings, the airline announced this had been completed a year ahead of schedule.
While the airline industry has been on a general uptrend, American Airlines was even better equipped to take advantage of declining fuel prices than its rivals. Unlike Delta, United, and Southwest, American Airlines did not hedge its fuel prices and is now able to fully take advantage of the savings from jet fuel now trading down about 50% from its pre-fall levels.
In recent comments, American's management expects to save $5 billion on fuel in 2015. By comparison, Delta Air Lines only expects to save $2 billion on fuel for 2015 despite having about 85% of American Airlines Group's fuel usage based on the most recent 10-K reports from each airline.
So far, the airline has aggressively pursued stock buybacks which makes sense given American Airlines is trading at about five times forward earnings compared to the industry average of 10 times forward earnings.
But how much in buybacks is too much? After all, the airline industry has historically been quite turbulent and the current fuel savings rely upon a volatile commodity.
Buybacks vs. dividends
While I see such a large increase in the buyback as reasonable, I am bullish on the fact that American Airlines Group chose a buyback increase over a dividend increase.
The buyback remains financially responsible since it can be stopped, which may be necessary if oil rises or industry conditions worsen. In contrast, dividend cuts tend to be a red flag to investors leading to share price losses.
A similar trend in keeping dividends small while running large buybacks can be seen at Delta, Southwest, and United as well. All three carriers have substantial buyback programs but like American's, Delta's and Southwest's dividends yield less than 1%, while United does not pay a dividend. Due to the volatility of the airline industry, I expect dividends to remain small although United may initiate a dividend so it can attract dividend-only investors.
At $2 billion, the current American Airlines buyback amounts to less than half the savings expected from reduced fuel costs. Given that the airline can still halt the buyback at any time, it fits into the category of being a large buyback but not an irresponsible one. Additionally, American Airlines' dividend is similar to those of its rivals so it has not committed too much capital to dividends.
Effects on shares
Using the closing price of $52.24 on Jan. 29, the buyback would be able to repurchase about 5% out American Airlines Group's outstanding shares. With American Airlines, the float and the outstanding shares are very similar in number so the repurchase is also enough to repurchase about 5% of the float.
In theory, this should push earnings per share about 5% higher. However, while this event is bullish in nature, a 5% estimated earnings increase for an airline is within the margin of error at this point.
If the airline can repurchase 5% of outstanding shares, it stands to save about $14-$15 million in annual dividends. Although this is relatively small compared to the $2 billion being spent on the buyback itself, it will provide a nice bonus to the airline.
Perhaps what is more useful is that the buyback will put more buying pressure on the stock providing a tailwind for the stock price; however, shares are likely to remain volatile since this is still an airline stock.
The bottom line
Due to its ability to take fully take advantage of falling fuel prices, American Airlines Group expects to reap significant fuel savings. The airline is now working on returning profits to shareholders through the early completion of a $1 billion buyback and the initiation of a buyback twice the size.
Since buybacks maintain flexibility for capital allocation and the buyback amounts to less than half of the expected fuel savings, I view this buyback as highly positive and see it as reasonable in amount.
Going forward, investors should look for announcements from other airlines to see if they follow American Airlines' lead in boosting returns to shareholders.
Alexander MacLennan owns shares of American Airlines Group and Delta Air Lines,. Alexander MacLennan has the following options: long January 2017 $25 calls on American Airlines Group and long January 2016 $60 calls 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 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.