American Airlines (NASDAQ:AAL) posted a record $1.9 billion profit last quarter. While that is believed to be the highest quarterly profit (excluding special items) in aviation history, American Airlines stock fell 7% on Friday following the earnings report.
The company's sometimes-contentious earnings conference call likely played a role in the poor stock performance. So what did American Airlines' management say to cause such a sharp reaction from investors? Let's take a look.
Taking on some extra costs
We've looked at a lot of what we were going to do in the back half of the year to reduce headcount and do other things. But we've decided to leave that in and leave it in place so that we can get through the integration.
-- American Airlines CFO Derek Kerr
Earlier this month, American Airlines increased its estimate for mainline unit cost growth for the second half of 2015. It attributed the increases to "lower capacity, timing of expenses shifting from the second quarter and increased investment in the operations to ensure operating reliability during integration."
CFO Derek Kerr confirmed that American Airlines is delaying headcount reductions in order to have extra reservations and customer service staff available, particularly for the reservation system integration scheduled for October. But by mid-2016, the company will be back on plan, which will mean better unit cost performance.
Unit revenue outlook for the next year is weak
But it looks to me like the first time you can really have a reasonable expectation for positive PRASM is the second half of next year.
-- American Airlines President Scott Kirby
The biggest revelation on the earnings call was that American Airlines doesn't expect its unit revenue trend to turn positive again in the near future. That's more pessimistic than what competitors have forecast.
Yet this is to be expected given the unique headwinds that American Airlines faces. It is by far the biggest U.S. carrier in Brazil and Venezuela, two key markets where demand has plummeted. American is also facing a big competitive capacity increase in the Dallas-Fort Worth market, where it operates its biggest hub. Capacity growth there won't fully annualize until next summer.
Turning the corner
And the second [synergy opportunity] is being able to essentially optimize the fleet, put the rightsized aircraft in the right market. ... It won't happen right away when we do the transition to a single res system, but we'll be able to start that process and it will probably take us 12 to 18 months just to get through the first big wave of that and then continue to optimize over time.
-- Scott Kirby
Unlocking revenue synergies will ultimately be a critical catalyst for American Airlines to return to unit revenue growth. Kirby estimated that the annual benefit from reallocating aircraft between the American Airlines and US Airways networks could reach $300 million.
That process can't start immediately after the reservation system integration. But it should begin in earnest during 2016, with the benefits ramping up over a 12-18 month period. This should contribute to a unit revenue recovery in the second half of 2016 and beyond.
Management also thinks it's only halfway to achieving the potential revenue synergies from boosting connectivity across the American Airlines and US Airways route networks. The rest of those benefits (approximately $150 million annually) will also come in the year or two following the reservation system integration.
Revenue tends to follow cost trends
I mean, what I think everyone acknowledges is ASMs have grown faster than demand of late... I think what you're seeing is fuel prices have fallen a good amount, and capacity has adjusted to those costs.
-- American Airlines CEO Doug Parker
While American Airlines expects unit revenue to continue declining for the next year, CEO Doug Parker made it clear that he thinks the market is overreacting to this trend. His main point was that just as airlines cut back capacity when fuel prices rose, they are adding capacity now because fuel is cheaper.
Even though that leads to lower unit revenue, profitability is still much higher because the fuel cost benefit far outweighs the unit revenue weakness. Furthermore, this interpretation implies that airlines would quickly return to "capacity discipline" if oil prices spike in the future. That's good since it means an oil price spike wouldn't necessarily drive severe margin deterioration at American Airlines and its peers.
The stock seems cheap
We would not have purchased $753 million of our stock in the quarter at an average price of $43.53, if we thought the stock wasn't worth more than $43.53. ... So what I'm getting at is the focus on -- the intense focus on unit revenues is ... important, but I'm just encouraged here if I look at valuation...
-- Doug Parker
Parker also pointed out that American Airlines aggressively repurchased stock last quarter. He made it clear that the company isn't just buying stock to try to prop up the stock price or juice EPS. It is buying back stock because it sees the shares as being extremely undervalued.
Considering that American Airlines stock currently trades for less than five times projected 2015 pre-tax earnings, it's hard to disagree. Even if American experiences some margin deterioration next year, there's a big margin of safety for investors at the current valuation.
It's clear that American's downbeat outlook for unit revenue over the next 12 months caused the stock's big slide last Friday. But as Parker implied, investors should probably be paying more attention to the stock's bargain-basement valuation than to the near-term revenue outlook.
Adam Levine-Weinberg is long November 2015 $40 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.