The sharp drop in oil prices over the past year has led to a big increase in airlines' profitability in 2015. The top three airlines in the U.S. -- American Airlines (NASDAQ:AAL), Delta Air Lines (NYSE:DAL), and United Continental (NASDAQ:UAL) -- are all on pace to earn billions of dollars in profit this year.
But while cheap oil is having a similar positive impact on profitability for all of the airlines, they each have distinct strategies for using this extra cash. Let's take a look at how each carrier plans to spend its windfall.
American Airlines: fleet renewal and buybacks
American Airlines is using most of its cash to fund a thorough fleet overhaul. These new planes were ordered years ago -- the purchases had nothing to do with cheap oil or the company's resurgent profitability -- but American Airlines' improved financial position is allowing it to fund most of the purchases with cash rather than debt.
For example, in 2014, American Airlines' operating cash flow totaled $3.1 billion. Meanwhile, the company spent $5.3 billion on capital expenditures: mainly for new aircraft. American Airlines had to draw down its cash and investments balance to fund the difference.
In 2015, capital expenditures are expected to rise to $6.4 billion, including $5.4 billion for new planes. However, thanks to cheap oil, American Airlines generated more than $4.8 billion of operating cash flow in the first half of the year. While airlines' cash flow tends to be frontloaded within the year, American will still bring in plenty of cash in the second half of 2015. As a result, it should be free-cash-flow-positive despite its heavy capital spending.
American's heavy investments in aircraft have already given it the youngest fleet among the major airlines. Its lead will widen over the next few years. This will boost its fuel efficiency, helping protect the company from a potential oil price rebound in the future.
American Airlines has nearly $19 billion in debt on the books. But rather than using its free cash flow to pay off that debt, it's actually borrowing a little more because interest rates are so low. Instead, it's using its leftover cash for share buybacks. American spent more than $750 million on share repurchases just last quarter, and doubled its total buyback plan to $4 billion. It also pays a small $0.10 quarterly dividend.
Delta Air Lines: balanced cash deployment
Delta Air Lines was already generating plenty of cash prior to 2015, but the dip in fuel prices is making it an even bigger cash cow. In each of the past two years, Delta produced at least $4.5 billion in operating cash flow, and it nearly reached that level in the first half of 2015 alone, despite being hit with significant fuel hedging losses.
Like American Airlines, Delta is buying back a lot of stock. It spent about $925 million on share repurchases last quarter, completing its old buyback program and getting started on a new $5 billion share buyback program announced in May. It also pays a modest $0.135 quarterly dividend. However, that's where the similarities end.
Delta has been much more careful about capital spending. It has laid out a long-term plan to spend $2.5 billion-$3 billion each year on aircraft replacement and other capital projects. That's less than half of what American Airlines will spend this year, even though Delta is only slightly smaller.
This means that Delta is generating lots of free cash flow. It has been contributing about $1 billion a year to its pension plans with a goal of having them 80%-90% funded by 2020: up from less than 50% funded at the end of 2014. Delta also plans to reduce its adjusted net debt to $4 billion by 2017, down from a staggering $17 billion as recently as 2009.
United Continental: focus on buybacks
United Continental has adapted its aircraft purchase strategy in recent years to be more like Delta's. For the next few years, it plans to spend $2.7 billion-$2.9 billion annually on capex, roughly in line with Delta's capital spending. As a result, even though it isn't as profitable as Delta or American, it's still producing plenty of free cash flow.
Like Delta, United has set a debt reduction target -- but its goal is much more modest. United's adjusted gross debt is currently about $17 billion, and it plans to reduce that to $15 billion. United also wants to maintain $5 billion-$6 billion in unrestricted liquidity (including a revolving credit line), which would put its net debt at a little more than $10 billion: more than double Delta's target.
Instead, United seems content to spend most of its free cash flow on share buybacks. Given that it has the lowest market cap of the three big legacy carriers, this focus on buybacks may be wise. United plans to complete a $1 billion buyback program announced last year during Q3, and it recently announced a new $3 billion share repurchase authorization.
What it means for investors
American Airlines, Delta Air Lines, and United Continental are all benefiting from the drop in oil prices, but they've adopted different strategies for using the extra cash they're getting. This makes each one better suited to a different type of investor.
For risk-tolerant investors, United Continental probably has the most upside. It is working hard to close the margin gap with its peers. If it's successful, its valuation would likely rise to match theirs. In the meantime, it's buying back a lot of stock, giving an additional boost to EPS. But if United fails to fix its structural deficiencies, the stock could remain a laggard.
Delta Air Lines is the conservative choice. Delta is using its strong cash flow to get rid of most of its debt and pension obligations, while still returning plenty of cash to shareholders. This strategy will give it maximum flexibility to respond to changing industry conditions in the future.
Lastly, American Airlines is a bet on the long-term health of the airline industry. By the end of the decade, it will have replaced virtually all of its older-technology jets, leaving it with a fleet of young, fuel-efficient planes. If industry conditions remain good beyond 2020, American should be able to take advantage of its young fleet to post industry-leading earnings and cash flow.