Through the first nine months of 2015, American Airlines' (NASDAQ:AAL) profit soared 62% year over year to $5 billion. Yet the stock has declined more than 20% this year and trades for less than seven times forward earnings.
American Airlines stock finally seemed to be gaining momentum during October. However, its rally quickly fell apart after CEO Doug Parker suggested during American's Q3 earnings call that the company might have earned an "artificially high" profit margin in 2015 due to the steep drop in fuel prices -- and thus, its profit margin might fall in 2016.
American Airlines stock has slumped more than 10% since Parker made those comments. However, it's looking less and less likely that American Airlines' profit margin will fall in 2016. As a result, its stock could rebound next year.
Fuel prices keep falling
Doug Parker's comment about the possibility of falling margins in 2016 was premised on the fact that oil prices had fallen about 50% in the past year. This sudden drop in airlines' biggest cost item led to faster capacity growth and a corresponding reduction in fares -- but not right away. In 2016, Parker expected the industry to face a full year of lower fares without the benefit of another drop in fuel prices -- hence a decline in margins.
However, oil prices have moved even lower in the past two months. The price of Brent crude oil for delivery in February has fallen from around $50/barrel in late October to less than $37/barrel at the end of last week. Looking out to December 2016, the price of Brent has fallen from $55/barrel in late October to around $44/barrel today.
Meanwhile, the El Nino weather pattern has led to unseasonably warm temperatures. This has reduced demand for heating oil, which is fairly similar to jet fuel.
As a result, jet fuel prices have fallen even faster than crude oil prices. The price of Gulf Coast jet fuel fell below the $1.00/gallon mark last Monday for the first time since 2004. That's down by nearly $0.40/gallon from Oct. 23 when Parker made his comments about 2016 margins.
This is a potential game-changer
American Airlines consumes more than 4 billion gallons of jet fuel annually. That means a $0.30-$0.40/gallon reduction in jet fuel prices represents about $1.5 billion in annual cost savings and a roughly 3%-4% margin tailwind.
That's probably the difference between expanding margins and contracting margins in 2016. During the first half of the year, American's unit revenue will probably continue to fall, but it could benefit from fuel cost savings of $0.60-$0.70/gallon relative to the $1.87/gallon it paid in the first half of 2015.
In the second half of 2016, American Airlines' fuel savings will probably be lower. But by then, the company's nonfuel unit costs should be flat or declining as the company starts to reduce its headcount following a successful integration effort.
More importantly, unit revenue could start to rebound by that point. Easier year-over-year comparisons will certainly help. Additionally, the reservation system integration completed in October will allow American Airlines to start optimizing its flight schedule and refining its revenue management techniques over the next few quarters.
Furthermore, American will roll out a new fare type aimed at price-sensitive travelers sometime next year. This should reduce the financial impact of matching budget carriers' prices. Finally, the Olympics in Rio de Janeiro will boost travel demand to and from Brazil -- a key market for American Airlines that has been very weak recently.
This stock is too cheap
American Airlines' rock-bottom earnings multiple -- less than seven times a very conservative estimate of 2016 EPS -- implies that investors are very skeptical about its ability to maintain (let alone grow) its earnings in 2016 and beyond.
American Airlines is using this opportunity to buy back tons of stock. Through the first three-quarters of 2015, the company spent $2.5 billion on share repurchases, and it currently plans to buy back another $3.5 billion of stock by the end of 2016.
These buybacks are driving a sharp reduction in American Airlines' share count, accelerating its EPS growth. This EPS growth will probably lead to a higher earnings multiple eventually -- rewarding patient investors.