American Airlines Will Likely Report Solid Results on Expanding Capacity & Healthy Operating Margin

American Airlines (NASDAQ:AAL) will announce its second quarter earnings Thursday, July 24. The carrier is coming off a strong first quarter in which its profits rose to $480 million, from a loss of $297 million in the same period last year. ^[1] This solid profit performance in the first quarter was phenomenal considering American emerged from bankruptcy just a few months back in December 2013.

In the second quarter, we figure the carrier will likely maintain its strong profit performance, as it expanded its flying capacity during the quarter raising its overall passenger traffic. In our opinion, the stable demand for air travel played a key role in enabling American to expand its flying capacity by about 3% annually in the quarter. ^[2] This increase in the carrier’s capacity was primarily driven by more active airplanes and larger gauge airplanes (which seat more passengers) replacing smaller gauge airplanes. Additionally, American’s second quarter unit revenues (amount collected from each passenger per seat for a mile of flight) also increased sharply on a year-over-year basis. All in all, we figure higher unit revenues and higher passenger traffic will likely raise American’s overall passenger revenues in the second quarter.

See our complete analysis of American Airlines here

Healthy Operating Margin

In terms of margin, American in an investor update filed earlier in July forecast solid pre-tax margin (excluding special items) of around 12-13% in the second quarter. ^[2] This margin guidance is highly impressive as Delta (NYSE:DAL), which emerged from bankruptcy more than fives years back and led the U.S. airline industry in profits last year, has forecast its second quarter operating margin to lie around 14-16%. ^[3] We consider it highly commendable that American has been able to lift its pre-tax operating margin in line with those of its peers, in spite of a very recent emergence from bankruptcy.

This solid operating margin also indicates that the integration of US Airways into American is proceeding smoothly. At a recent conference, American said that its on-time departure and on-time arrival rates have improved steadily, again indicating that ground level operations of the carrier are operating smoothly, despite the ongoing integration of US Airways. ^[4] In contrast, United (NYSE:UAL) faced many issues while integrating with Continental, and consequently the carrier’s on-time arrival and departure rates suffered for many months in 2012. Persistent delays in arrival are baneful as fliers then start opting for other carriers. Though American’s operating performance in terms of on-time arrival and on-time departure has been good so far, we figure the carrier still has a lot of ground to cover before it fully integrates US Airways. The threat from integration issues to American’s on-time arrival rate will likely persist through the next year or so.

Special Charges Will Temper Growth from Capacity Expansion

Separately, American has informed that its second quarter profits will be impacted by special charges. During the quarter, the carrier sold off its remaining fuel hedging contracts, and therefore it will incur a corresponding non-cash tax charge of approximately $330 million. ^[2] The new leadership team at American that includes many members from US Airways’ management, is shifting to US Airways’ policy of not engaging in fuel hedging. The team believes that the current cost of entering into fuel hedging contracts exceeds their potential benefits. In simple terms, fuel hedging contracts protect airlines from a sudden rise in jet fuel prices. However, in American’s opinion, the cost of buying this insurance in the current environment is higher than its potential benefits. In our view, given the stable outlook for crude oil prices over the next few years, such a stand is not bad for the time being. But over the long term, not having fuel hedging contracts in place will leave the airline highly vulnerable to sharp rises in fuel prices. American on its part, says that it can re-enter into fuel hedging contracts in future, whenever it deems such a move to be fit.

Apart from the special charge related to the sale of its fuel hedging contracts, American has also forecast to incur one-time merger related charges of about $250-300 million in the second quarter. ^[2] Despite these significant one-time charges, we expect the carrier to be able to post healthy growth in its results on gains from its capacity expansion and solid operating margin.

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1. American Airlines Group Reports Record First Quarter 2014 Financial Results, April 24 2014, www.aa.com [↩]
2. IR Update – July 9, 2014, July 9 2014, www.aa.com [↩] [↩] [↩] [↩]
3. Delta’s July 2014 investor update, July 18 2014, www.delta.com [↩]
4. Barclays 2014 High Yield Bond and Syndicated Loan Conference, May 13 2014, www.aa.com [↩]