Scenarios That Can Move American Airlines’ Valuation

The US airline industry has been in the limelight lately due to its exceptional performance on plummeting global crude oil prices. As jet fuel costs constitute nearly a third of an airline’s total operating expenses, the 50% drop in oil prices over the last ten months has accelerated the earnings of all major US airlines. American Airlines, the world’s largest airline by traffic, was among the top gainers from this fall, as the airline recorded a 5% increase in its EBITDA margin in 2014. The airline’s stock price reached an all-time high of $56.20 per share in January when crude oil prices touched $45 per barrel. Our current price estimate for American Airlines stands at $54 per share, assuming a gradual recovery of oil prices over the next two to three years. However, in this article, we will discuss three scenarios that can significantly impact the airline’s current valuation.

See our complete analysis for American Airlines here

Base Case: Gradual Oil Price Recovery

Since July of last year, crude oil prices have plunged from over $110 per barrel to $45 per barrel in January of this year on weak global demand, led by slow growth in the Chinese economy, and surplus oil production due to the rising tight oil production in the US.  In addition, the Organization of Petroleum Exporting Countries’ (OPEC) decision to maintain its current production rates has further aggravated the demand-supply mismatch. While the crude oil prices declined drastically in the second half of 2014, the full year prices averaged around $100 per barrel. Over the last few weeks, crude oil prices have increased to $60 per barrel, showing signs of recovery due to the large cutbacks on production by major oil companies. Keeping this in mind, we expect oil prices (Brent) to average around $75 per barrel this year and gradually increase to $85 per barrel over the next two years before rising back to the $100 per barrel mark by the end of our forecast period.

While the decline has weighed heavily on oil producing companies in the US, it has been extremely profitable for most of the US airlines, particularly American Airlines. The Texas-based airline’s decision to adopt US Airways’ policy of not hedging its fuel consumption post its merger helped the airline to translate the entire decline in crude oil prices into fuel cost savings. As a result, the airline’s consolidated fuel costs as a percentage of its revenue, dropped from 33.5% in 2013 to 29.5% in 2014. This, coupled with the integration of full-year results of US Airways, enabled the airline to record a net profit of $2.9 billion in 2014 compared to a loss of $1.9 billion suffered in 2013.

Therefore, in our base case scenario for American Airlines, we estimate the US fuel costs as a percentage of revenue to decline from 34.4% in 2014 to 27.2% in 2015 and, thereafter, rise to 32.3%, closer to its historical levels, by the end of our forecast period. Similarly, American’s international fuel costs as a percentage of its revenue are expected to fall from 34.4% last year to almost 29% by the end of this year, before rising to 32.4% in the later years of our analysis. Accordingly, the airline’s consolidated EBITDA margin is expected to improve from 22.4% in 2014 to close to 29% by end of this fiscal year, and stabilize at around 26% in the outer years of our forecast period.

See our Base Case Scenario for American Airlines here

V-shaped Oil Price Recovery (-30%)

If we look at a more optimistic oil price scenario, where we presume that demand for crude oil will improve significantly due to increased economic activity in China and, concurrently, tight oil production in the US will decline, there could be the possibility of a sharper, V-shaped recovery in oil prices. Moreover, if the OPEC decides to change its current stance and cut its production, we estimate crude oil prices to reach over $120 per barrel by the end of our forecast period. In that case, we estimate American Airlines’ fuel costs for US operations to rise sharply to almost 36% by 2016, and revert back to its pre-2014 levels, i.e. more than 39% of its revenue, by the end of our forecast period. On the same lines, the airline’s international fuel costs will also increase to 37.3% in 2016, and continue rising to 39.2% by the end of our forecast period. Consequently, we forecast the airline’s EBITDA margin to drop severely from an all-time high of 29% in 2015 to close to 20% over our forecast period. Hence, our price estimate for American Airlines would fall to $38 per share, a 30% downside to our price estimate in the base case scenario.

See our analysis for V-shaped Oil Price Recovery for American Airlines here

Sustained Decline in Oil Prices (+27%)

Contrary to our V-shaped recovery scenario, if demand for oil does not improve, either because of a continued slowdown in the Chinese economy, or due to the use of alternative fuels owing to technological advancements, oil prices will take longer than expected to recover. Additionally, if the OPEC continues to operate at its current production levels, or alternatively plans to increase its production rates to eliminate competition and increase its market share, the global oil market will experience depressed oil prices for a prolonged period. Under this scenario, we forecast American Airlines’ fuel costs for US operations to drop to 24% of its revenue in 2016, and thereafter rise to 25.5% by the end of our forecast period. Also, the airline’s international fuel costs as a percentage of its revenue would dip to almost 25% in 2016 and improve marginally to 25.6% of its revenue by the end of our analysis. As the sustained decline in fuel costs will boost the airline’s bottom line growth, we expect its consolidated EBITDA margin to shoot up from 22.4% in 2014 to close to 32% in the outer years of our forecast period. Taking this into account, we arrive at a price estimate of $69 per share for American Airlines’ stock, an upside of 27% to our current price estimate for the airline.

See our analysis for Sustained Decline in Oil Prices for American Airlines here

Seat-Surplus due to Excessive Capacity Additions

Now, we look at flying capacity, a key determinant of air fares, which, in turn, drives the profitability of an airline. Large network carriers, including American, have restricted capacity additions over the last few years to match the decline in air travel demand post the financial crisis in 2008-2009. This capacity discipline has enabled these airlines to raise average ticket fares, which has lifted the industry out of its huge losses (Also Read: Restrained Capacity Addition Is Key To Sustaining Airline Industry Profits). American, United, and Delta, which together control more than half of the total domestic capacity, have indicated their intent to add capacity with restraint over the coming years. However, the recent dip in oil prices that enhanced the earnings of these airlines, may force them to indulge in capacity and price wars to increase their market share.

In our base case scenario, we assume American Airlines to continue to follow capacity discipline due to which we assume its share in the US and international markets to remain constant at 21.2% and 11.5% throughout our analysis. Consequently, we forecast its passenger yield (a measure of air fares) to improve to $0.152 for US operations and $0.165 for international operations over our forecast period. However, we estimate the airline’s domestic occupancy rate (percent of seats occupied in flights) to fall marginally from 85% in 2014 to 84.7% by the end of our forecast period and its international occupancy rate to drop from 78% in 2014 to 77.5% by the end of our forecast period.

Now, we assume a scenario where American and other large carriers resume capacity expansions at a faster pace. This will probe the low cost carriers (LCCs) such as Southwest, Alaska, and JetBlue to continue to add capacity at a high rate to improve their domestic market share. Hence, there will be an oversupply of seats in the market which will undermine the ability of these large airlines to charge profitable fares. In such a scenario, we expect American Airlines’ domestic passenger yield will drop sharply from $0.153 in 2014 to $0.141 through the end of our analysis, while its domestic occupancy rates will decline to 81% over our forecast period. However, the airline’s international operations will be more severely hit by these expansions, leading to a much more  drastic decline in its occupancy rate from 78% in 2014 to 73.5% by the end of our analysis period. Further, the airline’s international passenger yield is expected to decline from $0.166 in 2014 to $0.153 through our forecast period. Accordingly, we forecast EBITDA margin to decline from 29% in 2015 to 25% over our forecast period, translating into a stock price of $48 per share, a downside of more than 12% to our current price estimate for the airline.

See our analysis for Seat Surplus Scenario for American Airlines here

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