American Airlines’ Profit Surges On Fuel Cost Savings, Unit Revenue To Remain Weak Until Mid-2016

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Despite posting an adjusted net income of $1.9 billion((American Airlines Announces Second Quarter Results, 24th July 2015, www.aa.com)), 27% higher than last year, American Airlines’ stock lost more than 7% on Friday, 24th July 2015, when the airline released its second quarter operating results. This negative market sentiment was driven by the steep fall in the airline’s passenger unit revenues during the June quarter, due to pricing pressure and currency fluctuations in its key markets. The Fort Worth-based airline does not expect its unit revenues, a key metric watched throughout the industry, to improve until the second half of 2016. However, lower fuel prices continued to drive the airline’s earning growth during the quarter. Going forward, we anticipate fuel cost savings to boost the network carrier’s bottom line, despite a decline in its top line owing to pricing pressure. In this article, we discuss the key trends noticed in American’s second quarter results and its guidance for the next quarter.

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Pricing Pressure Pulls Down Revenue

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Despite facing the brunt of rumors of an excess supply of domestic seats in the last two months, American Airlines, the world’s largest airline by traffic, grew its system capacity by 1.9%((American Airlines Second Quarter 10Q filing, 24th July 2015, www.aa.com)) in the latest quarter. While this capacity growth attracted 1.1% more passengers, the airline’s load factor fell 1.7%, implying that the airline had to fly more empty seats as opposed to in the same quarter last year. However, the pricing pressure in key markets coupled with foreign currency headwinds took a toll on American’s unit revenue. The airline’s passenger revenue per available seat mile (PRASM), a measure of unit revenue, slipped almost 7% in the last three months, as previously anticipated by the airline. Yet, the legacy carrier managed to post quarterly revenue of $10.83 billion, 4.6% lower compared to last year, slightly missing the analyst forecast of $10.89 billion.

AAL

Source: Google Finance

Fuel Cost Savings Result In Record Bottom Line Growth

Due to the slower-than-expected oil price recovery during the quarter, American Airlines’ fuel price averaged $1.90 per gallon((American Airlines Second Quarter 10Q filing, 24th July 2015, www.aa.com)), 37% lower compared to last year. In addition, the no-hedging policy enabled the legacy carrier to realize fuel cost savings of more than $1 billion in the June quarter. However, the impact of these cost savings was partially offset by a 9.3% increase in the labor costs and 2.5% rise in the unit costs (excluding fuel and special items). Despite this, the airline’s operating expense dropped 10.5%, resulting in an operating margin of 17.7% versus 12.3% in second quarter of 2014. As a result, American generated GAAP net profit of $1.7 billion, or $2.41 per diluted share, more than twice the profit earned a year ago.

Returning Value To Shareholders

In the second quarter, American Airlines returned $823 million to its shareholders through quarterly dividends of $70 million and share repurchases of $753 million, or 17.3 million shares((American Airlines Second Quarter 10Q filing, 24th July 2015, www.aa.com)). In total, the airline has returned approximately $1.1 billion to its shareholders in the first half of 2015. Further, the legacy carrier authorized an additional $2 billion share repurchase program to be completed by 2016. This new buyback program is in addition to existing $2 billion repurchase program approved in January 2015, under which shares worth $943 million have already been repurchased.

AAL Return

Source: Bank of American Merrill Lynch 2015 Transportation Conference

Interestingly, American Airlines has already completed its share repurchase program of $1 billion ahead of its schedule in 2014. Besides, the airline has also paid down high cost debt of $3 billion since its merger with US Airways in December 2013((Bank of American Merrill Lynch 2015 Transportation Conference)). This shows that the airline is committed towards strengthening its balance sheet and providing value to its shareholders.

S&P returns

Source: Bank of American Merrill Lynch 2015 Transportation Conference

Apart from this, American Airlines has been investing in development of its product. The airline expects to spend $5.4 billion on new aircraft for the full year 2015, of which $2.5 billion((American Airlines Second Quarter 10Q filing, 24th July 2015, www.aa.com)) will be spent in the second half of the year. In the June quarter, the legacy carrier took delivery of 24 new mainline aircraft and nine new regional aircraft, and retired 34 older mainline and eight older regional aircraft. Further, the airline aims to invest $2 billion to enhance its product, including improvements to aircraft interiors, international Wi-Fi connectivity, and upgrades to its Admirals Club lounges.

AAL fleet plan

Source: Bank of American Merrill Lynch 2015 Transportation Conference

Outlook For 3Q and Beyond

Given the fears of an oversupply of seats in the market, American Airlines has lowered its full year capacity growth target to 1%, constituting full year domestic capacity growth of 1% to 2% and an international capacity increase of approximately 1%((American Airlines Investor Update, 24th July 2015, www.aa.com)). Since American anticipates the currency headwinds and pricing pressure to continue for the rest of the year, the airline’s unit revenues are expected to remain depressed and fall by 6%-8% during the third quarter. Further, the airline does not expect the unit revenues to improve until mid-2016. On the cost side, the airline projects its fuel price to average between $1.73 and $1.78 per gallon during the September quarter on the back of depressed crude oil prices. However, the network carrier expects its unit costs (excluding fuel and special items) to go up by 3%-5% in the next three months. In consequence, the airline’s operating margin is expected to be in the range of 16 to 18 percent for the third quarter.

AAL Guidance

Source: American Airlines Investor Update, 24th July 2015

To summarize, while currency fluctuations and pricing pressure are expected to drive down American’s unit revenue and, in turn, its top line, we expect fuel cost savings to continue to boost the airline’s earnings growth for the next quarters.

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