Is American Airlines Making The Most Of Its Increased Cash Flows?

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American Airlines

Sustained weakness in global crude oil prices continues to create an upsurge in the profits of the majority of the US airlines. The top six US airlines – American Airlines (NASDAQ:AAL), United Continental (NYSE:UAL), Delta Air Lines (NYSE:DAL), Southwest Airlines (NYSE:LUV), Alaska Air Group (NYSE:ALK) and JetBlue Airways (NYSE:JBLU) – delivered a GAAP net profit of $5.4 billion in the June 2015 quarter, which is 62% higher compared to the profits earned in the same quarter last year. Since the timing of the rebound in oil prices is unknown, US airlines are taking all possible measures to judiciously utilize the excess cash flows to mitigate the sensitivity of their earnings to the oil prices to some extent. These measures include re-fleeting of aircraft, reducing debt obligations, and returning value to the shareholders. In this article, we will analyze the strategies being adopted by American Airlines and determine if the airline is making the best use of the extra cash at its disposal.

Our price estimate for American Airlines stands at $48 per share, about 20% ahead of its current market price.

See Our Complete Analysis For American Airlines Here

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Let’s begin by looking at American Airlines’ current financial status. The world’s largest airline (by traffic) reported a net income of $1.7 billion in the second quarter of 2015, almost double the profits generated a year ago((American Airlines Second Quarter 10Q filing, 24th July 2015, www.aa.com)). This huge jump in profits was driven primarily by the airline’s no hedging policy, which resulted in fuel cost savings of more than $1 billion. Consequently, the airline generated operating cash flows of $4.8 billion in the first six months, which are expected to grow even higher in the later half of the year. However, the airline currently has long-term debt of close to $19 billion on its balance sheet. This translates into a debt to capitalization rate of over 42%, which is much higher than the industry average. Thus, the most logical use of the extra cash generated during the year should be to pay down the airline’s long term debt. However, the airline does not seem to be taking that path.

On the contrary, the Fort Worth-based airline is using its cash flows to overhaul its existing fleet of aircraft. The airline expects to spend close to $5.4 billion on new aircraft in 2015, which should be easily funded through its annual operating cash flows and some incremental debt, if required. Though it may appear irrational at first to take on more debt to finance newer aircraft, things become clearer if we take a closer look. The airline had ordered several Airbus A320-neo aircraft before filing for bankruptcy in 2011. However, it has been delaying in taking the delivery of these planes due to a variety of reasons. But now, with stronger cash flows, the airline is set to replace its older and smaller planes with bigger and more fuel-efficient planes. These planes will not only enable the airline to expand its capacity to fight the increasing competition, but will also improve the airline’s operational efficiency, that will reflect on its margins in the long term. However, that does not resolve the issues related to a highly levered balance sheet.

AAL fleet plan

Source: Bank of America Merrill Lynch 2015 Transportation Conference

American Airline is fully aware of the concerns that an excess leverage can cause and as a result, the airline has been proactively working towards reducing it. The legacy carrier has paid down over $3 billion of its high cost debt since its merger with US Airways in December 2013 and has refinanced the remaining debt at lower rates. For example, the airline has raised a new debt financing of $1.7 billion with a blended rate of 3.7%, which is very low compared to the industry standards. Thus, despite having a huge amount of debt on its books, the interest obligation of the airline has actually gone down due to the lower interest rates. This implies that the airline is quick enough to take advantage of any attractive opportunity which can prove to be beneficial in the long term.

AAL Debt

Source: Bank of America Merrill Lynch 2015 Transportation Conference

Apart from re-fleeting, American Airlines is investing its cash flows on repurchasing its own shares from the market. In the second quarter, the airline repurchased 17.3 million shares worth $753 million((American Airlines Second Quarter 10Q filing, 24th July 2015, www.aa.com)). Further, the legacy carrier authorized a $2 billion share repurchase program to be completed by 2016, in addition to an existing $2 billion repurchase program approved in January 2015.  In addition to this, the airline has been paying a quarterly dividend of $0.10 per share over the last four quarters. In all, the airline has returned approximately $1.1 billion to its shareholders in the first half of 2015. This indicates the airline’s willingness to share its growing profits with its shareholders, which is likely to reinforce investor confidence in the airline.

S&P returns

Source: Bank of America Merrill Lynch 2015 Transportation Conference

To conclude we would say that while the high debt on American Airlines’ books is likely to raise investor concerns, the airline knows what it is doing and its strategy is likely to bear fruits in the long term.

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