Overview: American Airlines Group Inc. Part III of III
Does American have funds to pay debts and expansion?
American’s funds
American Airlines (AAL) plans to add 83 mainline aircrafts in 2014 consisting of ten A319s, 42 A321s, three A332s, 20 B738s, two B788s, and six B773s. It plans to retire 82 older aircrafts. It added one mainline aircraft to its fleet of 970 in 2013. The airline’s regional fleet is expected to increase by seven aircrafts to 565 in 2014. This adds up to a net addition of eight aircrafts in 2014. The company’s estimated capital expenditure for 2014 totaled $2.1 billion, out of which 1.2 billion, 57%, were related to aircraft purchase and $898 million were non-aircraft capital expenditure. This will result in an increase of 42% in available seat miles (or ASM) to 239 billion in 2014 from 168 billion in 2013. The increase in ASM will allow the airline to carry more passengers leading to increased revenue provided the load factor and yield don’t decrease.
Leverage
Although all operating and performance metrics of American Airlines Group (or AAG) has shown improvement after the merger, leverage is one area that needs considerable improvement. AAG’s debt has almost doubled from $8,535 million in 2012 to $ 16,894 million in 2013 after merging. U.S Airways added $5,492 million secured debt and $551 unsecured debt in American’s debt portfolio. AAG plans an average annual principal repayment of $1.6 billion in the next five years.
Cash—liquidity
It is often advantageous if a company’s capital expenditure can be financed through internal cash flows rather than through debt. AAG’s debt is already very high. In March, 2014, AAL had a cash and short-term investment balance of $10.6 billion. It had an undrawn revolving facility of $1 billion. With a total liquidity of $11.6 billion and operating cash flow of $1.2 billion in 1Q14, which is sufficient to cover the entire year’s capital expenditure of $2.1 billion, the company has the capability to expand with internal funds if everything goes favorably as in the first quarter. In addition to capital expenditure, AAG’s debt repayment burden has increased after the merger requiring an annual debt repayment of 1.6 billion.
AAL’s liquidity in 1Q14, measured as total balance sheet cash and undrawn credit facilities, as a percentage of last 12 months (or LTM) revenue was the highest among its peers at 28.4%. This was closely followed by low cost carriers, Alaska with 27.1%, Jet Blue (JBLU) with 25.8%, and Southwest (LUV) with 25.3%. It’s important to note that American is far ahead of its legacy competitors United (UAL) and Delta (DAL) with 16.7% and 14.6%, respectively, of liquidity as a percentage of last 12 month (or LTM) revenues. A higher liquidity will give American more flexibility in planning its expansion plans.
Estimated synergies in past airline mergers
The two categories of synergies expected from an airline merger include network synergy and cost synergy. While network synergies arise from expanding routes and destinations and efficient scheduling of round trips, cost synergies arise out of increased operational efficiencies, savings in integrating information systems, better utilization of gate space, and other facilities.
Delta Airlines (DAL) revised its initially estimated synergy from $1 billion to $2 billion in 2008 with a 70% network synergy. United Continental (UAL) estimated $1 billion to $1.2 billion with up to 80% network synergy. U.S. Airways and American West estimated $600 million with up to 60% network synergy, Southwest (LUV) estimated more than $ 400 million, up to $680 million, and the recent merger between American (AAL) and U.S. Airways is estimated to have synergy benefits to the extent of $650 million to $1.05 billion with up to 85% network synergy. However, Jet Blue (JBLU) hasn’t had any recent mergers.
Network synergies versus cost synergies
Network synergies accounted for almost 50%–85% of the total synergy benefits in the past airline mergers. According to the American Antitrust Institute (or AAI), the higher percentage of estimated network synergy as against cost synergy could be for two reasons—because of the already efficient operations of standalone airlines or because network synergies are difficult to verify by the Department of Justice (or DOJ) and can get approval easily.
With regard to cost synergies, according to the AAI, most of the reductions estimated are for fixed costs. It takes a longer time to reach consumers in the form of lower fares compared to marginal cost reductions that can be passed on to consumers immediately. Another concern is that the integration costs are generally high and may negate the estimated cost synergies. Details regarding integration costs of past mergers will be covered in the next section in this series.
Break-up of American Airlines’ synergy estimate
American Airlines Group estimates a $1 billion synergy benefit to be derived from network and cost synergies.
Network synergy is estimated to be $900 million, 85% of the total, from improved schedules and routes, increased passenger loyalty through the expanded frequent flyer program, and fleet restructuring to better align supply with demand.
Cost synergy of $550 million is expected from overlapping facilities and airport services, less expensive contracts through improved purchasing power, and efficient use of information technology.
Costs related to combining employees of the two airline is expected to reduce the benefits to the extent of $400 million.
According to the AAI, it should be noted that American is said to have stated to the DOJ that synergy benefits include network benefits of $500 million and cost benefits of $150 million totaling to $650 million. This is almost 60% less than the $1 billion reported in the company presentation.
Overview: Integration costs exceed expectations in past mergers
In past mergers, integration costs exceed expectations.
We spoke about the past airline merger synergy benefits in the previous section. A comparison of costs with benefits will reveal the actual value generated from the merger. The following table compares predicted integration costs of previous mergers in the airline industry with actual integration costs reported to date. Integration costs include costs of integrating information systems, payroll reconciliations, standardizing aircraft interiors, obtaining a single operating certificate, combining frequent flying programs, and labor integration. The actual integration costs for the three previous mergers have been higher in almost all cases. Also, the time frame for the integration also has exceeding the three-year standard in many cases.
Delta Airlines’ (DAL) actual integration cost was 200% higher at $1.5 billion. United’s (UAL) was 33% higher as of 3Q13 and expected to increase as integration still isn’t complete. Southwest (LUV) had a 22% higher integration cost as of 3Q13 and it’s expected to be higher.
Integration issues have commonly extended for a few years after the merger. For example, United Continental haven’t resolved labor integration issues yet. It has had flight delays due to failure of integration of information systems. U.S. Airways and America West couldn’t decide on pilot seniority even eight years after the merger. Jet Blue (JBLU) is one of the few airlines that hasn’t been involved in mergers recently. As a result, it will be fair to assume that the integration costs of American (AAL) and U.S. Airways might exceed the expected $1.2 billion in the next few years.
Must-know: Airline stock price performance
Airline stock price performance
Comparing the stock performances of American Airlines (AAL) with its peers, the IVT ETF and the S&P 500 index reveals that American has outperformed the market and its peers in share price growth throughout the period between 2012 and 2014 followed by Delta (DAL), Southwest (LUV), and United (UAL). Jet Blue’s (JBLU) share price growth was more or less in line with that of the index. Shares of all airline companies have increased during the period when economic recovery boosted air travel.
The Dow Jones Transportation Average Index Fund (or IYT) index tracks the performance of the transportation sector of the U.S. market, including airlines, railroad companies, trucking, freight, and industrial companies. Many major airline companies, including Delta Air Lines (DAL), United Continental Holdings (UAL), Southwest Airlines (LUV), and Jet Blue (JBLU), are part of this index.
American (AAL) has proved its renewed strength after the merger in its 1Q14 results when it recorded a 5.5% increase in operating margin from 1.8% to 7.3%. This explains why share price increased by 48.8% by the end of the first quarter after merger. The price currently has increased by 81% since the merger closed. It has had the highest growth in share price among all its peers during this period.
Overview: Operating performance and valuation indicators
Indicators of operating performance and valuation
American Airlines (AAL) has successfully managed to emerge from bankruptcy and regain the confidence of investors by providing returns beyond expectation. Even after the merger there have been no hiccups in the airlines’ operations. Also, on-time arrivals have improved to 80% in May, 2014. Among the legacy carriers, American Airlines ranks second with an American Customer Satisfaction Index (or ACSI) score of 66. There’s scope for further improvement as the overall score for airlines was 69 and its strongest competitor, Delta (DAL), scored 71.
The operating metrics, as seen in the previous table, also show that AAL is posing strong competition to its peers. It has the second highest passenger revenue per available seat mile (or PRASM) calculated as the product of revenue passenger miles (or RPM) and yield divided by the available seat mile (or ASM). AAL already has the highest RPM and capacity measured by ASM. With an improvement in the capacity utilization measure by load factor—currently lower than peers at 80%—it should be able to further improve PRASM. This is combined with the lowest cost per available seat mile (CASM) among the legacy carriers. However, the company has a high leverage of 94% after the merger which is compensated to a certain extent by a strong liquidity position—highest among its peers.
Looking at its valuation multiples AAL seems to be undervalued as its pricing-earnings (or P/E) ratio is lowest compared to its peers. Also, a forward earnings before interest, taxes, depreciation, and amortization (or EBITDA) multiple of 14%, which is in line with the peer average, looks good for a forward enterprise value (or EV)/EBITDA of 5.4x. Among its legacy peers, DAL also is a fundamentally strong company with the highest forward EBITDA margin among its peers and lower leverage, but United (UAL) with the lowest EBITDA margin of 9.9% isn’t a comparable investment. Although its low cost competitors, Jet Blue (JBLU) and Southwest (LUV), have a forward EBITDA margin comparable to AAL’s, their P/E ratios are high—14.5x and 11.9x—compared to AAL’s 6.3x which means investors have to pay higher price for each dollar of earnings.
If AAL maintains the same rate of growth as reported in the first quarter, its operations continue to gain efficiency, and it’s able to reduce leverage, its valuation would make AAL shares an investment worth considering.
By Tejeshwari Chandrappa-Market Realists
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