Description

Note that the EPS, EBIT, and FCF numbers listed above incorporate $95 Brent and do not net out tax (2014 and 2015 are gross of tax. 2016, in the table below, is net of tax, as discussed in the body below). Happy to answer any model assumption questions as well if there's any confusion.

American Airlines Overview:

American Airlines Group operates two major network carriers, American Airlines and US Airways. The two companies merged on December 9, 2013, enabling AMR Corporation (American’s predecessor) to exit Chapter 11 bankruptcy, which it entered in November 2011. Following the merger, American is now the largest airline in the world and the largest airline domestically, with ~27% domestic market share.

Industry Overview:

The airline industry is highly competitive. Multiple airlines typically compete for the same routes, which has resulted in price competition to maintain market share and compressed margins. Meanwhile, cyclical increases in demand have historically been met with inelastic industry capacity increases. However, over the last 13 years, the domestic industry has consolidated from 12 large carriers in 2001 to just 6 today. The four largest carriers (American, Delta, United, Southwest) have roughly 85% market share, with the top six (including Alaska and JetBlue) totaling 93%. This consolidation has played an enormous role in pricing and cost stability, expanding margins, and sustainable industry-wide profitability. Most notably, the industry has shifted towards capacity discipline, growing capacity no faster than GDP growth, which strengthens pricing and allows capacity to be cost-effectively pulled to respond to changing demand landscapes. Management teams are focused on increasing margins and ROIC, strengthening balance sheets and reducing interest costs, and returning capital to shareholders, all of which further reduce the industry’s cyclicality such that it can drive positive earnings even through recessionary periods.

Thesis:

The American story is a two part thesis: earnings growth through revenue and margin expansion combined with multiple re-rating as the market assigns airlines a multiple more comparable to those of high quality industrials peers. Revenue growth going forward will be a combination of growth in capacity and passenger revenue per available seat mile (PRASM). While capacity should grow roughly in line with GDP growth over the longer term, in the near term, it will also benefit from increasing the seating density of aircraft. In 2015, 1.5% of capacity growth should come from adding additional seats to existing planes, which is extremely high margin revenue given there are essentially no incremental costs. PRASM will also grow as American continues its revenue initiatives to increase seat prices. One large initiative that will begin in 2015 is choice seating, which allows passengers to pay extra for window/aisle seats or to sit closer to the front of the aircraft. Choice seating alone is a several hundred million dollar proposition.

On the margin side, synergies from the merger with US Airways should enable further margin expansion. Originally forecast to be $1 billion, the total synergy target has already been increased to $1.4 billion, and management is confident it can meet or exceed that level. Much of the integration synergies will begin in 2015 when larger items such as attaining a single operating certificate and reservation system migration are slated to occur. Additionally, American is in the middle of a re-fleeting program that will not only optimize seating to the benefit of revenue, but will move the airline to more fuel efficient planes, reducing fuel cost, and give American the youngest fleet in the industry (limiting maintenance cost increases).

The re-rating of the multiple should occur as investors increasingly believe in the more stable industry profile as a result of consolidation and the resulting ability to generate positive earnings through the cycle, discussed above. As a result, the current discount in earnings multiple to leading industrials companies, while unlikely to be eliminated given the variability of oil cost for airlines, should become smaller.

Management:

Doug Parker, Chairman and CEO, became CEO of American following its merger with US Airways. Previously, he was Chairman and CEO of US Airways, and was Chairman, President, and CEO of America West prior to its merger with US Airways. Under Mr. Parker’s leadership at US, the airline achieved record revenue growth with some of the lowest cost growth in the industry. Mr. Parker currently owns 1.48 million shares of AAL, equivalent to $71.6 million. In 2014, he will receive $2.1 million in cash compensation (his salary is 20% lower than peers, per his request) resulting in a 34.1x ownership to cash compensation ratio.

Valuation:

Under base case assumptions, American is expected to grow revenue by 4.6% and 4.3% in 2015 and 2016, respectively, through a combination of capacity and PRASM growth. Excluding fuel, operating costs are expected to grow by 5.7% in 2015 (largely due to pilot salary increase) and 3.2% in 2016. In an effort to normalize oil price fluctuations, a price of Brent of $95 per barrel (36% higher than current spot pricing) is used for fuel costs. While American does not currently pay cash taxes given historical net operating losses, it expects to begin paying taxes in 2016-2017 and the valuation applies a full 38% tax rate to 2016 earnings. Using the above base case assumptions, American trades at a 2016 P/E of 9.0x. Applying a base case forward 12 month earnings multiple of 12x implies a stock price of $64.20, for a one year return of 33.9% including dividend. A downside multiple of 8x results in a stock price of $42.80 (-10.4% return), while an upside multiple of 15x results in a price of $80.25 (+67.2% return). Should Brent pricing differ from the assumed $95, the matrix on page 1 outlines potential returns.

Divergent View:

Looking to 2015 and 2016, the largest source of cost increases will come from pilot salary (pilots are currently in negotiations with the Company). In speaking with American, management is confident that a deal will occur that is similar to their most recent offer of an 18% salary increase immediately, with 3% incremental increases for the next four years. The Street appears to be modeling a ~15% increase in total Company salary in 2015. However, pilot salary is only ~$2.5 billion of the $8.5 billion in total salary. As a result, salary cost (after factoring in an additional $110 million for flight attendant raises) should increase by roughly $610 million, rather than the $1.3 billion increase modeled by the Street. To be conservative, I model a $770 million increase, resulting in $0.70 of incremental 2015 EPS vs the Street.

Additionally, as discussed further below, fuel costs are a large component of American’s cost structure (~33% of 2014 operating expenses). The Street currently models 2016 oil prices of $90-105 vs Brent 2016 futures closer to $80. While the valuation framework above uses an oil input of $95 to normalize earnings, should oil prices remain depressed, American’s earnings power would be meaningfully higher than expectations.

Investment Risks/Considerations:

Oil price: American currently does not hedge any of its oil exposure, compared to 20-30% hedging by Delta and United. A $1 increase in Brent results in a ~$130 million increase in fuel cost. Similarly, a $10 increase in Brent reduces 2016 EPS by ~$1.13.

GDP growth: Airline demand moves largely in line with GDP growth globally. Should GDP growth turn negative, especially in the US, where American generates ~65% of its revenue, revenue growth would likely slow or potentially turn negative. This risk is somewhat mitigated, however, by the fact that should global GDP turn down, oil price will like move lower as well, reducing the impact to earnings.

Capacity increases: As discussed above, the airline industry has historically been plagued by capacity mismanagement, which frequently created supply/demand imbalances and led to large swings in profitability. While the largest domestic carriers have acknowledged this risk and are focused on avoiding capacity growth in excess of GDP growth, international carriers have continued to grow capacity, resulting in near term imbalances in the Atlantic and Latin America. Domestic carriers have quickly moved to cut capacity in these markets, but international airline capacity should be monitored.

Integration risk: As with any large merger, the risk of not achieving synergy targets does exist. For example, United’s integration has been slower and more arduous than many had hoped. This risk is somewhat mitigated by management’s slow and steady approach to integrating the businesses piece by piece that has thus far enabled synergies to be achieved on time and in greater size than originally expected, and the potentially conservative synergy targets.

High fixed costs: Using my 2016 estimates, fixed operating costs equate to ~$19.3B, which, combined with interest costs of $873MM, equates to total fixed costs of $20.2B on revenue of $44.8B. As a result, a 10% decline in revenue (holding capacity constant), reduces 2016 EPS at $95 Brent from $5.35 to $1.98. A 10% decline in capacity (which would flow through to fuel costs), reduces 2016 EPS to $3.06. As mentioned above however, a decline in revenue of this magnitude would like be the result of a wider global slowdown that would decrease the cost of Brent, buffering the earnings decline. Although the negative impacts are large, these decreased earnings compare to massively negative earnings in similar environments historically (American and US combined to lose $1.7B in adjusted earnings in 2009). As a result, the market would likely assign a higher multiple to the names given 1) the nature of multiples for cyclical companies at cycle troughs and 2) recognition that airlines can generate positive earnings even at cycle troughs.

Catalyst

Catalysts:

Should American move to hedge some or all of its fuel use at the current depressed oil price, the stock’s multiple would likely re-rate materially higher as the primary factor in earnings uncertainty would be lifted. In speaking with the Company, however, while management is open to opportunistically implementing long term hedges if oil falls to “unsustainably low levels”, it tends to hedge very infrequently and is unlikely to do so in the near term.

Additionally, the Company will provide full year 2015 guidance in its Q4 earnings call in late January. In doing so, it will clarify some of the line items (such as salary) that the sell side is incorrectly modeling and provide guidance for fuel input cost, which will likely be below current Street inputs, such that earnings estimates re-rate higher.