The Covid-19 pandemic has delivered a severe blow to the airline industry. As I discussed in a GuruFocus article earlier this month, airline operators are facing one of the toughest market environments in their history.
In order to survive, industry players have been forced to make hard decisions. In the case of American Airlines Group Inc. (AAL), this has meant the standard cutting costs and raising debt.
Liquidity in focus
When American Airlines reported first quarter earnings in April, few were surprised by its painful results. Severe losses were expected as a result of the collapse in passenger air traffic during the quarter, and American Airlines was no exception. The embattled operator posted a whopping $2.2 billion loss for the quarter compared to a $245 million profit in the same period last year.
With passenger air traffic likely to take years to return to pre-crisis levels, operators’ survival will depend on the strength of their balance sheets. Thus, as CNBC airline industry analyst Phil Lebeau pointed out on April 30, liquidity is what really matters for airline operators in the current environment:
“American Airlines loses $2.2 Billion in Q1,...but the real focus is liquidity. It ended Q1 with $6.8 Billion... expects to end Q2 with $11 Billion.”
Ending the second quarter with $11 billion would put American Airlines in a decent financial position as the economy gradually tries to get back to normal.
Cutting cash burn
American Airlines has also sought to implement radical cost reductions in the second quarter in order to stem its inexorable cash burn. On June 12, the company announced a series of sweeping cuts, as MarketWatch reported:
“American Airlines has cut $13.5 billion from its operating and capital budgets for the year through 'significant cost reduction actions' around marketing, maintenance, events, training, airport facilities, and other areas. The company said it has ‘passed the peak in cash refund activity’ as flight demand has started to improve. That's helped American Airlines' cash burn rate improve to an estimated $40 million a day for the month of June, from a peak of more than $100 million a day during April. The company is hoping to reduce its cash-burn rate to about zero by the end of the year ‘as expected demand conditions continue to improve and its cost initiatives continue to gain traction.’”
American Airlines’ announcement received an enthusiastic response from the market, which sent the company’s stock soaring. However, while these cuts may help get the company back on firm financial footing for the present, slashing its operating and capital budget may have long-term consequences for its competitiveness.
Debt threatens outlook
In order to further enhance its liquidity in the face of a multi-year rebuilding effort, American Airlines has opted to tap the debt markets once again. Last week, the company announced plans to raise $3.5 billion, including $1.5 billion in secured debt. Unfortunately, debt investors were reticent to take up the offer. On June 22, Bloomberg reported that the embattled airline has been forced to sweeten the deal, raising the yield on its $1.5 million junk bond to an eye-watering 12%:
“As the most debt-laden of the largest U.S. airlines, American is having to pay up. The yield on the bond is more akin to that of riskier CCC debt currently trading around 11.65%, even though the offering is expected to have at least two ratings in the Double B ratings tier, the highest in the junk market.”
That is a very expensive debt offering, especially in a time of astonishingly cheap debt. As Bloomberg’s Lisa Abramowicz observed on June 22, American Airlines’ cool reception from debt investors is a sign of real debt demand weakness and “speaks to profound angst about the air industry's future at a time when money is the cheapest ever for top-rated companies.”
My verdict
Airlines are going to take a long time to recover. Overcapacity, dangerously high leverage and risk of inter-operator price wars will all weigh on the industry. For a heavily indebted operator like American Airlines, it could prove especially challenging to navigate the “new normal” emerging in the wake of the Covid-19 crisis.
In my view, investors should approach this name with caution. A lot could still go wrong for American Airlines. The road to recovery may well prove far harder and longer than the market now expects.
Disclosure: No positions.
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