American Airlines Group Inc. (AAL, Financial) has occupied a spot of dubious honor among the top four U.S. airlines throughout the Covid-19 pandemic. With a balance sheet that is far weaker than its competitors, many have speculated about when and how it would finally decide to file bankruptcy to escape the pressures of the dramatic drop in travel demand.
In the most recent step in American Airlines' constant efforts to lessen its crushing debt load, the company said it plans to issue $5 billion in bonds and seek a $2.5 billion term loan. The new debt, which will be backed by its frequent flyer program, will be used to pay back federal loans that Congress issued at a 4% interest rate. Essentially, it will transfer the company's debt to a new debtor with lower interest rates.
This by no means indicates that bankruptcy is any more or less likely for the airline operator. It has so far managed to avoid bankruptcy during the heights of the pandemic in 2020 and early 2021, so it stands to reason that the combination of continued low interest rates (allowing deals such as the above where the company can decrease its interest burden) and the expected recovery of the domestic travel industry in the U.S. could mean American Airlines is soon to see its financial troubles ease.
However, whether it can take full advantage of improving conditions is another question entirely. The pandemic has highlighted the differences in how the four major U.S. airlines operate, making it clear that among the top players, American Airlines is the one that cuts the most corners. In the short term, this may seem like a great idea to shareholders as it can increase profits at the outset. As time goes on, though, such a strategy begins to show its cracks, which can lead to a much bigger downside.
American Airlines' focus is on cutting (most) costs to increase its profits cutting ticket fares to gain market share, cutting safety measures faster than its competitors during the pandemic to put more passengers on flights, and so on.
One notable exception is that the company has taken on more debt to pay for unsustainable amounts of share buybacks that are needed to make up for the high issuance of executive stock option compensation plans. This last one may not be cutting costs, but it is certainly cutting corners, taking money out of the pockets of shareholders even if it appears to do the opposite.
While it may appear attractive to shareholders at first glance, and it often does produce stellar profits even for years at a time, this is the kind of "fair weather" strategy that needs everything to go right in order to succeed. A company that makes every sacrifice for the sake of increasing profits on paper stands on shaky ground when things take a turn for the worse.
For example, during the pandemic, American Airlines had to cut around 19,000 jobs and halt service to at least 15 remote markets. Despite being the U.S. airline that carried the most passengers in 2019, this was even worse that the situation at United Airlines (UAL, Financial), which had to furlough 13,000 employees. Delta (DAL, Financial) and Southwest (LUV, Financial) managed to mostly avoid furloughs by negotiating early retirement, voluntary leave and other deals with employees.
American Airlines was also the first of the top four airlines to reopen middle seats and begin booking full flights after the pandemic began. Its cash burn was simply too high for the company to remain solvent without reducing the number of aircraft in operation, which meant as many seats needed to be filled as possible on each flight.
The struggle for market share
The company had to stop service to several areas during the pandemic. In comparison, Southwest Airlines, which has comparatively better financial health, actually added multiple service stops.
A weaker balance sheet means that American Airlines will have to spend more of the recovery period than its competitors simply making ends meet rather than trying to compete with other companies in the sector.
Indeed, this trend already began to play out in 2020. From January to June of 2020, the carrying capacity of American Airlines dropped from the number one spot at 4.8 million to the number four spot at 1.6 million. Over the same period of time, Southwest went from the number three spot with 3.7 million to the number one spot with 2.4 million. Delta dropped from number two to number six due to continued flight capacity reductions to protect customers from the pandemic, while United dropped from the world's top 10 airlines list entirely.
As the travel industry recovers from Covid-19, American Airlines will see its profits increase again, but it will also likely face a higher burden of interest from its debt compared to other major airlines. Even if it manages to issue lower-interest debt to repay higher-interest debt, this is also an option that is available to its peers, so it will not be of any help from a competitive comparison.
An unsustainable strategy?
In hindsight, spending $12.4 billion buying back stock over a six-year period through 2019 at an average price of $39.76 per share does not seem like a sustainable strategy. Perhaps if the company could have deployed that same capital to grow its income, it would have been a different story, but what it ended up doing was hurting the company's long-term prospects to achieve short-term results.
To be fair, the company's executives did not seem to think this strategy was unsustainable. The theory was that as long as they could not think of a better way to deploy capital, buying back massive amounts of shares was the best way to go, especially since they could always keep repaying the interest on the borrowed funds with future earnings without having to worry about profits ever dropping.
As for why management was so optimistic despite how the company suffered during the financial crisis a decade before, it might have had more to do with the company's credit card revenue, ironically enough.
In 2017, CEO Doug Parker made a bold claim that American Airlines would never lose money again, even during a crisis like the Great Recession. This was due to the company's transition to a strategy of losing money flying planes while making money selling its frequent flyer miles. The fourth-quarter 2019 cost per available seat mile was 15.06 cents, while passenger revenue per available seat mile was 14.72 cents. Despite this seeming discrepancy, net income grew 27.5% year over year for that same quarter due to the sale of frequent flyer miles.
American Airlines undoubtedly faces issues as a financially weak player in its industry coming out of recessionary conditions that typically favor those with stronger balance sheets. The company's billions worth of share buybacks in the preceding years, coupled with its strategy of actually losing money on its flights in order to make a profit on selling miles, will undeniably impact it going forward.
The company has tried to mitigate the worries of investors and employees alike, saying that "some online commenters have tried to oversimplify" its complex strategy. This statement strikes right at the heart of the issue American Airlines' method of making money is difficult to understand without extensive study. Thus, whether this business model is sustainable in the long run is also more difficult to assess, adding another tally mark against the company to join weak financials and loss of market share.
As Warren Buffett (Trades, Portfolio) said in regard to his sale of Berkshire Hathaway's (BRK.A) (BRK.B) holdings in the top four U.S. airlines, "The world has changed for the airlines I don't know if Americans have now changed their habits or will change their habits because of the extended period." The pandemic revealed a lot about the operations of the different airlines, and the state of the industry and its top players upon recovery seems unlikely to mirror the past.
Disclosure: Author owns no shares in any of the stocks mentioned. The mention of stocks in this article does not at any point constitute an investment recommendation. Investors should always conduct their own careful research and/or consult registered investment advisors before taking action in the stock market.
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