American Airlines Group Inc. (AAL, Financial) is an interesting company to analyze. On one hand, it has been a star performer in the airline sector. Posting strong earnings and a healthy outlook, the legacy carrier looks poised to do well in 2023 and beyond.
However, the stock is hardly rallying. Shares did not move much when the airline upped its fourth-quarter 2022 targets, nor did they gain much momentum when it soared past analysts' estimates on Jan. 26. Shares are changing hands for just 8.52 times earnings, while the sector trades for 17.98 times. At the same time, the price-sales ratio stands at 0.23.
The price movement is puzzling considering the airline sector is doing very well following the significant effects of the Covid-19 pandemic. Despite forecasts of a recession in 2023, American Airlines and its peers, United Airlines (UAL, Financial) and Delta Air Lines (DAL, Financial), have been able to produce better-than-expected earnings for the quarter and provide bright outlooks for 2023.
Airlines became a no-go area for investors during the pandemic as travel restrictions led to there being less demand. However, the industry is now back on its feet. Despite recessionary pressure, airlines have been able to raise fares due to the high level of travel demand and aircraft scarcity.
As such, the stock may be a good option for investors currently.
Gearing up for a big year
American Airlines revealed few surprises when it posted its fourth-quarter earnings report toward the end of January. The company had already upped its guidance for the recently completed quarter a few weeks before and airports were packed over the holiday season, so markets understood that airlines were doing well. However, by upping its guidance, American gave investors plenty of reasons to bid up the stock.
Instead, when the earnings report dropped, new elements grabbed investors' attention as it operated with 6.1% less capacity during the three-month period. For instance, a consistent track record of performance is emerging. In the fourth quarter, the legacy carrier reported earnings of $1.17 per share, which was up from a loss of $1.42 a year ago. Revenue reached $13.19 billion, a rise of 40% from the year-ago period. Both numbers handily beat analysts' estimates.
When comparing these numbers to 2019, however, the stats become all the more impressive. When pitted against 2019, when results were not affected by the pandemic, quarterly revenue of $13.19 billion grew 16.6%. Similarly, earnings of $1.17 per share were better than the $1.15 reported in the fourth quarter of 2019.
As such, the company believes it can meet aggressive targets for 2023, guiding for earnings between $2.50 and $3.50 per share.
The company reported an average per gallon of fuel of $3.50 for the fourth quarter, up 48% year on year. It expects that to come down somewhere between $3.33 and $3.38 per gallon in the first quarter of 2023. The jet fuel price will positively impact the bottom line, potentially resulting in approximately $1 billion in lower costs.
Based on those cost estimates and where demand is going, American Airlines hopes to have $5.5 billion in operating cash flow this year, with $3 billion in free cash flow. Considering the company's current liquidity is already at $12 billion, most of the free cash flow will be used to pare down debt.
Paying off debt is a priority
Airline companies had to take drastic measures during the pandemic to stay afloat, which included taking on debt. American Airlines was no exception. Its debt peaked at $37.2 billion during the first and second quarters of 2021.
American Airlines still has some $25 billion in debt on its books. With no major capital spending increases planned over the next few years, it is well prepared to pay down its debt.
"Reducing total debt continues to be a top priority," Chief Financial Officer Derek Kerr said in October. The airline targets $15 billion in debt reduction from its 2021 peak, or roughly $22 billion, by the end of 2025.
According to a December filing, the company repaid $1.18 billion of its debt early, backed by its slots at New York LaGuardia and Washington Reagan National Airport. It was not due until December 2023.
The company ended 2022 with $12 billion in total available liquidity. The legacy carrier plans to have the liquidity to survive another shutdown, keeping between $10 billion and $12 billion on its balance sheet.
As for aircraft deliveries, these will be manageable in 2023 and 2024 due to American's mostly complete fleet renewal program. The company guided for aircraft capital expenditures of $1.5 billion in 2023, a level well below the budgets of its closest peers, who have heavier delivery schedules.
Although American Airlines is expected to take more 737 MAX and 787 aircraft ahead of 2025, total capital spending is expected to remain manageable.
As the company continues to cut down its debt and reclaim previously encumbered collateral, it is increasing its financial flexibility.
Risks to the thesis
American Airlines is one of the world's most well-known and successful airlines. However, there are some risks that investors need to consider.
First, airlines are experiencing increased profits from growing demand, making them a rare bright spot in a volatile market. With widespread inflation taking hold and interest rates rising, the industry has undeniably become a surprising one. However, the airline industry could decline due to increasing labor and operating costs and the market's uncertainty.
Further, the airline industry is experiencing growing labor and operating cost issues. It could be in for a significant downturn due to these costs.
The airlines are considering different ways to reduce operating costs and labor expenses. They are looking at options such as increasing automation, expanding their fleet sizes and retiring planes.
Recently, airlines have been able to generate higher revenue and offset rising costs by increasing fares. However, pilot wages might inflict a significant dent in the profits that carriers have been enjoying in 2023. The other major issue is higher rents and landing fees tied to operating and expanding in high-cost terminals.
Meanwhile, there are signs the U.S. economy could be headed for a recession in 2023. Several notable names have sounded the alarm, from big banks like JPMorgan (JPM, Financial) to institutions such as the World Bank. Honing in on the sector, Mastercard (MA, Financial) believes current-quarter revenue growth for airlines will fall short of Wall Street forecasts. However, the boost from pent-up demand for travel will diminish as new market changes occur.
American Airlines expects healthy numbers in 2023 on the assumption of resilient demand. However, the factors discussed could weigh heavily on these forecasts.
Takeaway
American Airlines had a tough time during the pandemic, but things are starting to look up. With the increase in demand, airlines are more profitable than ever.
As the stock continues to recover, investors will likely benefit as well.
