American Airlines Group Inc. (AAL, Financial) rewarded shareholders with healthy returns in 2016. The stock was off to a dull start heading into 2017, but it is back on the right track. The stock is up nearly 15% year to date.
The primary reason for the company’s turnaround this year is falling oil prices. Brent Crude oil prices currently hover around $48 per barrel, down from $58 per barrel in January 2017. Not only American Airlines but almost every airline has managed to find its way into the green as the fall of oil prices has always been a game changer for the aviation industry.
Although oil prices have rebounded from their bottom in early 2016, the U.S. shale oil producers have noticeably surged their output over the past 12 months. This has caused the price of oil to fall again.
According to the forecast from the Energy Information Administration, crude oil prices will average $53 per barrel this year. It also estimated that volatility will not be the same as that in 2016. Moreover, the average price of Brent Crude oil per barrel is projected to reach $80 by 2020 which will act as a significant headwind for the airline going forward.
American Airlines is the largest airline in the U.S. and carries on producing substantial profits and returning capital to shareholders at a healthy rate. Despite being highly profitable, the stock has traded flat for almost 2½ years now.
In the first quarter, the company detailed that it will increase pay for pilots and flight attendants. In spite of a contract in place for the next few years, the airline decided to escalate pay up to industry levels so as to generate goodwill with employees.
As a result, this move will lead to an additional expense of $360 million per year though the airline pointed out that those costs would escalate by 2020 with or without this move. On the other hand, the company publicized in May that it will shrink passenger legroom to a minimum of 29 inches in several rows on its new 737 MAX 8 airplane.
The company recently changed that decision and now plans to provide a minimum of 30 inches seat pitch. American Airlines already has a confined configuration and further reducing its legroom will negatively impact its brand image in the long run.
Moreover, the company’s decision to decrease passenger legroom in an effort to lower costs could lead travelers to consider shifting to more customer-friendly airlines like Southwest Airlines (LUV, Financial).
Over the past two years, runaway costs have become a huge problem for American Airlines. Although the company’s management said that cost growth should slow significantly in 2018, it still has much work to match its rivals in terms of unit costs. This is probably the reason why American Airlines plans to add additional seats to its new 737 MAX 8 aircraft.
Summing up
American Airlines displayed good performance in 2016 mainly due to poor crude oil prices in the first half of the previous year, but oil prices are projected to move upward in the year ahead which will negatively impact the airlines’ margins going forward.
On the other hand, decreasing passenger legroom might pay off for the company in the years ahead, but it could make it ripe for disruption in the immediate future. Apart from this, American Airlines’ long-term debt remains a significant concern. The airline is using debt to fund considerably greater investments in new fleet, but it cannot be said that the strategy definitely will pay off in the future.
Also, American Airlines’ net income has not been growing in comparison to the rising debt also looks concerning. The airline currently trades at a price-earnings (P/E) ratio of 13, slightly less than that of the industry’s average.
I would recommend shareholders consider booking profits as the stock currently trades near its all-time high.
Disclosure: No position in the stocks mentioned in this article.
