Leaner, Meaner Model Will Push American Airlines Higher

When I last wrote about American Airlines (NASDAQ:AAL) stock, I voiced my concerns regarding the strategy the company employed in response to the novel coronavirus pandemic. Almost all the major carriers had opted to streamline operations. However, the company decided to soldier on through operating low-income yielding hubs despite widespread criticism.

Turbulence Ahead for AAL Stock as Cash Preservation Rules
Source: GagliardiPhotography / Shutterstock.com

But it looks like management has decided to change course. The company has announced that it will halt service to 15 smaller airports effective Oct. 7 and has also agreed to cut 19,000 jobs. Both of these initiatives are necessary yet painful belt-tightening initiatives.

American is also looking extensively at cutting its debt, a welcome move that will clean up its bloated balance sheet. It does not have sizable non-aircraft debt maturities until June 2022, but liabilities remain very high. On a positive note, cash burn rates are on their way down as well, a net positive for AAL stock.

Shares are trading at 0.16x trailing price-to-sales, quite reasonable even after accounting for weak demand. However, the decision to invest in the stock will remain your own. AAL came into this crisis with flawed fundamentals. But recent events indicate management wants to rectify this situation and come out of this crisis stronger. That’s why the stock popped on the day AAL revealed it was streamlining its operations.

The fact that AAL is trying to stem the tide deserves brownie points for sure. Any initiatives the company takes to reduce costs while waiting for demand to return will pay dividends. With management now firmly focused on reducing operating and capex costs, expect AAL stock to start making up lost ground.

What Will Drive AAL Stock Higher?

First, let’s look at the positives. In the second quarter, American managed to reduce cash burn to $55 million from $70 million. Although break-even cash burn rates seem a bit far fetched at this stage, American has said it plans to reduce cash burn in the forthcoming quarters aggressively.

One of the main drivers of this reduced cash burn will be the leaner, more streamlined operating model the company looks to employ. Under this strategy, the company cut its active fleet by around 150 aircraft. That is expected to result in $15 billion of operating and capex savings. Reduction of the fleet will also lead to lower maintenance costs and will also save on fuel and environmental expenses.

While we are on that subject, oil prices are still off their 2019 peaks, a favorable tailwind, considering 22% of total expenses represent fuel costs. Production cuts are a thorny issue, with OPEC+ members at loggerheads regarding oil supply during this crisis. The U.S. government has had to intervene and play peacemaker among the members to ensure supply remains limited.

But as the year rolls on, we will see an easing of production cuts from all members involved. That will lead to prices dropping further, considering demand is most likely to remain sluggish this year, providing more cushion to the company.

Problem Areas

Now that we have gotten the positives out of the way, let’s look at some trouble spots for the airline: fundamental strength and the balance sheet.

Even before the pandemic, the company wasn’t whirring on all cylinders. Many of its key operating metrics like EPS, cash flow from operations, and long-term liabilities were going the wrong way. The drop in EPS is even more worrisome since outstanding shares dropped to 444 million shares in 2019 from 734 million shares in 2014. On a positive note, revenues did increase over the last five years before the pandemic struck.

Chart shows American Airlines (NASDAQ:AAL) data on Revenue Per Share and Diluted EPS
Source: Chart by Faizan Farooque, data from filings.

Now, looking at the balance sheet, the one thing that stands out is the debt position of the company. At the end of the latest quarter, when adding pension liabilities and capital leases, aggregate long term debt stood at $41.68 billion. In comparison, cash was just shy of $10 billion – not a healthy position by any means.

Right Steps

In the second-quarter earnings call, CEO Doug Parker promised cash burn would come down substantially in the forthcoming quarters. I believe that will happen because of two things.

Firstly, TSA data shows that passenger numbers are increasing with each passing day. Most of these are vacationers, which constitute the most significant chunk of AAL’s customers. Unlike Delta Air Lines (NYSE:DAL), AAL does not rely heavily on business travelers, and so its recovery is unlikely to be as sluggish as other airlines in the sector that depend on corporate travel.

Secondly, American Airlines has also taken recent steps to streamline its operations. It will halt services to 15 small centers, and roughly 19,000 employees will be let go as the terms attached to federal aid run out. Although these are painful initiatives, they are necessary considering the state that the airline sector is in at the moment.

Providing Color to the Numbers

Daniel Cravens, managing director of investor relations at American Airlines, recently discussed moves made by the airline. He was asked what prompted the recent change in strategy. After all, it wasn’t that long ago when Chief Revenue Officer Vasu Raja was articulating a very aggressive response to the pandemic.

In an email, Cravens acknowledged to me that American felt a need to streamline operations, given demand had not rebounded. Regarding the decisions made, he said, “Unfortunately, given that demand hasn’t rebounded like we all thought it would back in March (when the CARES Act was passed), we have had to make adjustments to our entire network, which regrettably includes furloughs and reduced flight service. Of course, this is a decision that no one wanted to make, but it is necessary given the tepid recovery.”

He added that the recently announced partnerships with Alaska and JetBlue (NASDAQ:JBLU) would allow for a “compelling schedule” for American’s customers on the East and West coasts during this time.

In a previous exchange with Cravens, he laid out some vital information regarding cash burn and long-term debt that readers will find interesting. He said the company calculates burn rates differently than its counterparts. Long story short, if we were to use Delta’s methodology, burn rates will be closer to what Delta guided for Q3.

Also, when speaking about debt, Cravens outlined that approximately $20 billion of it prepayable with no prepayment penalty. The conversation reinforced the company’s plans to deleverage as soon as demand returns. This is a prudent strategy that should put shareholders at somewhat ease.

The Final Word

Airlines are going through a tough time at the moment. Understandably, due to the nature of the crisis, we have to take the issues the sector is facing into account when analyzing American Airlines.

Since I last wrote about AAL stock, management has taken sensible decisions to scale down and mitigate against losses. With an uncertain future, that seems the most appropriate way to go at this point.

AAL is a less risky stock than a month ago, but there are still a lot of ifs and buts regarding its future. The company does, however, deserve brownie points for moving ahead and making some difficult decisions. That will undoubtedly instill confidence in the markets and its shareholders.

On the date of publication, Faizan Farooque did not have (either directly or indirectly) any positions in the securities mentioned in this article. 

Faizan Farooque is a contributing author for InvestorPlace.com and numerous other financial sites. He has several years of experience in analyzing the stock market and was a former data journalist at S&P Global Market Intelligence. His passion is to help the average investor make more informed decisions regarding their portfolio. 

Article printed from InvestorPlace Media, https://investorplace.com/2020/09/leaner-meaner-model-will-push-aal-stock-higher/.

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