American Airlines (NASDAQ:AAL) stock is starting to look like a really good bargain, especially now. just days after it reported its first profit in six quarters. Moreover, it is the first quarter of clear free cash flow (FCF). This bodes very well for AAL stock, especially now that the airline can start paying down its debt.
AAL stock tipped a year-to-date high of 26.04 on June 3, then gave back 23.9% through mid July before clawing back some of that loss following the July 22 earnings.
While the carrier’s shares were about flat for Q2, they are up 34.4% for 2021, up from $15.77 at the end of last year. My view is that AAL stock has a good chance now of regaining its former height, as it becomes clear that it will be paying down debt fairly quickly.
I will show that investors in AAL stock can expect to make 44% annually over the next three years.
Where Things Stand For American Airlines
American Airlines reported that it is going to begin to quickly pay down its $40 billion in debt over the next four years. Its balance sheet now shows that it has $18.9 billion in cash and investments. So, its net debt is now $21.05 billion.
Compare that to its cash flow from operations (CFFO). Deep in the July 22 earnings release, in the section describing the company’s “cash build,” it reported that its Q2 CFFO was $3.47 billion.
In the subsequent conference call, CFO Derek Kerr said its capital expenditure was minimal, although it included $900 million in non-aircraft capex spending. So, on an ongoing basis, that means that its FCF works out to $2.57 billion. On an annualized run-rate basis that works out to $10.28 billion.
So, you can see where I am going with this: This $10.28 billion could pay down the company’s net debt of $21.05 billion in a little over two years.
Here is what I mean by that, just to be clear. The airline has $40 billion in gross debt. But if it wants to it can pay off $18.9 billion of that with its cash and investments on its balance sheet (what it calls liquidity). That leaves $21.05 billion. Since the free cash flow that its airline business is now generating works out to $10.3 billion per year, the remaining debt could be paid off in two years.
Potential 4x Market Value
Here is a very simplistic model of how to value AAL stock that results in a value of AAL stock at $62.35 per share. (The July 23 close was $21.20 a share.)
Let’s say that its FCF works out to $10 billion over the next several years. But in two years the FCF will be significantly higher with no debt outstanding. If it was paying 7% on average in interest on $40 billion, that would free up another $2.8 billion in FCF. Now going forward the FCF is $12.8 billion. However, remember that my model does not include much capex spending. So let’s lower the FCF amount to $12 billion annually.
Now, using a very high FCF yield figure of 20%, we can see that the target value of AAL stock should be $60 billion (i.e., $12 billion / 0.20 = $60 billion). That is over 4.4 times its present market value of $13.57 billion.
In fact, just to be even more conservative, let say that the company can only make $8 billion in free cash flow in two years. Even using a very high 20% FCF yield, its market value is worth $40 billion. That still gives it an implied upside over the market value of $13.57 billion of 195% (i.e., $40 billion / $13.58b-1 = 1.95x). This means that AAL stock is worth up to $62.35 per share (i.e., 2.95 x $21.16).
Calculating Annual ROI for AAL Stock
So, given its profitability, debt reduction news, and its now positive free cash flow, it looks like AAL stock is a bargain at $21.20. But it could take longer than one year for this to happen, especially since the market will want to see the debt go down.
But even assuming it it takes three years for this price to occur. that would still imply an average annual compounded return of 43.4% over each of the next three years (i.e., $2.95 ^(1/3)-1 = 0.434). There aren’t many opportunities in the market like that.
On the date of publication, Mark R. Hake did not hold any position in any of the securities mentioned in the article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.