Time to Sell AMR

| About: American Airlines (AAL)

By David Sterman

Investors have short memories. Every time the airline industry starts to rebound, they forget many major airlines only recently flirted with the prospect of bankruptcy. But airlines have been trying to change this perilous dynamic. In recent years, they've been joining forces to cut costs and improve their competitive positioning. Delta's (NYSE:DAL) merger with Northwest and Continental's merger with United Airlines (NYSE:UAL), for instance, have clearly created stronger airlines, better built to withstand the inevitable hurdles the industry faces during economic downturns.

Then there's AMR (AMR). We'll never know whether the parent company of American Airlines wishes it had found its own partner, but the industry's game of musical chairs is now over and AMR failed to snag a good seat.

AMR recently made headlines by announcing a massive order for new planes with Airbus and Boeing Co. (NYSE:BA). The carrier aims to acquire more than 450 new planes in the next seven years so it can start to replace hundreds of inefficient planes that consume far too much fuel. AMR's fuel consumption is so inefficient, the carrier just loss $0.85 a share in the second quarter, $0.10 worse than the consensus estimate.

The carrier's fuel costs rose 31% from a year ago and are expected to be 40% higher in the current quarter, assuming oil prices stay at their current levels. Even so, Merrill Lynch figures AMR will generate $1 billion in negative free cash flow this year. If oil prices were to spike higher in coming quarters, then AMR's income and cash flow statements would be devastated.

A coming labor headache
In some respects, AMR's management has had it easy the past few years. The company's labor force made major concessions when the economy went south in 2008, but it may soon have to revisit these concessions now that the economy appears to be on the mend. "Unions have been working under old contracts for more than three years, and the risks of a strike are increasing, particularly for flight attendants," predict Merrill Lynch's analysts. Morningstar figures "the new contracts probably will result in higher wages that will further AMR's labor cost disadvantage relative to its network peers." Adding insult, AMR will need to come up with $8 billion to match its underfunded pension plans.

Labor and fuel costs are only part of the problem. The recent massive wave of industry consolidation has put rivals on much better footing, and they are pressing their advantage. "Scale matters in the airline industry, and we fear that AMR's share of corporate travel may be falling as mergers have created competitors with broader networks," noted Merrill's analysts. This may explain why AMR has lost market share in every region it serves (domestic, trans-Atlantic, trans-Pacific and Latin America) so far in 2011.

In response to these challenges, AMR's management is stepping on the gas, hoping an upgraded fleet can help lower expenses enough to put the company back into the black. But the decision to lease so many new aircraft simply makes a very weak balance sheet even weaker. Capital spending is now on track to exceed $3 billion every year beginning in 2013. This is a lot of dough for a company that hasn't generated free cash flow since 2007 and carries nearly $9 billion in long-term debt (not to mention the $8 billion in pension underfunding).

That debt load is already starting to bite. AMR is on the hook for $2 billion in loan repayments this year and another $5 billion during the next four years. "A better strategy would be for the airline to shrink its domestic operations through the further retirement of aging aircraft," suggest analysts at Citigroup.

In effect, AMR is hoping and praying that broader industry conditions remain in check, highlighted by reasonable jet fuel prices, strong demand for air travel and stabilization in market share. But is this a realistic set of expectations? This approach may work if all falls into place, but AMR is "precariously positioned should things go awry," note analysts at UBS.

It's actually quite easy to see how things could go awry, simply because this has happened many times before. In past cycles, either the economy gets stronger and pushes fuel prices to uncomfortable levels or the economy gets weaker and leaves carriers with a lot of empty seats.

With all of the debt on its books, AMR must generate a minimum set of financial results to avoid breaching agreements with lenders. If fuel prices surge or demand for air travel sinks, then AMR looks increasingly set to breach these covenants. When this happens, the company's stock could quickly sink as lenders exercise their right to take control of AMR's assets. Management could look to issue a major block of new stock, but even the prospect of such a move would hammer shares down to multi-year lows. AMR has skirted bankruptcy before, but with rivals getting stronger, market share shrinking, fuel and labor costs at uncomfortably high levels, the carrier may not be able to avoid the hangman this time around. So if you own shares of this stock, you should think about selling.

Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.

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