By David Sterman
"How do you make $1 million in the airline industry? Start with $2 million and know when to quit."
As the economy drifts toward a possible recession, investors are increasingly scrutinizing balance sheets of major air carriers for signs of real trouble. Companies that carry too much debt can end up in bankruptcy court if sales fall and losses grow. Venerable names such as Braniff, Eastern, Pan Am, National, Midway and Aloha Airlines no longer exist after bumping up against a weak economy. That was precisely the logic behind my bearish call on AMR (NYSE: AMR), parent company of American Airlines, back in July. The mere perception of a bankruptcy scare is enough to spook investors.
Shares have lost half their value since my bearish view two months ago, highlighted by a 33% drop on Monday, Oct. 3, alone. Investors are surely recalling the events of 2003, when AMR saw its stock slide to just $1.25 on the heels of a bankruptcy scare. AMR managed to avoid bankruptcy back then, and its shares moved back to $40 by 2007.
The good news: the chances of a bankruptcy are still remote, and this obvious short candidate may just be morphing into a long candidate with significant upside.
Let me explain...
How steep a drop?
The question for AMR and its fellow airlines is a clear one: How would these firms fare if demand slumped and price wars kicked in? For carriers with relatively strong balance sheets, such as Southwest (NYSE: LUV) and JetBlue (Nasdaq: JBLU), rising losses can be tolerated for an extended period. For carriers that carry ample debt but also operate in a very low-cost manner -- such as Delta Airlines (NYSE: DAL) -- exposure to falling demand is also limited. AMR is stuck with the double whammy of high operating costs and a lot of debt.
Yet a series of factors should swing in AMR's favor, helping it to avoid bankruptcy. For starters, AMR had been especially hard hit by rising fuel prices because it carries the thirstiest fleet in the business. Management has long talked of modernizing its fleet toward more fuel efficient planes, just as United Continental (NYSE: UAL) has, but limited financial firepower has crimped AMR's fleet upgrade plans. (The average age of an AMR plane is 14.8 years, compared to the industry average of 11.7 years. The older a plane, the less fuel-efficient it is likely to be.) Luckily for AMR, a global economic slowdown also means a drop in the price of jet fuel.
AMR's balance sheet is also not quite as bad as the plunging stock price may indicate. The company has roughly $4 billion in unrestricted cash and about $3 billion in bonds coming due in the next two years. This implies the carrier can't burn more than $500 million in the next two years before bankruptcy concerns really start to bite.
At first blush, AMR's financial picture seems awfully tenuous. Merrill Lynch forecasts the carrier will lose around $200 million in free cash flow for the rest of this year and another $350 million in 2012. By that logic, AMR's cash balance would move below $500 million by the end of next year, once upcoming tranches of debt are repaid.
Increasingly, this looks like a worst case scenario. Instead, AMR is likely to extract better-than-expected concessions from its pilots and other labor associations, simply because few stakeholders have an interest in pushing the company into bankruptcy. Lower labor costs -- the carriers' second-largest expense after fuel -- will surely help.
Moreover, Merrill Lynch's analysis doesn't incorporate falling fuel prices, and the recent drop in jet fuel is likely to save AMR nearly $100 million in 2012. (Fuel expenses account for 33% of estimated industry 2011 costs, up from 15% in 2000.) Lastly, current forecasts don't account for AMR's ability to simply shrink away from unprofitable routes, taking its most inefficient planes out of service.
All about capacity
It's that last factor that industry bears may be overlooking. A key theme of the recent airline industry rebound has been a tight grip on capacity. For example, the major carriers have been planning route cuts throughout this year, and total domestic industry capacity in 2012 should be close to 5% less than 2011. This means carriers will be less prone to vicious price wars to fill empty planes, as has been the case in the past. Revenue and yields (the percentage of seats filled) will surely drop if we go into recession, but not likely to the extent many fear.
Airline stocks are taking it on the chin these days, perhaps to an even greater extent than the broader market. If the economy stays flat or slips into only a mild or short-lived recession, then the current sell-off surely creates a compelling entry point for investors. The stock you find appealing should be based on your risk appetite. JetBlue, for example is low-risk because it has a strong balance sheet and its market value of $1.1 billion is well below its tangible book value of $1.7 billion. Delta carries more risk, thanks to nearly $15 billion in debt, but is also quite lean and better-equipped than most for lean times. As I noted a few months ago, this stock could rise sharply in a better economic picture.
What about AMR? Well, as noted, the odds of an actual bankruptcy filing are still quite remote. And in the event industry pricing and crude oil prices stabilize, investors will start to take note that the carrier now trades for less than two times projected 2012 EBITDA. Indeed, AMR's stock likely has the greatest upside of any airline carrier, perhaps 300% or 400%, if the economy ends up back on a growth path in 2012 or 2013. The downside of course, is the stock could go to zero, so AMR is only suitable for investors with a high degree of risk tolerance.
Risks to consider: What could go wrong? Plenty. Americans are still traveling -- for work and for pleasure -- but a deep or prolonged economic slowdown would boost the popularity of "staycations" and video-conferencing. Industry balance sheets are unlikely to be rocked in the near-term, but they can't really withstand losses that extend beyond four to six quarters. You need to calculate burn rates for these carriers and steer clear of any carrier that has less than 12 months of cash left based on current quarterly loss rates. That's not a red flag for any of the carriers I mentioned yet, but it would be by late 2012, in a worst case scenario.
The airline industry is a notorious black hole for investors' cash when industry conditions suffer. But also recall that AMR's stock rose from $1.25 to $40 in the middle of the last decade. The risk is considerable. But so is the reward.
Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.