American Airlines (NASDAQ:AAL) has beaten the analysts' estimates for 4 consecutive quarters. Even better, the company posted record earnings last year and is expected to report still great profits this year and next year. Nevertheless, the stock has plunged 55% off its peak last year and is now trading at extremely low P/E ratios, i.e., a trailing P/E = 3 and a forward P/E = 5.
Therefore, it is only natural that investors wonder why the stock is so cheaply valued by the market. Before they purchase the stock, they should be well aware of the reasons behind the cheap valuation in order to evaluate the prospects of the stock.
First of all, it is really surprising that the stock has plunged since early 2015 despite the continuously suppressed oil prices. Not only has the price of jet fuel remained suppressed during the last year but it is also expected to have limited upside for the foreseeable future, as a great rally would lead many shale oil producers back to production. Therefore, it is really impressive that the stock of American Airlines has not been helped by this major tailwind.
A major reason behind the cheap valuation is the pronouncedly high debt load of the company. To be sure, American Airlines has net debt (as per Buffett, net debt = total liabilities - cash - receivables) of $35.1 billion, which is about 11 times this year's expected earnings. While even this great amount of debt seems manageable under the current circumstances, investors should never forget that the airline industry is highly cyclical and strongly leveraged to the status of the economy. Therefore, conditions can change at any moment. If the economy turns south, American Airlines will be greatly burdened by its debt load and its profits will plunge due to its high interest expense, which currently eats "only" 14% of its operational profit.
Prudent managements always try to keep the debt load limited during good times, so that they can handle recession periods much more readily. However, airlines are infamous for their great boom-bust cycles, as they do not retain their profits during good periods. Instead, during good periods, they tend to invest excessive amounts on the expansion of their capacity. This is exactly what most major airlines have done during the last 3 boom years.
More specifically, American airlines spent $3.8 billion on capital expenses in 2013, spent all its earnings ($2.9 billion) on capital expenses in 2014 and almost doubled its capital expenses (to $5.6 billion) last year. Thus it greatly expanded its capacity during the last few years, but did not retain any profits to weather a potential downturn of the sector. Therefore, it is very vulnerable in such a scenario and, even if it does not have any problem servicing its debt, it will certainly see its profits collapse in such a scenario due to its excessive leverage.
While the airline industry has no relation to the off-shore drillers, the two sectors have one thing in common; they are highly cyclical. Therefore, the current status of the airline stocks reminds me of the status of offshore drillers two years ago. While they were enjoying record profits, they were surprisingly trading at remarkably low, single-digit P/E ratios. In addition, lured by their profits, they were spending heavily on expanding their capacity, thus bringing forward the peak of their cycle. Since the peak, their profits have collapsed, and their stock prices have followed closely, with losses in the area of 80%-90%. Even worse, their market is still heavily oversupplied, without any light on the horizon.
Of course, I am not saying that the airline stocks will face equally heavy losses in the near future. On the other hand, I advise investors to be cautious when cyclical companies spend all their profits on growth projects during their best years because the sector will peak and the profits will plunge at some point. The market seems to agree on this view, as it has already sent American Airlines 55% lower than its top.
To sum up, some investors are greatly surprised that American Airlines is trading at only 3 times its trailing earnings even though it has been thriving. However, before these investors pull the trigger and purchase the stock, they should be well aware of the risks of the stock. Its excessive debt load renders it highly susceptible to a downturn of the sector or the economy.
In addition, as most airlines have markedly expanded their capacity during the last boom years, the chances are high that the sector peaks in the near future and the cycle reverses. Due to the excessive leverage of the airlines, the reversal will be painful as always.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.