American Airlines: Q2 Full Of Warning Signs

| About: American Airlines (AAL)

Summary

The market reacted positively to AAL's second quarter.

But Q2 was full of warning signs.

We still like AAL for the long term, but AAL may be in for a rough couple of years.

The market reacted positively to American Airlines' (NASDAQ:AAL) second quarter. Revenue decreased 4.3% year-over-year but still beat estimates by $40 million, and EPS beat by $0.09, sending shares up 4%. Heading into earnings, investors were most concerned about how rising oil prices would impact profitability. But average fuel prices were down 25.2% year-over-year, and while profit margins did contract from last year's record highs, it was because of lower sales rather than higher expenses (operating expenses fell 3.3% due to a $530 million decrease in fuel costs). Management expects fuel costs for FY16 to be $1.3 billion lower than last year, and investors are optimistic that AAL can sustain high profits throughout the year. I still believe American Airlines is an interesting choice for long-term investors, but the latest quarter was full of warning signs and the company may struggle during the next few years.

Let's start with revenue. Even though total capacity (average seat miles) increased almost 2%, sales declined 4.3%. This was on top of last year's 4.7% decline, and the fact that currency was less of a headwind compared to last year makes the decrease more worrying. After five years of rapid growth, the airline cycle appears to be peaking, at least in the US where AAL generates 70% of its revenues. Capacity growth has outpaced demand growth in recent years, and it's taking a toll on pricing. Passenger revenues declined 4.4% in the second quarter due to lower yields. The macro environment is sluggish but AAL intends to grow capacity 2% this year. With oil prices remaining low we expect competitors to do the same, creating additional pricing pressures.

On the cost side, non-fuel expenses on rising. Excluding fuel, average mainline cost per seat mile increased 4% as a result of higher wages and a new profit sharing program. Despite the fuel windfall, adjusted operating margin was 150 basis points lower than last year, and management expects non-fuel CASM to be 4-6% higher in 2016 than in 2015. Part of this is the result of slowing capacity growth (management lowered its capacity forecast half a percentage point), which means less fixed cost leverage. We also suspect that rising depreciation costs are built into the forecast. In May AAL decided to accelerate the retirement of 37 jets, which should increase depreciation expense by shortening the useful lives of these assets. Both cases reflect a slowdown in demand that should worry investors in the short-term.

There are two more warning signs that investors should be aware of. Management increased its valuation allowance, a contra asset account (for deferred tax assets) that represents the uncertainty that future taxable income will be high enough to fully realize the asset (similar to a credit loss provision). Without delving too deeply into the accounting, companies increase the valuation allowance when they anticipate that future earnings may not be high enough to fully realize the DTA, and in AAL's case, it could reflect the expectation of weaker pricing and rising costs. It is also worrying that AAL decided to push back deliveries from Airbus into late 2018. Between the jet retirements and delayed order deliveries it just seems that AAL doesn't need any more aircraft, an indicator that capacity has finally caught up to demand.

Conclusion:

AAL went higher thanks to low fuel costs, but there are important warning signs. Non-fuel costs are rising and it appears the US airline cycle has reached a peak. We still like the long-term outlook and believe that AAL will benefit from secular travel trends, especially if it can deepen penetration in the Asia Pacific. But investors should be cautious and AAL may be in for a turbulent few years.

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.