American Airlines Is Too Cheap

| About: American Airlines (AAL)
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Summary

American Airlines' share price has fallen significantly.

The basics of the airline business has not significantly changed in the last six months.

The liabilities carried by American Airlines are large but should not threaten its solvency.

American is grossly undervalued.

With the largest and newest commercial fleet in the world, one would expect American Airlines (NASDAQ:AAL) to have some sort of benefit from its economy of scale. Granted it boasts the largest fleet thanks to an ongoing merger, and the novelty that the fleet has been paid by debt. However, it is hard to comprehend that the stock has fallen by almost 30% so far this year.

Without a doubt American Airlines is the most leveraged of the big four American Airlines, but nothing has really changed in the last 6 months. Some may cite that the market is finally pricing in the large liabilities that American is saddled with, but this should only be a problem should American have an unacceptable plan to manage or pay down these liabilities.

American's liabilities are broken down into two broad categories, pension liabilities and debt. I will begin with pension liabilities, which are often overlooked when talking about American Airlines. Per their 10-K, American has a projected benefit obligation of roughly $16.3 billion, and has set aside roughly $9.6 billion in a plan to help fund its pension obligations. That leaves a roughly $6.7 billion unfunded pension gap.

Given revenues of $40.6 billion and net income of $7.4 billion, this seems more than manageable. Another note of warning is that American has an expected rate of return of 8%. That seems very optimistic, but again the pension gap is small enough for the company to fill the gap from earnings. When American begins contributing again to its pension plan in 2018, it will have some considerable catching up to do, and it will be a drag on earnings for a time, but this can be seen as some necessary deleveraging.

The second category of liabilities is debt. With a long-term debt load of roughly $20.8 billion, this has been at the heart of the American Airlines debate. Per their 10-K, American has other obligations such as airplane leases, and like I said above pension obligations. It's hard to sound optimistic when talking about the liabilities of any company, particularly any company that has a highly levered balance sheet, but its ability to pay off that debt should not be in question.

For starters, falling CAPEX will allow American to make payments and begin paying its debt moving forward, among other things. It is also debt, for the most part, that carries a low interest rate, so prepayment is not necessarily a good option. Additionally, American has considerable liquidity ($6.9 billion) to make payments for years, so solvency should not be an immediate or medium-term concern.

American's potential for growth and continued profit, by finishing its fleet renewal program or developing its merger synergies, is a major plus. There have been a number of issues raised regarding headwinds for the company, from a drag from lower Latin American growth to a potential recession, to potential future declines in passenger revenue per available seat mile.

However, there are a number of reasons to consider why these headwinds should be discounted, and more importantly, investors should focus on the tailwinds that American enjoys, such as partnerships around the world, the largest commercial fleet in the world, and frankly a share price that has fallen over 30% this year. First, the slowdown in Latin America is cyclical. There may be lower growth because the commodities super cycle has ended, but Latin America as a whole (Mercosur countries aside) are countries with growing populations and growing economies.

As to recession, there is always the risk, but a recession does not eliminate the secular advantages of American, and it may even shock the management to kick start the deleveraging process, an action that would be seen by many of the critics of American as a benefit. As to the metric of passenger revenue per available seat mile, the decline up until now has been a reflection of falling oil prices. This metric should stabilize, and as long as it does, the increased capacity of AAL will lead to higher revenue.

American is not a perfect company, it is highly leveraged, and it has been a disappointment for shareholders that bought its shares so far this year. That being said, I believe this company has a huge upside potential considering a share price under $30. It may require a long holding period but when American begins deleveraging, its share price should skyrocket, not to mention the more short-term upside considering the share price of American only six months ago. Not much has changed and I believe the fall in price is not, and has not been, warranted.

Disclosure: I am/we are long AAL.

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.

Additional disclosure: I may increase my long position in AAL over the next 72 hours.