American Airlines Will Never Escape Its Debt Burden

Summary

• Recently Warren Buffett sold his entire stake in American Airlines, along with his investments in their peers.
• This was partly due to the additional borrowings they are taking from the government, which takes away from the upside of any recovery.
• Whilst these borrowings have thus far allowed them to avoid bankruptcy, they still face an insurmountable task reducing their swelling debt burden even in the most optimistic future.
• Based upon my analysis it appears as though that even by 2030 their leverage will likely still not be safe, even with very optimistic future assumptions.
• Given this I will continue maintaining my neutral rating, as they are not attractive for long-term fundamental investors but may still be desirable for short-term traders.

Introduction

The biggest recent news for American Airlines (NASDAQ:AAL) is that Warren Buffett has sold his entire stake in the company, partly due to their additional borrowings from the government taking away from the upside. Whilst this government support has been a relief for shareholders who otherwise faced seeing their company enter bankruptcy, in the long term they still face the seemingly insurmountable task of reducing their swelling debt burden even in the most optimistic future.

Background

I previously warned late 2019 that they were vulnerable and inadequately prepared for any downturn following years of pursuing debt funded share buybacks on the back of negative free cash flow. This left their leverage heading into this downturn at high levels that are only considered manageable for companies with strong and economically resilient earnings. Since this is all in the past now, it has little bearing over this analysis and if interested in more details, please refer to my previous article or my subsequent follow-up analysis.

Image Source: Author.

Assumptions

The assumptions underpinning this analysis were purposely selected to be the most optimistic possible, not because I believe that these will actually eventuate, but rather to illustrate the severity of their situation.

Assumption One

The first assumption relates to when a recovery eventuates for their industry as well as the extent to which it recovers. Although no one knows exactly when air travel will return to its levels before the coronavirus struck, virtually everyone agrees that a full recovery will take several years. To provide the most optimistic scenario possible, it was assumed that 2021 sees a partial recovery that keeps them cash flow neutral. After which conditions completely recover by the start of 2022 with operating cash flow then reaching the average of 2017-2019 at approximately $4b per annum.

Assumption Two

The second assumption relates to their net debt, which stood at $21.506b at the end of the first quarter of 2020. Following this they have begun receiving grants and loans from the Federal Government, with them seeking an additional $4.75b of loans on top of the $1.7b loan they have only just received since the previous quarter ended. If these amounts are simply added to their net debt, it produces a total of $27.956b. Although naturally there are uncertainties surrounding their cash outflows for the remainder of 2020 and thus to once again be optimistic, it was assumed that they end 2020 with net debt of $25b. Whilst it sounds abnormal, a few billion dollars difference does not materially change the outcome of the analysis.

Assumption Three

The third and final assumption relates to their future free cash flow generation and requires the biggest leap of faith to believe will ever eventuate, as they have virtually no history of producing free cash flow. Naturally if they cannot produce any free cash flow, they cannot ever deleverage and thus the analysis would conclude at this point.

Nevertheless to continue providing the most optimistic assumptions possible, it was assumed that once conditions recover in 2022 their free cash flow as a portion of their operating cash flow surges to the same level as the average of their three largest peers from 2013-2019. It can be seen in the graph below that Delta Air Lines (DAL), Southwest Airlines (LUV) and United Airlines (UAL) all have produced superior results in every single year. The average of their collective results is 34.83%, which would imply their free cash flow beginning 2022 would be approximately $1.4b per annum based upon the aforementioned operating cash flow assumption of approximately $4b per annum.

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Results

Thankfully the results in the table below speak for themselves, which indicate that even if these incredibly optimistic assumptions eventuate and last uninterrupted until the end of 2030, their leverage would still be moderately high for an airline. Whilst net debt-to-EBITDA and operating cash flow of 2.40 and 3.10 respectively, are safe for an economically resilient company with low capital intensity, this is certainly not the case for an airline.

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Obviously at some point in time during the remainder of this decade there will be another downturn, if not more than one, which will negatively impact their earnings and thus their ability to deleverage. It is not realistic to expect that a company operating in a cyclical industry known for bankruptcies could see more than ten years straight of these optimal operating conditions. Based on their tarnished history, it is actually debatable whether they could even see more than two consecutive years of generating any free cash flow, let alone ten years around industry leading levels.

These results indicate that without an equity raising or a Chapter 11 restructuring they cannot deleverage, as their future is almost certainly nowhere near as bright as this scenario assumes and even if it were somehow this rosy, they would still not adequately deleverage. I fail to see any reason that an investor would wish to put more of their capital into a company with such poor economic fundamentals with a cloudy future outlook. Whilst some investors may argue that they can pursue asset divestitures to reduce their net debt and thus their leverage, given this will also shrink their company and thus their earnings, I am skeptical that this will work any better than it did for Chesapeake Energy (CHK).

Data Sources

The list below includes all the data sources that have not yet been linked elsewhere in the article.

American Airlines' SEC Filings.

Delta Air Lines' SEC Filings.

Southwest Airlines' SEC Filings.

United Airlines' SEC Filings.

Conclusion

Obviously this very optimistic scenario is virtually assured to never eventuate and was conducted to clearly illustrate the point that absent of raising equity, they will never realistically escape their debt burden. The bottom line is that even if they survive this downturn, they will continue being vulnerable to future downturns. Given all of these factors I believe that maintaining my neutral rating is appropriate, as they are simply a poor long-term fundamental investment but may still be suitable for short-term traders.

Analyst’s 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.