Cabot Turnaround Letter Issue: October 30, 2024

American Airlines (AAL): Benefiting from a Nationwide Air Travel Rebound

For much of the last four years, the “friendly skies” have been anything but for the airline industry and its customers. The restrictive measures of the Covid era put the entire $1.2 trillion air travel industry into a tailspin, causing massive financial losses and layoffs for the major carriers, not to mention major headaches for travelers.

The problems began in March 2020 and continued through that year, but by the start of 2021, industry-wide losses totaled over $35 billion, with no fewer than 64 airlines around the world ceasing operations. By the time Covid restrictions were lifted in 2023 (in the words of a contemporary CNN report), “A handful [of airlines] have revived after announcing bankruptcy, or changed names, but the vast majority are gone for good.”

In total, the U.S. federal government bailed out the airline industry to the jaw-dropping tune of $54 billion in 2020 through 2022, provided mainly through the CARES Act and later extensions. The government also suspended a 7.5% excise tax on domestic air travel, as well as payments to airports and contractors.

Even after receiving bailout money, the major airliners were forced to do a massive amount of housecleaning to maintain their operations. Delta Air Lines cut its staff by 31% and American Airlines shed $500 million a year in annualized payroll by reducing its nonunionized workforce by 30%. Additionally, according to a 2023 Mercatus research report, “Airlines also retired aircraft fleets, necessitating pilots to be retrained on new aircraft.”

These upheavals, combined with chronic labor shortages during the pandemic and even the early post-pandemic years, kept the major airliners from fully returning to their pre-pandemic normal levels of service, capacity and revenue for nearly four years. But by late 2023, the global airline industry had finally returned (or nearly so) to pre-Covid capacity levels.

According to the International Air Transport Association (IATA), total worldwide air travel for 2023 was at 94% of 2019 levels. Capacity levels increased substantially in the two biggest international travel markets, namely Europe and North America, with Asia-Pacific showing the strongest year-over-year overall recovery rate among the world’s major regions.

However, as referenced by Bloomberg last October, “Industry profit will be less than 40% of 2019’s level [for 2023], according to the IATA. Business travel still hasn’t fully recovered, and it’s unclear when—or indeed if—it will.”

Indeed, per a more recent International Airport Review study:

“The global airline industry’s net profit margin for 2024 is projected to be approximately 2.7%, generating a net profit of $30.5 billion. Although this figure reflects a significant recovery from pandemic lows, it remains lower than pre-pandemic profit levels.”

By comparison, 2019 profits exceeded $25 per passenger, while 2024’s per-passenger profit is estimated at just over $6 per passenger. On a related note, U.S. airfares still remain below pre-pandemic levels

Further, the IATA has noted that while airline operating costs in 2024 are anticipated to be high due to increased fuel prices, revenue will increase, but profit margin will remain “thin.” Cargo revenue for this year, meanwhile, is expected to decline from the peak pandemic years but remain higher than in 2019, highlighting the industry’s overall continued recovery despite “shifting demand and cost factors.”

For passengers, however, all the above-mentioned factors mean the potential for more affordable air travel going forward compared to recent years. According to Nerd Wallet, the addition of new routes and increased competition—especially from budget airlines—has led to more affordable airfares, with international ticket prices also projected to further decline in response to increased air routes and a greater number of flights, especially on transatlantic and transpacific routes.

And there are plenty of signs that travelers are taking full advantage of it. As mentioned in a previous issue of the Cabot Turnaround Letter, the airline industry is rounding out what has been a stellar 2024 by several measures. And it has been a year that has shown tremendous improvement in both domestic and international flight trends following the downbeat Covid era. According to the IATA, net profits for the global airline industry are expected to improve in 2024 by 11% from a year ago, while total travelers are expected to reach a record high of five billion. And as the following graph from Statista shows, total worldwide flights in 2024 have nearly recovered to 2019 levels.

Domestically, airlines are coming off one of the strongest summers ever, as travel demand broke several records in the U.S. during the latest travel season. Among the records set was the highest six-month total ever for ticket sales, record full-year revenue and record anticipated passenger revenue. In addition, the full-time U.S. airline workforce is the highest it has been in over two decades.

All of this is by way of introduction for this month’s spotlighted turnaround candidate, American Airlines (AAL), the world’s second-largest airline as measured by scheduled passengers carried, revenue, passenger miles and daily flights. If recent company trends are any indication, the carrier is poised to benefit from continued improvement in the travel demand backdrop mentioned above.

Recommendations

Purchase Recommendation: American Airlines (AAL)

1 Skyview Drive
Fort Worth, TX 76155
Web Site: www.aa.com

Symbol: AAL
Market Cap: $8.6 Billion
Category: Mid-Cap
Business: Airlines
Revenues (2024e): $53.7 Billion
Earnings (2024e): $1.5 Billion
10/29/24 Price: $13.60
52-Week Range: $9.05-$16.15
Dividend Yield: N/A
Price target: $20-$21

Background:

Like its peers, American Airlines suffered a devastating setback during the Covid years, with operating revenue declining by a whopping 63% in 2020 year-over-year. However, this improved in 2021 with a 76% Y/Y revenue increase. By 2022, revenue had hit a multi-decade high as travel demand returned with a vengeance, signifying a significant improvement as the company’s long-term turnaround plan began to bear fruit.

The stock, however, remained grounded and even continued declining before bottoming out this year. But it’s my contention that investors are only now beginning to grasp the significance of management’s efforts at revitalizing the company, and further, that the stock represents a bargain at current levels for participants willing to risk potential short-term price volatility in exchange for intermediate-term gains.

Analysis:

A brief list of the positive fundamental factors in the airline’s favor include: better on-time performance compared to industry peers, improved short-term bookings and lower fuel prices, not to mention the benefits that will almost certainly accrue over time from the falling interest rate environment—all of which bode well for the airliner’s continued recovery going forward.

On the performance front, despite disruptions and financial impacts from the recent hurricanes and CrowdStrike outage, American reported the highest flight completion rate among U.S. network carriers. It also registered its best Q3 in terms of load factor since merging with U.S. Airways in 2013 in a major show of efficiency and reliability.

The company also just highlighted its efforts at minimizing flight cancellations while maximizing on-time departures during high-traffic periods like the upcoming holiday season. As mentioned in the latest earnings call, “This success reflects [American’s] focus on reliability, including investments in operational management and collaborations with agencies like the FAA to address air traffic control delays.” The firm’s efforts, moreover, have led to an industry-leading on-time flight performance of approximately 75%, which further underscores American’s dependability compared to previous years.

In terms of valuation, American compares favorably to its sector peers across a number of key metrics. Its current forward P/E of around 6x is far below the sector median of 20x, underscoring its attractive valuation—especially given its revenue and EPS growth improvement since the dismal days of 2020-21. Meanwhile, the forward EV/EBITDA multiple is currently around 5, which also places it in a favorable position compared to industry peers.

The top brass has also lately emphasized that among its top priorities is the improvement of operational and profitability adjustments to meet its fiscal 2024 goals. While the firm’s debt currently exceeds its market cap ($33 billion versus $9 billion), American continues to de-leverage and is on track to reduce total debt by at least $13 billion from peak levels by the end of this year. What’s more, American has reiterated its goal of reducing total debt by $15 billion from peak levels by year-end 2025.

Granted, the company has a long way to go before debt returns to historically normal levels, but the stability of American’s revenues suggest it will eventually succeed in reaching the long-term debt reduction targets set by management.

On that score, falling interest rates should help American’s attempt at not just reducing its debt by refinancing existing loans or issuing new debt at lower rates, but also in freeing up cash the airline can use for operational improvements, expansion or reserve building.

Additionally, the lower rate environment should further help American in its efforts at providing customers with a better service, primarily through fleet modernization (newer aircraft with better seating) and in-flight experience (upgraded in-flight entertainment and enhanced Wi-Fi connectivity), and also through increased loyalty rewards and premium travel options.

Going forward, consensus estimates are for American’s annual revenues to continue improving in the next four years as the company executes on its turnaround plan. Earnings, meanwhile, are expected to improve by a notable 40% in 2025 from the current year, with an additional 30%-ish improvement in 2026.

Among management’s other plans are to decrease capital spending to help further reduce debt and generate cash flow, defer aircraft deliveries by a few years (including the delivery of 10 Boeing 787-9s), as well as improve the balance sheet in the company’s ongoing attempt at strengthening its image and improving its overall position in the competitive air travel space.

For investors with a long-term timeframe, I think the stock looks reasonable for nibbling around current levels, or on minor weakness, with an eye toward an intermediate-term upside target of 20-to-21 and a short-term target of 16. BUY

Other Ratings Changes:

I’m changing the rating for our position in Baxter International (BAX) from Buy to Hold.

The position was first initiated back in February by my predecessor, and while the stock hasn’t performed badly, it hasn’t yet produced a meaningful gain. However, given the sale of Baxter’s kidney care business, coupled with its debt paydowns and efforts to improve the balance sheet, the company is in a good position to expand margins while increasing shareholder returns via stock buybacks. For these reasons, I believe the Hold rating is merited.

In company news, it was announced in late October that Baxter plans to restart its North Cove manufacturing facility in North Carolina, which was knocked offline by Hurricane Helene. Resumption of production is expected by the end of October, but Baxter is still unsure when pre-hurricane production levels will be restored. However, the company said that staffing at the plant, which was damaged by flooding during the storm, would return to pre-hurricane levels by the end of the third week of October. The plant is America’s biggest producer of intravenous and peritoneal dialysis solutions.

Separately, Baxter announced that the FDA has temporarily authorized the importation of certain IV solution products made at its plants in Thailand and Singapore with a goal of returning to 90% to 100% allocation of this product category by the end of this year. HOLD

Performance

The following tables show the performance of all our currently active recommendations, plus recently closed out recommendations. You can find more details by visiting our website at cabotwealth.com.

The chief analyst of the Cabot Turnaround Letter does not yet personally hold shares of every company on the Current Recommendations List, but that will change over time subject to the following guidelines. The chief analyst may purchase securities discussed in the “Purchase Recommendation” section or sell securities discussed in the “Sell Recommendation” section but not before the fourth day after the recommendation has been emailed to subscribers. However, the chief analyst may currently hold and may purchase or sell securities mentioned in other parts of the Cabot Turnaround Letter at any time.

The following tables show the performance of all our currently active recommendations, plus recently closed out recommendations.

Most Recent Closed-Out Recommendations

Notes to ratings:
1. Based on market capitalization on the Recommendation date.
2. Total return includes price changes and dividends, with adjustments as necessary for stock splits and mergers.
* Indicates mid-month change in Recommendation rating. For Sells, price and returns are as-of the Sell date.
** BNT return includes spin-off value in BAM shares.
*** GE total return includes spin-off value of GEHC shares at January 6, 2023 closing price to reflect our sale.
**** Indicates a partial sell.

The next Cabot Turnaround Letter will be published on November 27, 2024.

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