AMR: Cleared for Takeoff
We at Standard & Poor's believe American Airlines, as the largest airline in the world, is well positioned to benefit from improving U.S. airline industry fundamentals. We think reduced industry capacity and the recent rash of U.S. airline bankruptcies is leading to a change in how airlines price their product, which, along with what we see as strong demand, is driving a sharply improved revenue environment.
At the same time, actions by its parent company, AMR Corp. (AMR; recent price, $23), to cut costs and leverage its revenue base over a smaller base of employees should drive a decrease in unit costs, excluding fuel. We expect the company to return to profitability in 2006, although rising oil prices create a risk. We also expect AMR to be strongly profitable in 2007.
While the stock has had a strong run in the past year, we don't think the current share price fully reflects what we see as AMR's earnings potential. We see significant opportunity for capital appreciation for the stock, driven by an improved industry environment, rising revenues, and ongoing cost cutting. While we strongly recommend purchase of AMR stock, ranked 5 STARS (strong buy), we note that the shares will likely remain very volatile.
American is the world's largest airline, serving 150 destinations throughout the globe. Hubs are located in Dallas/Ft. Worth, Chicago (O'Hare), Miami, St. Louis, and San Juan, Puerto Rico. With $20.7 billion in revenues in 2005, AMR had a market share of about 14% of the total U.S. airline market, according to data from the Air Transport Assn. As of April, 2006, the company had an 18% market share as measured by revenue passenger miles, according to Aviation Daily. The company derived 36% of its 2005 revenues from international travel.
Over the past five calendar years (2001-05), AMR lost a total of $7.1 billion. The company has taken numerous steps to cut costs, including a 2003 agreement with labor groups that reduced employee costs by $1.8 billion. Other actions include "de-peaking" hubs (spreading flights out through the day, leading to greater aircraft utilization), phasing out older aircraft types, and cutting capacity where warranted.
Most recently, on June 8, AMR announced that it would let leases on 19 Boeing 757s lapse next year, which should save it about $50 million annually. The company also plans no major expenditures for new planes until at least 2013. We think this creates the opportunity to devote significant amounts of free cash to restructuring the balance sheet.
In 2006, we see AMR's revenues rising about 15%, to $23.8 billion. We project mainline capacity to increase about 3% to 5%, with domestic capacity likely to be flat and international capacity likely rising about 8% to 10%. We expect average airfares to be aided by capacity cuts throughout the industry and Delta's recent retreat in Dallas/Ft. Worth, AMR's largest hub.
We see declines in wages, aircraft rentals, maintenance, distribution costs, and other expenses as a percentage of revenues. AMR has targeted $700 million in cost savings in 2006. It recently negotiated a new, less costly agreement with WorldSpan, and hopes to lower its costs with the other major Global Distribution System (GDS) ticketing companies as well. AMR will also be looking to continue its hub-simplification actions, which should cut costs and improve productivity, in our view. In addition, unit costs per available seat mile are likely to benefit from leveraging the increased revenues we see over an existing or slightly lower cost base.
Partly offsetting the cost cuts and higher revenues we foresee should be another year of sharply higher fuel costs. In 2005, fuel costs at AMR jumped 41%, or $1.6 billion. We see an additional 25% rise in fuel in 2006.
In the first quarter of 2006, AMR posted revenue growth of 12.5%, and operating profit improved to $115 million from $23 million. The company cut its net loss to $92 million from $162 million by leveraging its revenue growth over a smaller rise in operating expenses. The company still lost money, but was able to improve results despite a 34% ($376 million) increase in fuel costs.
We expect the summer travel season to be particularly strong this year, with capacity cuts throughout the industry driving sharply higher fares, while at the same time planes are likely to remain at record to near-record load factors. We don't expect major fare sale activity until we reach the fall travel season, and even that activity is likely to be more restrained than in the past.
For the 2006 full year, we expect EPS of $1.75. For 2007, we see EPS of $3.28 on revenue growth of about 5% to 6%.
PACKING THEM IN.
The U.S. airline industry has endured five bad years of multi-billion-dollar losses, starting after the attacks of 9/11 and continuing through 2005. Over the past five years, S&P estimates the 10 largest U.S. airlines lost a total of $58.6 billion. These large losses, as well as the bankruptcies of United (UAUA, Not Ranked, $28), Delta, Northwest, and U.S. Airways (LCC; 4 STARS, buy; $48), the merger of America West and U.S. Airways, and the liquidation of Independence Air, have forced a lot of excess capacity out of the industry. At the same time, low-cost carriers have been feeling the heat of rising oil prices and, we think, have been forced to be less aggressive in their pricing policies.
Year to date through April, available seat miles (ASMs), the industry statistic used as a proxy for industry capacity, had fallen 1.5% after rising 1.5% in 2005. Domestic ASMs were down 3.4% through April, after declining 1.5% in 2005. While not dramatic, this decrease in capacity at the same time that passenger traffic is rising is leading to a sharp increase in how full flights are, which is one reason airfares have been rising.
Revenue passenger miles (RPMs), the industry proxy for passenger traffic, was up 1.6% in the first four months of the year. Passenger load factor, the industry statistic that tells us how full flights are, on average stood at 78.5% in the first four months of 2006, a 2.4 percentage point improvement over the prior year.
These stats are the reason why passenger revenue for the industry has risen 12.4% in the first four months of 2006, according to the Air Transport Assn. At the same time, yield, a proxy for average airfares, has increased about 11%. This increase in revenues comes while many carriers have sharply cut their capacity, which we think could lead to market-share gains for American and certain other carriers. We expect these trends to continue through 2006 and into 2007. AMR, as the largest airline in the world, should be a major beneficiary of these trends, in our view.
Our 2006 and 2007 Standard & Poor's Core Earnings estimates are $1.58 a share and $3.08 a share, respectively. These projections differ from our operating earnings estimates by 17 cents and 20 cents in the respective years, or a percentage difference of 9.7% in 2006 and 6.1% in 2007. The difference relates to our estimate of the cost of pension accounting.
Our 12-month target price of $40 values the shares at 12 times our 2007 EPS estimate of $3.28. This is in line with the company's historical p-e average during past periods of airline industry profitability. It would also be about in line with the average airline industry p-e of approximately 11.5 times our 2007 EPS estimates for the universe of airline stocks that we cover. We note that our revenue forecast of $25 billion in 2007 is quite sensitive to oil prices, and with only an estimated 190 million shares outstanding, our EPS forecast would be significantly affected by sharp divergences from S&P's oil-price forecast.
Our $40 target price, an estimated debt level of about $20 billion (including aircraft-operating leases), a projected 190 million shares outstanding, and an expected $5.0 billion cash balance results in an estimated enterprise value of about $22.6 billion. Based on that number, and our forecast of 2007 EBITDA of $2.8 billion, we arrive at an enterprise value-to-EBITDA multiple of 8 times, which is also in line with the industry and AMR's historical multiple during past periods of airline industry health.
Our 12-month target price represents significant appreciation potential from the current share price. Our target price forecasts a leveling of oil prices and continued growth in airfares and customer demand. We also expect the shares to be highly volatile.
We have a favorable view of the company's corporate-governance practices. Positives of note, in our view, include the sole use of independent outside directors on the nominating, audit, and compensation committees; that all directors own stock in the company; and that the board meets on its own without the CEO present. The board is also controlled by a supermajority of independent directors, and the full board is elected annually.
On the negative side, we're concerned that the board can change the number of authorized shares without shareholder approval, and that the board may amend the corporate bylaws without shareholder approval.
There are risks to our recommendation and target price. We consider the shares to be very volatile and high risk for several reasons. First, oil prices have risen dramatically and may continue to rise, which is offsetting a lot of other cost cuts at the company.
In addition, AMR has a very high debt load of about $20 billion (including operating leases) and an underfunded pension plan, both of which are likely to be a drain on cash resources over the next few years. The net pension obligation at the end of 2005 exceeded the fair value of the assets in the plan by about $3.2 billion. AMR is attempting to get its debt level down, but this won't be an easy task, in our opinion.
AMR currently has about $5.0 billion in cash on its balance sheet, which we think will allow it to pay interest expense, repay maturing debt obligations, and fund the pension plan while continuing to pay operating expenses for at least the next two years. However, if operating losses continue, at some point cash levels could become an issue. Legislation pending in Congress may give AMR more time to address its pension underfunding, but if this legislation isn't passed, the company will have to devote a significant amount of cash to the plan over the next few years.
The U.S. airline industry has been, and is likely to continue to be, highly competitive, with new entrants continually coming in with lower cost structures due to less senior staffs that have lower pay rates, newer planes that require less maintenance, and lower other costs. We think this gives these carriers the ability to underprice legacy carriers like American.
Over time, these advantages recede as companies mature, but there will likely continue to be newcomers to the industry. In addition, we have seen mainline carriers go to extremes to protect their market shares and periodically engage in destructive pricing practices. We have recently seen a change in this behavior due to industry losses and high oil prices, but this historical trend could re-emerge at some point.
Also, AMR is competing with some carriers that have gone through the bankruptcy process one or more times, which has allowed them to shed their pension plans, lower costs, and exit unprofitable contracts and leases. AMR, which has never filed for bankruptcy, stands at a competitive disadvantage vs. those carriers, in our view.