American’s leverage and operational record make it easy to miss, but hiding underneath is an improving airline with clear capital allocation priorities, strong demand, and an industry that continues to move in favor of larger carriers.

 

 

From 2008-2013, the U.S. airline industry consolidated from 10 main carriers down to 4: Delta, United, American, and Southwest. Pre-financial crisis, a big problem for airlines was increasing demand led to a larger supply response; good times inherently led to increased capacity and losses. Post-consolidation, however, large carriers controlled enough capacity (~70-80%) to roughly match supply and demand (under most circumstances). They’d give up some share to smaller carriers if needed, but a growing industry with low fuel costs as a tailwind meant a period of profits and growth (2015-2019).

 

Large carriers became more than just airlines, using frequent flier and credit card programs to drive loyalty, incremental revenue, and differentiate themselves from others. Additionally, more efficient pricing models, including ticketing options extracted more value from each seat.

 

   

 

The pandemic made the previous decades’ progress irrelevant, reducing demand to 0 and financially destroying airlines (requiring a government bailout of ~$54bln). Airlines cut everywhere they could, reducing capacity by up to 90% during early pandemic months, retiring or parking aircraft, offering early retirement, and focusing on other revenue streams (cargo). 

 

 

A quick bounce back in demand left airlines scrambling to bring back capacity, and operations were stretched to breaking point. The summer of 2022 was beset by cancellations, delayed flights, lost bags, and >3x increase in customer complaints. Despite all this, massive demand for travel meant rising revenues and a return to profit in the back half of 2022. This has continued into 2023, with American’s Q2 RASM up ~22% vs Q2 19 (CASM up ~14%). 

 

The concern is that as ASMs increase, RASM will be pressured as capacity normalizes, and costs will continue rising due to inflation in both labor and equipment (as well as macro recession risk). This is true, but I think the following key factors make this an opportunity:

 

1. Capacity issues will persist over the medium-term, meaning structurally higher airfares. 

 

There are multiple reasons for this. Firstly, on fares, ASMs are still below 2019 levels; demand will be there if airlines bring back capacity prudently. The consumer continues to spend on experiences and flying remains the most efficient way to travel long distances. Large airlines are focused on profits and smaller airlines are struggling with operations. 

 

Next, there’s a shortage of pilots; ~50% are scheduled to retire over the next 15 years, and there isn’t a quick fix. Increased training programs will help over time, but the 1500-hour rule, expensive training, and limited funding options for trainees mean it will be a slow process (there is some proposed legislation to reduce the 1500-hour rule and increase the retirement age, but pilot associations and large carriers are opposed). Additionally, commercial airline hiring isn’t all from internal training. In the 1980s, ~67% of commercial pilots had some form of military experience. That number has steadily declined to ~33% as the military increased their required service period from 6 to 10 years (due to increased training costs) and the number of military pilots decreased. Oliver Wyman estimates a 17k shortage of pilots in the U.S. by 2032; this is down from their original forecast of ~29k (made in 2022), but still ~15% below anticipated demand.

 

To combat the shortage, larger carriers, who offer better overall comp packages, are hiring away from regional and smaller players, as well as maxing out training programs. The recent labor agreements signed by American and other large carriers will increase pilot pay by >40%, but increased pay is significantly easier for large carriers to absorb (higher RASM and cost base). 

 

 

 

Aircraft delivery delays are also slowing potential capacity growth. Boeing and Airbus are averaging ~3-6 months late on deliveries due to supply chain challenges and the unexpected return of demand. Additionally, an engine issue identified by Pratt & Whitney is impacting A320/21neo planes delivered since 2016 (~1200 worldwide). Spirit is grounding 7 planes post Labor Day (~4% of the fleet with potentially more needing inspection) and Hawaiian is cancelling 5 routes. 

 

These issues impact all carriers, but large players are better equipped to absorb the increased costs from the pilot shortage and the delay in new jets reduces potential capacity growth for smaller players. Large carriers have shown when they control capacity (with reasonable demand), they can generate consistent profits.

 

 

Firing most of your employees and then trying to replace them a year later leads to operational issues and inefficiencies. This has been obvious for customers. Just from personal experience, I’ve seen airlines cancel flights 20 mins before departure due to crew mix ups, bags lost, a whole family of planes grounded due to missed maintenance checks, and hours on a runway due to ATC and weather issues (the list could go on…). Airline operations are getting better as they catch up on hiring, but new employees are simply not as efficient. Delta has hired ~30k employees since late 2021 in an organization of ~100k. Running an organization where up to 30% of employees could have <2 years’ experience (admittedly some could be boomerangs), all during a period where the business has underestimated demand is a recipe for inefficiency. I expect airlines to lower costs as their employee base stabilizes. This won’t fully offset the increasing cost from new labor contracts etc. but will keep CASM growth at moderate levels.

 

Smaller airlines, again, are struggling the most. Spirit recently negotiated pushing back aircrafts (which are already delayed), so they can “digest the previous few years of growth”. Their Q2 23 CASM is up >25% vs Q2 2019, with only a 10% increase in TRASM. JetBlue is expecting margin headwinds as they unwind the NEA (significantly smaller part of American's business), and a recent filing error leaked some optically bad numbers for the merger (i.e., increase Spirit fares by as much as 40%). Frontier is the worst performing airline in terms of on time departure, with ~35% of their flights being delayed (big four are ~25%). 

 

 

Bottom line, the market is right that RASM, especially domestically, will be pressured as ASMs grow and near-term CASM headwinds impact all carriers. But, more importantly, large carriers are in control of capacity and LCC/ULCCs are struggling with operational issues. Add in increased demand for premium seating, the continued growth of credit card rewards, higher interest rates dissuading new entrants, and large carriers hold an advantageous competitive position. 

 

 

American has the youngest fleet of the large carriers, with an average age of ~12.5 years after spending ~30bln on aircraft from 2014-2020. Capex spend for 2023 will be ~$2.5bln and average ~$3.5bln for the rest of the decade (includes non-aircraft capex). They’ve simplified their operations by reducing their mainline fleet from 8 to 4 aircraft types (737, A320/21, 787, 777); this creates a simpler airline with more flexibility. Their main operating hubs in the sunbelt (DFW, Charlotte, Phoenix, and Miami) are also well positioned to take advantage of recent demographic shifts. These characteristics have allowed American to improve their margin profile vs 2019; they are the only airline in the industry to grow RASM more than CASM (Q2 23 vs Q2 19).

 

Debt reduction is American’s main capital allocation priority. They have a stated goal of reducing debt by ~$15bln from peak levels (2021) by the end of 2025. They’ve reduced debt by ~$11bln so far, but this is inflated by a non-cash reduction in their pension obligation due to a higher discount rate used in the calculation.

 

 

 

 

I’m converting American’s $1bln 6.5% notes due 2025 for simplicity (~62mm shares convert at ~$16.2 a share), I’ve increased pension liability to $4bln to account for aggressive ROA assumption (management has it ~$2.5bln liability with 8% ROA assumption). 2023 Ebitda estimate of ~$7.5bln on ~$54bln of revenue: ~5x EV/Ebitda multiple.

 

 

Looking out to 2026:

 

 

The key assumption is that CASM grows only slightly quicker than TRASM (based on discussion above). If American keeps CASM growth roughly in line with TRASM, this likely works over the next few years (assuming no demand killing macro event). This scenario gives us a ~20% IRR and ~16% free cash flow yield in 2026.

 

 

Macro is obviously the biggest risk to airlines. A demand shock like the recent pandemic and there’s nothing that will save an investment in airlines; a $150mm airplane can’t disappear and airlines are forced to chase available demand (through low fares). Recession, weather disasters, and terror are other risks that could impair demand, but I do think there's some recency bias around the severity of the pandemic (most other macro events shoudn't mean bankruptcy/bailout). The easier question to ask yourself is are you okay taking on these unpredictible macro type risks for a ~15-20% free cash flow yield? This was roughly the bet made by those before the pandemic (slightly lower fcf yield), but I think the current supply contraints make it a better bet now.