American Airlines Group Stock Is No Sure Thing
The new American Airlines Group took flight last week following the completion of its merger with US Airways. Eager investors bid up shares by more than 10% in the first few days after the merger closed, believing that the merger will be very successful and that integration risks are minimal. However, American Airlines stock is very far from being a safe bet.
While CEO Doug Parker has integration experience from the 2005 merger of America West and US Airways, bulls have probably overstated the value of this experience. Airlines are extremely complex organizations, and while executives have focused on avoiding some of the pitfalls of the America West-US Airways merger, other issues that they don't expect will undoubtedly arise.
That said, integration risks are not the biggest challenge facing Parker and his management team. The one big reason why American Airlines stock is too risky for me to recommend is that the company has enormous capital commitments. Whereas successful rivals like Delta Air Lines have tried to hold down capital spending, American Airlines is in the midst of a costly plane-buying spree that will tie its hands for years to come.
New planes galore
Prior to its bankruptcy filing in 2011, American Airlines announced plans for a grandiose fleet transformation to replace its aging narrow-body planes. The company ordered a total of 460 new Boeing 737 series and Airbus A320 series jets, for delivery between 2013 and 2022. That order included 54 already-scheduled Boeing 737 deliveries as well as firm orders for 57 wide-body Boeing aircraft from the 777 and 787 aircraft families.
In other words, American Airlines plans to replace nearly its entire aircraft fleet within a span of about 10 years. (At the time the merger with US Airways was announced earlier this year, American's mainline fleet totaled just over 600 planes.)
This fleet renewal project will be a phenomenally expensive undertaking. As of the end of September, American had committed about $2 billion a year for aircraft purchases between now and 2017, and has more than $12 billion in commitments beyond 2017. US Airways had also committed about $4 billion for aircraft purchases between now and 2019.
That only covers a portion of the new American's fleet renewal costs. In order to keep its own capital expenditures to reasonable levels, American Airlines arranged lease financing for many of its new aircraft.
This will drive up American's aircraft rent costs dramatically over the next few years. Last year, American Airlines paid just $550 million in aircraft rent. By 2017, this cost will swell to $1.67 billion annually due to all of the shiny new leased aircraft the company is receiving.
A different direction
American's aggressive fleet renewal plans stand in stark contrast to the strategy adopted by Delta Air Lines. Back in the late 1990s, Delta went through a similar phase of rapid fleet renewal, and it got burned during the industry downturn after 9/11. With heavy capital commitments, Delta suffered several years of negative free cash flow, and lacked the flexibility to cut capacity in response to the weak travel environment.
Now, Delta's management has vowed, "Never again!" Instead, the company is committed to a program of gradually updating and replacing older planes with a combination of new and used aircraft, with a goal of keeping capex steady.
By contrast, American's heavy investment in new aircraft today should rapidly reduce its fuel and maintenance costs. However, as the planes age over the next decade, maintenance costs will creep up again. Furthermore, the fuel savings of American's new fleet will eventually be surpassed by even more fuel-efficient aircraft.
Meanwhile, with so much money invested in new "metal", capacity cuts -- one of the main tools used by Parker to improve results following the America West-US Airways merger -- won't be a viable option. In fact, the new American's fleet order basically forces it to grow.
The growth risk
This built-in growth is the most troubling part of American's fleet plan. As of Sept. 30, American Airlines (excluding US Airways) had firm orders for 488 new planes, but only 355 older-model planes ripe for retirement.
For the next few years, American has plenty of older planes that it can retire, allowing it to adjust capacity according to demand trends. However, with American taking more than 60 new planes a year on average for the next four years, it will soon run short of these older planes. At that point -- if not before -- American's new aircraft will have to be used for growth, rather than replacement.
Capacity discipline has been one of the driving forces behind the airline sector's recent upswing. However, American Airlines' fleet plan is predicated on long-term growth, and there is no way to know today whether the market will be able to absorb that growth. This is a big long-term risk that shareholders need to recognize.
Foolish bottom line
Many investors and airline analysts are very bullish on the new American Airlines, expecting a smooth merger integration process and speedy rise to the top of the industry. Indeed, there are good reasons to expect strong earnings in the next few years. A flood of new aircraft will allow American to cut fuel and maintenance expenses, while the combination of the complementary American and US Airways networks should create revenue synergies.
However, the combined company's massive aircraft orders will soak up much of American's cash flow over the next 10 years. Over time, those new planes will start to age, and maintenance expenses will eventually rebound.
Lastly, because American has significantly more firm aircraft orders than older aircraft ready for retirement, it will eventually need to grow capacity. This forced end of capacity discipline could rapidly undermine American's profitability, depending on future market conditions. Even if the merger appears to be successful in the next few years, the new American's massive capital commitments are a ticking time bomb that could bring the company down later on.
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The article American Airlines Group Stock Is No Sure Thing originally appeared on Fool.com.Fool contributor Adam Levine-Weinberg has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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