Airlines have been a hotly debated topic lately. Some investors who hope for a full recovery think that the sector is worth buying, others believe that it is doomed. A crucial piece of support came from the US Federal government and this, together with hopes of a quick pick-up of air travel is keeping airline stocks afloat. On the other side we have industry reports and insiders that say that it can take a long time for air travel to pick up and even the CEO of Boeing (BA) adding fuel to the fire.
The industry is clearly in dire shape but the US Treasury reached out its saving hand with loans and grants. American Airlines Group (AAL) is the biggest recipient of the payroll support program for airlines. But, as the NYT pointed out, it is going to be tough after September and few in the industry expect the public to ‘tolerate another bailout’. This calls attention to the air traffic liability of AAL and its ability to generate cash flow for the rest of the year. After all, its bonds still trade at steep discounts to par, implying a huge bankruptcy risk.
My cash flow forecasts in this article show how difficult the road ahead is for AAL and why a stock price of $5 makes more sense than the roughly $12 at which it currently trades.
Airline ticket demand and ATL
Airline traffic may catch up, but even if that happens quite soon, I don’t expect people to pay in advance for their tickets like they used to. This is a problem to AAL as ATL or Air Traffic Liability on its balance sheet primarily shows sold but not yet used tickets for air travel.
There are several factors at play: first of all, there is less traffic/demand so fewer people will order tickets which causes less advances paid to AAL. Second, a lot of ‘credit’ is still in the hands of consumers and that will be booked as revenue but reduce ATL over the next quarters. Third, many consumers may opt not to use certain airlines that they view as vulnerable or they may not want to pay in advance for their tickets altogether because they fear bankruptcy of the airline. Nobody wants to have a claim on a bankrupt airline and if people don’t book their ticket six weeks in advance but just three weeks, that cuts the ATL run-rate in half.
There is evidence of this cautious consumer behaviour already from China, published by IATA.
If we take the chart above in mind, I cannot imagine that booking behaviour of US consumers will be positive for the working capital development of airlines. Lastly, AAL has stated in its last quarterly earnings call that it expects $1.2bn to $1.3bn in refunds for Q2, but that amount could go higher still as AAL has not always been forthcoming enough with its refunds according to filers of a class action lawsuit.
Demand for new tickets is also a very important driver of the ATL. The figure below shows that the number of flights is slow to pick-up in the US. Clearly there is not a lot of demand from travellers, the number of flights are down by about 70% since earlier this year. In China, we’re seeing a better recovery towards about 60% of the previous level after four months. The US is lagging China by two months and this implies that we can see a pickup in July of the number of flights.
Source: The Daily Shot.
The number of flights don’t tell the full story. In fact, they are probably a better proxy for fuel expenditure than passenger revenue. Actual US travel volume data is shown in the chart below.
Source: author’s own calculation based on TSA passenger throughput data.
For the months of April and May, the total number of passengers is at 7% of last year. Optimistically, we could imagine that the number for June will be 20% if the current level of 14% rises strongly to ~25% by the end of the month. If we suppose that the level for June will be 20%, we’ll see a Q2 passenger level that is less than 12% of last year’s.
Revenue and ATL forecasts
Passenger revenue will see a more severe impact than passenger volume. Two factors influence this. The first one is that fuel costs have plummeted, i.e. the marginal cost of flying a plane is much lower which puts pressure on ticket prices (though it’s not a problem to airlines as savings equal lost revenue if planes are sufficiently full).
A more serious pricing issue is that demand across the sector is low and carriers are trying to fill their airplanes. So we can imagine that while less planes are flying, they will each be earning less while a large part of the fleet remains idled in Q2/Q3. I think that ticket prices will gravitate towards the marginal cost. This is what the Southwest executive referred to as ‘brutal low-fare pressure’. It makes perfect sense as any opportunity to cover even a bit of overhead/fixed expenses (including operating leases and aircraft depreciation) by flying an additional plane will be seized by the airlines. Also, as crew payroll is mostly covered by the CARES Act, and is more or less a fixed expense for now, that could pressure ticket prices further for flights in Q3.
In my estimation, the pre-tax losses for airlines as a group should equal at least depreciation plus interest expenses.
Source: author’s own estimates for 2020. All changes are versus the same quarter in 2019. * Fuel costs are part of (implicit) pricing and assumed to rise and fall perfectly will revenue in 2020. The number is also excluded from passenger volume impact to remain mathematically correct. ** The impact from pricing is calculated after fuel and passenger volume impacts. Fuel prices are expected to be down 50% YoY for the remainder of 2020 (roughly in-line with IATA data) and fuel consumption is expected to be down 70% in Q2, 50% in Q3 and 33.4% in Q4, in line with the number of flights.
The table below shows my estimates of passenger revenue based on the above table. It also shows ATL and ATL as a percentage of next quarter’s passenger revenue.
Source: company reports and author’s own estimates.
Clearly, the ATL of 1Q20 is oversized relative to the estimated passenger volume of the next quarter. I think that the ATL will experience gravity and reduce by the ~$1.25bn forecasted refunds in Q2 but also by flyers who use their credit. Given the factors noted earlier, such as shorter advance booking, airline distrust, and slow air travel recovery (which makes sales geared towards the end of the quarter), it would be reasonable for ATL to eventually drop even below 54% of next quarter’s revenue. ATL is the main driver of working capital fluctuations, and in my estimate, about $3bn could fly out of the door before the end of the year. This takes us to cash flow forecasts.
Cash flow forecasts
A good start to a cash flow forecast is to use what we know for sure. The company included a useful table in its last report that shows obligations for the remainder of the year shown below.
Source: AAL Q1 2020 10-Q.
I have taken several items, such as debt repayments and aircraft purchase obligations, from this table and used them directly in my forecast. In addition I have used revenue and ATL estimates of this article, as well as other estimates. It is important to note that the payroll support is split evenly between Q2 and Q3 but that $2.3bn is logged as a liability on the Q2 balance sheet, improving working capital cash flow for Q2, but hurting it in Q3.
Source: author’s own estimates (in blue) and calculations (in black). I have not forecasted any debt issuances or repayments outside the ones scheduled and didn’t look up the exact dates of 2020 debt expiration or aircraft purchase commitments which is why they’re split evenly between Q3 and Q4 (in cash from investing activities and cash from financing activities). While EBITDA is called ‘Cash EBITDA’ in the table above, working capital movements are captured by the line item ‘working capital & other’.
When I was working on this forecast, I could not see where the company would most logically come up with $11bn in liquidity at the end of Q2 and was stuck at $10bn. A possible difference is that some passengers possibly lose their claim to a ticket/credit/refund when they fail to show up for a flight. Another possibility is that I’m too bearish about costs or working capital. Though I did pencil in a 25% saving on ‘less variable’ OpEx in Q2 and 35% for Q3. Note that this excludes wages because those are covered by the government program. After from that, I’ve set ambitious cost targets for the company, forecasting a 20% YoY saving on all ‘less variable’ costs in Q4 as passenger volume is estimated to be down by 40% YoY in the same quarter.
While my estimate of Q2 ending liquidity looks comfortable above $10bn, it quickly goes downhill from there. Primary drivers are working capital, financial commitments and negative EBITDA. The working capital is an issue because the company normally operates on a negative (variable) working capital of about $7bn. As the company’s business shrinks, so will its working capital decline. Many suppliers have granted the company some extra time to pay their bills but that won’t last for the rest of the year. An example is AerCap (AER), an aircraft leasing company that has given many customers a 2-3 month rent deferral (link to Irish times). This can help AAL preserve capital until the reporting date in June, but I think that AER and other suppliers are hesitant to keep financing a heavily indebted company on its way down. More likely is that suppliers start demanding cash payments before they provide new goods or services to the company and that would make a serious dent in its working capital (I did not model for that).
The worrisome part is that though I think that the estimates are quite reasonable, they show how quickly cash can leak away from AAL. It may seem a positive that liquidity including RCF is forecasted at $175m by the end of the year, but debt covenants stipulate that the company should maintain a cash or undrawn revolving credit facilities level of $2bn. So in my forecast, they need to raise billions.
‘But’, the bull would say, ‘there could still be help from uncle Sam, right?’ That’s not too likely because other majors have less debt and may not need a second bailout as much as AAL does. So in a scenario with a fair recovery that is still too slow for AAL, it could well be the only airline that really needs a bailout. This is a problem as it doesn’t make sense for the U.S. government to only help AAL, because would distort the competitive landscape. So again, there is only one scenario that will work for AAL, which is a strong and swift recovery in demand, coupled with favorable financing conditions.
After the cash burn
Let’s suppose American Airlines manages to remain liquid through all of this. How will it remain solvent? Equity was negative and debts were sky-high even before the pandemic hit AAL. In my calculation, the company has a net debt (including pension obligations) of $27.5bn as of March 31st. In my estimate, the remainder of 2020 will add $10.5bn in net debt to its balance sheet. We will then have an adjusted net debt of $38bn. To put that into perspective: EBIT was about $4bn in 2019, at the peak of the economic cycle. Even more perspective: cash burn will be over $6bn in Q2 and the company’s market cap is $5bn.
If the company fully recovers back to its 2019 operating profit, the EV/EBIT would be at 11 ($43bn/$3.9bn). That is more than the company traded for during most of the past 5 years as one can tell from the chart below.
Source: Seeking Alpha.
The valuation is bizarre but it’s not a given that the market will let the company refinance itself with a debt of this size. Investors are also thinking about how the company can get out of this debt hole.
Sometimes quarterly earnings calls can be fun when there’s an analyst asking the tough questions. The following was asked in the latest Q1 earnings call by Hunter Kay from Wolfe Research:
“[H]ow do you plan on digging out of this debt pile here, Doug? Based on what Vasu said, it doesn’t seem like you guys are going to be really gutting costs, so pragmatically speaking, how do you dig out of this debt pile? How do you generate that free cash flow once you get through this crisis?”
Unsurprisingly, the analyst has an underperform rating. Back on topic: the answer to the question in the call could be summarized as ‘through earnings… at some point’.
The problem is that I just don’t see the company digging itself out from the debt pile without a restructuring. In my estimate, AAL will likely end the year with financial liabilities approaching $40bn and a subdued outlook for 2021. IATA expects 2021 passenger volume to remain down over 20% versus 2019. That is also an environment with excess capacity and depressed pricing. I can’t see how this is going to work. Creditors would also want a larger risk premium for their funds. Another negative is that tangible equity is negative by $8.8bn as of the end of Q1 (and this will deteriorate further this year). So in my view, selling or encumbering assets is a temporary fix at best and ultimately a road to nowhere.
The huge debt pile is also the reason for AAL not to cut too drastically in its network or hubs. If it impairs its future ability to make money, it will never get out of this hole. The only hope is a strong, V-shaped economic recovery and a highly effective medicine or vaccine that’s available to anyone before the end of this year so people want to travel again. Further cost cuts won’t save AAL, and they know it. This is a company that will either just survive or go bust. In my view, it doesn’t make sense for it to continue down its current road absent a very swift and strong recovery.
I concede that there is potential option value in the stock. But given the negatives ahead, the shareholders should demand the room for it to at least double or triple, if the positive scenario unfolds. It clearly doesn’t have that room now as a 150% gain would mean that the stock is above the level where it was at the start of the year. A stock price close to $30 is an impossible level to recover to in the near term, given the mounting debt the company has to bear. The current price of $12 is the fair value when taking into account the best-case scenario of a speedy recovery. A stock price below $5 is more fitting in my opinion.
AAL is fighting a tough battle. It must cope with declining passenger numbers, try to keep working capital aboard and also balance between cutting costs and still remain able to make money once passenger volumes return to normal levels. I think that the company will have a hard time doing that and bankruptcy risk is very substantial. Even if the company does not go bankrupt, it will be saddled with so much debt that an equity investment still doesn’t make a lot of sense at its current valuation. To a shareholder it is in essence a ‘bet on black’ at the roulette table with no payout if you win. From this perspective, AAL looks like a terrible buy and the perfect stock to sell.
Disclosure: I am/we are short AER. 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.