American Airlines‘ (NASDAQ:AAL) recovery from the COVID-19 pandemic accelerated last quarter, according to a recent investor update from the company. That’s welcome news for the struggling airline giant.
However, while business is improving faster than previously expected, American continues to trail competitors like Delta Air Lines (NYSE:DAL) in terms of profitability. Combined with the company’s weak balance sheet, that will keep American Airlines stock grounded for the foreseeable future.
A solid guidance increase
In early June, American Airlines told investors that booking momentum and load factors (the percentage of seats filled with paying customers) had increased as the summer approached. At that time, the company reaffirmed its initial guidance for revenue to decline 40% compared to the second quarter of 2019 on 20% to 25% less capacity.
On Tuesday, American raised its outlook. Management now estimates that revenue fell 37.5% from the second quarter of 2019 — better than its previous guidance — on a 24.6% capacity reduction. Additionally, the carrier’s cost control measures were more effective than expected. As a result, the airline expects to report an 11% to 12% increase in adjusted nonfuel unit costs relative to Q2 2019 — better than its previous forecast of a 13% to 17% increase.
This improvement to its guidance may enable American Airlines to record a slight pre-tax profit under generally accepted accounting principles (GAAP) in the second quarter. However, that includes a roughly $1.4 billion benefit from government payroll support grants. Excluding those grants, the airline expects to lose at least $1.4 billion before tax, putting its adjusted pre-tax margin between -19% and -20%.
Better doesn’t mean good
American’s projected Q2 performance compares unfavorably to the results that Delta Air Lines reported this week. Delta recorded a sizable GAAP pre-tax profit of $776 million last quarter. After backing out payroll support grants and other special items, it posted an adjusted pre-tax loss of $881 million. That translates to a -13.9% adjusted pre-tax margin.
Looking just at Delta Air Lines’ core airline business, the underlying performance gap between the two carriers was even greater. Delta’s oil refinery posted a $157 million operating loss last quarter due to the high price of renewable fuel credits, adding significantly to the company’s overall loss.
American Airlines’ ongoing margin deficit compared to key rivals like Delta doesn’t bode well for its future profitability. In the long run, high competition will keep a lid on profit margins at the industry level. Thus, if American’s pre-tax margin continues to lag best-in-class rivals by more than five percentage points, the full-service airline is likely to be stuck with single-digit margins.
American Airlines ended the first quarter with a colossal $48 billion of debt and lease liabilities, along with a $6.8 billion pension deficit, compared to just $14 billion of unrestricted cash and investments. This represents by far the biggest debt load in the industry.
While American’s net debt decreased last quarter, that included $2.6 billion in cash payroll support grants. Moreover, the second quarter tends to be seasonally strong for airlines’ cash flow. Without those tailwinds, net debt could increase again in the second half of 2021.
Despite the company’s weak cash flow, subpar earnings prospects, and massive debt load, American Airlines’ market cap is higher than it was at the beginning of 2020 (i.e., before the pandemic). To put it bluntly, that doesn’t make sense. This is one airline stock that long-term investors should avoid.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.
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