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G r o u p 4 : K a r a S t e s s l , S p e n c e r W h a r t o n , B r i a n J o n e s , J i m m y Y u , B e n D r a b i n s k i , T r e n t B r u c h h a u s

Quick Facts • Symbol: AAL • Exchange: NASDAQ • IWF Ranking: 66 • Market Cap: $33.91 billion • Current Price: $49.22 • Shares Out: 696,650,000 • 52 Week Range: $28.10 – 56.20 • Dividend Yield: 0.82% • Sector: Consumer Discretionary • Industry: Airlines

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STOCK ANALYSIS: American Airlines Group

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April 12, 2015

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S t o c k & A n a l y s i s : & A m e r i c a n & A i r l i n e s & G r o u p &

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Stock&Analysis&&&&&&&

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American Airlines Group: Stock Analysis

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STOCK ANALYSIS: AMERICAN AIRLINES GROUP|BUSINESS DESCRIPTION The American Airlines Group (NASDAQ: AAL) was formed on December 9, 2013 through the merger between American Airlines and the US Airways Group. It is the largest airlines company in the world, generating over $40 billion in revenue annually (Exhibit 1). It operates in the airline industry under the consumer discretionary sector and mainly competes against United Airlines, Jetblue Airways, and Delta Airlines. The American Airlines Group operates a number of airline divisions including: American Airlines, Envoy Air, US Airways, Piedmont Airlines, PSA Airlines, American Eagle, and US Airways Express. As of the close of Friday March 13, AAL had a stock price of $49.22 (Exhibit 2).

BUSINESS QUALITY Post-Merger Formation and Strategy The American Airlines Group flies over 193 million passengers annually on a fleet of 962 aircrafts. Through the merging of US Airways and American Airlines Group in 2013, the largest airline in the world was formed. Under the merger agreement, the shareholders of American Airlines (formerly AMR) retained 72% of the newly formed AAL with the remainder allocated to the shareholders of US Airways. Additionally, agreements included appointing the majority of management positions to US Airways’ management team, including appointing Doug Parker as the CEO of the newly formed entity. The US Airways division was agreed upon to be absorbed under the American Airlines brand name and the headquarters would remain at American Airlines’ current location, Fort Worth, Texas.

In order to create a more cohesive transition, AAL created a five step strategic plan in order to “restore American to the greatest airline in the world” (Exhibit 3). The plan entails: 1.) focusing on customers’ needs and wants 2.) being an industry leader 3.) engaging team members 4.) providing a return for investors and 5.) looking to the future. This is not the first airline merger that management has experienced. AAL CEO Doug Parker was formerly CEO of American West Airlines. In 2005, American West and US Airways merged with Doug Parker continuing on as CEO. Through his leadership, once both divisions merged under the US Airways name, US Airways was recognized as the number one major carrier in 2008, leading the way in on-time departure and arrivals. This was a major improvement accomplished over the course of a year when, in 2007, US Airways had performed last out of 20 airlines in system-wide on-time performance. By 2011, US Airways was recognized as the top performer in Airline Quality Ratings. Given Doug Parker’s previous experience merging American West and US Airways, his experience will prove invaluable as the challenge of integrating American Airlines and US Airways will be fairly familiar territory.

Competit ive Advantage American Airlines Group’s primary competitive advantage lies in its routing structure and international placement. With 339 destinations offered in 54 countries, AAL has the largest network of flights in the entire world (Exhibit 4). Including these destinations, AAL averages 6700 flights a day throughout 10 hub locations: JFK, Laguardia, Chicago, Dallas, Miami, Los Angeles, Charlotte, Philadelphia, Phoenix, and Washington DC. Approximately 65% of AAL’s revenues are generated through its domestic operations with the remaining 35% coming from its international flights. AAL became the dominant position in the domestic market following the merger. With the #1 position in the East Coast and Mid-West regions, AAL has the largest market share in the US at 19.9% (Exhibit 5). With its dominant US market position and its variety of international destination offerings, AAL has the largest opportunity to take advantage of its placements in routing and hubs. Looking forward, CEO Doug Parker has identified China and South America as key countries for expansion. In addition to its location advantages, the post-merger AAL has experienced significant economies of scale. It’s capacity to scale upwards is unmatched by any other airline in the industry. AAL plans to take advantage of this opportunity as it implements its fleet purchasing program over the next few years to hold the largest and youngest fleet of airplanes. Lastly, AAL has created a more entrenched brand name. By combining American Airlines and US Airways under one loyalty program, AAL expects increased sales and revenues. Travelers with frequent flier miles at either airline will be able to maximize their options by selecting travel options from either airline. Furthermore, AAL is expecting to receive a single operating license by the end of 2015 that will allow it to begin the process of uniting its US Airways division under the American Airlines brand name.

Management Quality The CEO of American Airlines, William Douglas “Doug” Parker, has worked in the airline industry for nearly thirty years, joining American Airlines in 1986. He worked in management positions at US Airways (pre-merger) and America West Airlines. He became CEO of American Airlines following the merger of American and US Airways in 2013. His experience includes financial analysis, financial management, operational improvements, and prior airline merger


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experience – all valid and vital components for guiding American Airlines through a successful merger and for long-term competitive success.

AAL’s board consists of 11 members, 10 of which are independent, meaning that these members have no direct impact in AAL’s business operations. The majority of the board’s members work in the financial services industry in banks, private equity, hedge funds, etc.

Industry Risks Similar to all AAL’s competitors, AAL faces industry-specific risks along with some company-specific risks that must be considered. There is the potential for significant losses in operating revenue given changes in fuel prices and economic shifts to name a few. The competition within the industry is considerable, especially given the current ease of purchasing tickets online and the limited number of airlines in a given market. Substantial indebtedness is another risk. The airline industry is notorious for its large debt burden given its high fixed costs. Financing this debt means the industry is highly sensitive to the interest rate environment and to its credit rating. Like all airlines the labor unions also constitute a significant risk since the wage expenses are normally one of the industry’s largest costs. The potential is also there for strikes, which could ultimately be costly and time intensive. A risk more inherent to AAL in particular is the failure to gain synergies that were expected through the American-US Airways merger. There is always the possibility that the full $1+ billion in synergies may not materialize.

Fleet Inventory and Expectations The current fleet of the combined American-US Airways is proving to be one of the largest in the industry. But with federal regulations regarding emissions and fuel economy ramping up over the next few years (as outlined in the government’s ‘Environmentally Responsible Aviation’ project), changes in the fleet are quickly coming to fruition. Between 2014 and 2020, American is expected to replace or add over 800 new airplanes to its fleet, which is more than double of any of its closest competitors (Exhibit 6 and 7). Adding these new planes will reduce its average fleet age from its current level of 13 years to 7 years by 2020 (Exhibit 8). This figure may even be conservative as the firm’s goal is to have the youngest fleet by this time.

A shift to a younger fleet is one of the results of the merger between American and US Airways but another result of the synergies may be appearing in the form of increased efficiency. One recent sign of this efficiency is the increased percentage of filled passenger seats, increasing from 78.4% in February 2014 to 79.3% in February 2015. Although a small statistic in the overall scheme of things, the importance of this efficiency improvement should not be understated.

Legal Proceedings As with most, if not all large, multinational firms, AAL has some legal proceedings that may impact its business results and should thus be considered. American Airlines emerged from Chapter 11 bankruptcy prior to the merger with US Airways in December 2013. Although resolved, the merger was a likely result of the firm’s bankruptcy. Another proceeding involves the promised pension benefits to the unions that were accumulated before the company’s bankruptcy. AAL considers these benefits no longer valid but has been sued for the approximately amount of $212 million by the unions. Thirdly, an anti-trust lawsuit against the merger has been planned, although no trial date has yet been set. Fourth, AAL charged Sabre with restricting its ability to sell its products and services to customers within its network and charging unfair fees. It was reported recently that AAL won this lawsuit and collected $222 million in settlement fees. The other cases mentioned have not reached any conclusion.

Industry Analysis The airlines industry is highly competitive and consolidated, with few players competing mainly on price and availability in an already mature stage of the business cycle. The threat of new entrants is fairly low as a large amount of capital is required to enter. In addition, larger airlines not only have a cost advantage, but have an established brand as well. Customers tend to choose large carriers with an existing brand identity. The threat of substitutes in the airline industry is medium. Besides different airline carriers, other modes of transportation such as cars, buses, trains, and boats are suitable substitutes for domestic travel. However, these substitutes come at the expense of time during travel and therefore, are not a strong substitute for those with time constraints. With only two main manufacturers of aircrafts, Boeing and Airbus, the buying power of suppliers is low. These suppliers compete for long-term contracts with relatively few carriers. Lastly, the buying power of buyers is also low. With the industry relatively consolidated, the carriers have the ability to keep prices high despite low switching costs between suppliers.


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Safety With the exception of high profile accidents of Malaysian Air Flights 370 and 17 in 2014 and the 2015 intentional downing of Germanwings, the airline industry is operating at record safety levels. 2014 has been the safest yet with 21 fatal accidents or 1 accident per every 1.3 million flights (Exhibit 9). American Airlines continues to match the declining industry trend in both accidents and fatalities; the current safety record has allowed the carrier to create and maintain a standard as one of the safest airline carriers in the world. Still, regardless of its impressive safety record, one of American Airlines’ core goals is to protect and improve the safety of its customers. Therefore, the company has taken aggressive steps to improve safety standards and surpass guidelines outlined by the FAA. In addition, by the end of 2014, American Airlines became the only United States based carrier to fully implement runway overrun safety protection in all of its aircraft. In 2015, American Airlines received the highest standard, 7 out of 7 stars, from Airline Rankings based on certain safety criteria: FAA and EU endorsed IOSA certification, ICAO parameters, and maintaining fatality free over the past 10 years. Moreover, Jacdec, an aviation safety database, found American Airlines to be the 5th safest United States based company and 39th in the world.

On-time Arrivals A major emphasis between the US Airways and American Airlines merger was to improve on-time arrivals, especially in the major hubs of Dallas-Fort Worth and Chicago. In 2014, the combined airlines saw an on-time arrival of 75.82%, slightly driven down by the US Airways fleet, but still on par with the American Airlines 5 year historically on-time arrival percentage. At the end of 2014, American Airlines ranked second amongst United States carriers, only behind Delta, in delivering their passengers to their destination on time.

Customer Satisfaction The annual J.D. Power airline satisfaction study gave American Airlines 3/5 stars in overall satisfaction placing third amongst traditional carriers (Exhibit 10). The company made the biggest gains industry wide scoring 24 points higher from 2013; continued scoring improvements are anticipated as American and US Airways continue to integrate their operations. American Airlines scored the highest marks in reservation experience and cost and fees, scoring higher than some low cost competitors. With customer satisfaction in mind, American Airlines announced a $2 billion investment in December 2014 to improve customer experience by improving on-flight Wi-Fi services, adding more in-flight entertainment options, and updating lounges and the assortment of complimentary snacks and beverages.

FINANCIAL QUALITY Airline Operating Metrics

! Load Factor: Load Factor measures the percentage of available seating capacity that is filled with passengers. A higher load factor allows airlines to operate more profitably as they can spread fixed costs over more passengers. The industry load factor has ticked up over the past 10 years to around 80% at year-end 2014. American Airlines’ load factor has increased, peaking in 2013 at 82.4% but holding steady above 82% in 2014. Versus its competitors, American has lagged behind the other legacy carriers for many years and at year-end 2014 was last amongst its peer group (Exhibit 11). However, although last, American Airlines is still operates above its breakeven load factor that is required to generate a profit.

! Yield: Yield measures the average revenue per passenger mile. Industry yields have continually trended upward with the exception coming in 2009 from a slow rebound following the financial crisis and spike in crude oil prices. American Airlines’ yield has grown from 13 cents to 17 cents over the 10-year horizon; amongst its peer group, American has outperformed United, and the low cost providers tracking steady for Delta for the top spot (Exhibit 11).

! R/ASM: R/ASM measures the revenue per available seat mile. Industry revenue has grown with increased prices in fares, baggage, and other fees. American Airlines has seen a steady growth in R/ASM to around 14 cents by 2014; amongst its peer group, American has ranked second in R/ASM for the last couple years only behind Delta Air Lines (Exhibit 12).

! C/ASM: C/ASM measures the costs per available seat mile. Costs have increased roughly five cents since 2005, but have been much more pronounced for the traditional carriers than low cost carriers. However, amongst traditional carriers American Airlines operates the most efficient (Exhibit 12). Although American


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experienced a huge spike in 2013, due mainly to reorganization from the merger, the company does the best at keeping costs down.

Profitabili ty Prior to the merger, American Airlines was struggling to turn a profit; from 2008-2013, the company consistently had both negative margins and returns on assets and invested capital, eventually leading the company to file for bankruptcy. In 2014, the first full year post-merger between American and US Airways, the company recorded not only record profits and margins, but more significantly the first profit since 2007. Moreover, gross and operating margins, ROA, and ROIC were the highest the company had achieved in over 10 years (Exhibit 13). Comparing American Airlines record breaking 2014 against its competition, American Airlines dominated, outperforming in gross and operating margins and crushing the competition in ROA and ROIC (Exhibit 14).

Financial Leverage Similar to profitability, American Airlines is a tale of its pre and post-merger life. Before 2013, long-term debt ballooned out of control for American Airlines, with the company levered up to 10x capital. In addition, the company found itself with the capacity to barely cover interest, and at one point, lacked the ability to cover debt payments (Exhibit 15). However, since the merger, American Airlines has maintained a level of debt much more in line with the industry and has an interest coverage ratio of 5.33 – the highest in over 10 years. Although versus the competition, American Airlines has taken on slightly more debt; however, its capacity to repay remains high and is near industry standards (Exhibit 16).

Hedging Practices

With former US Airways management making up the majority of the AAL management team, they continued their philosophy of not hedging fuel prices. With the drastic drop in fuel prices over the last few months, AAL is expected to save up to $5 billion throughout 2015 as a result given expectations that fuel will range from $1.71-$1.81 per gallon. However, despite the lower costs of fuel, AAL will continue its operations as though crude oil was still $100 a barrel.

GROWTH American Airlines has been steadily improving its key industry matrices. The Passenger Revenue per Available Seat Miles (PRASM) grew from ~11.54 cents in 2009 to ~13.97 cents in 2014. The cumulative growth rate of the PRASM was at ~4%. In addition, AAL maintained a higher than industry average load factor of above ~82% from 2011 to 2014. AAL also benefited from tailwind coming from cheaper jet fuel. The Cost per Available Seat Miles declined ~60% due to crude saving and operating savings (Exhibit 17).

AAL experienced one time revenue, EBITDA, and net income growth after merged with U.S. Airways. AAL reported negative earnings from 2008 to 2013, leading to large deferred tax assets account on their balance sheet. AAL will be able to utilize the deferred tax assets to offset its future tax payments in the next five years, which will be another tailwind to this company (Exhibit 18).

American Airline is well positioned to exploit the continued trend of high domestic yield. American Airlines led the U.S. full service carriers in growing its capacity at ~2-3%, slower than the projected domestic economic growth at ~3.3%. Full services airlines will gain from constrained capacity growth in order to maintain pricing power over business travelers (Exhibit 19 and 20). American Airline will expand its profitability due to lower jet fuel cost. The jet fuel is expected to maintain at a low level due to oversupply in the crude oil market. Lastly, major airlines will enjoy the low interest rate environment and strong economic growth in U.S.

MOMENTUM Price In examining the price momentum of American Airlines, we wanted to not only compare it to its direct competitors, but to several indices as well. In the first comparison, we compared American Airlines to the MSCI World Index, the Consumer Discretionary Sector in the S&P 500, as well as the S&P 500 as a whole (Exhibit 21). As can be seen, since the merger of American Airlines and U.S. Airways into the American Airlines Group (AAL), has continuously outperformed all the indices. American Airlines stock price did have a dip in the early part of the fourth quarter of 2014. However this dip


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was quickly recovered as the price of oil started to decline around the same time, helping American Airlines recover to well above where it was trading before it dropped.

A similar trend can be seen when we compare American Airlines to its direct competitors in the industry. As is shown in Exhibit 22, American Airlines stock price was plotted against Delta Airlines and United Continental Holdings. Since the merger, American Airlines has been consistently above its competitors. Aside from a spike by United Continental in early 2014 and a universal dip across all three stocks in the beginning of the fourth quarter of 2014, American Airlines has maintained a significant spread above its competitor’s stock prices. Following the drop in 2014, American Airlines fell slightly more than the other two airline companies, however, it never dropped below the competitors. The rebound coming out of this decrease due to the drop in oil prices was much greater for American Airlines than its competitors and allowed American Airlines to bounce back to higher than it was originally trading. This shows that not only is American Airlines a performer against the indices, but also outperforms its direct competitors within the industry.

Earnings American Airlines’ earnings momentum further supports our findings. American Airlines has been consistently at or better than analysts forecasted earnings since the end of 2013 (Exhibit 23). This has a significant impact on American Airlines stock price as positive earnings drive the stock prices upward. Another convincing signal for American Airlines is its strong rebound as it emerged from bankruptcy. Both these points lead to positive earnings momentum for American Airlines.

VALUATION AND TARGET PRICE Now that there are qualitative reasons on why AAL should provide positive return, the next step is to do some research to evaluate if the numbers back up the reasoning. The intrinsic valuation and relative valuation both offer different viewpoints and allow us to analyze public perception, along with financial quality. Using the discounted cash flow method, AAL looks to be undervalued by close to 25% (currently trading at $49.22, valued at $61.50). There are some key factors that go into this valuation. The weighted average cost of capital is extremely low for the airline industry and even lower for AAL. This valuation used the industry average with the thought that AAL will approach the average as the company continues to grow and mature. This valuation also projects 4% short term growth (3 years projected) due to the fact that AAL looks to be in an acquisition period and looking to grow inorganically. The growth was tapered down to 3% for long term with the thought that the airline industry would tend to follow GDP growth (Exhibit 24). AAL is in great position compared to its peers as well. It currently trades at a P/E (LTM & NTM), P/Sales, EV/EBITDA, and EV/Sales that are all below the industry average and are among the lowest among competitors (Exhibit 25). Performing a relative valuation (using industry medians) shows that AAL is undervalued using all five of multiples. All five of the multiples yield a valuation range well above the current trading price (Exhibit 26). The relative valuation suggests a stock price of $65-$75 and a potential upside of 32.1% up to 52.38%. Due to AAL recently coming out of bankruptcy, as well as them being in a growth phase and not having very stable cash flows, the relative valuation should be given more consideration than the DCF. That being said, the DCF does highlight some of the risks that are involved with AAL. With that in mind, AAL could reach a price of $65, which offers a return of 32.1% and could go even higher if AAL management continues to improve and grow the company.

SUMMARY Overall, we would recommend the American Airlines Group (AAL) as a strong buy. AAL has already performed strongly over the past year as it garnered the 2nd highest shareholder return amongst S&P 500 companies (Exhibit 27). On both a DCF and relative valuation basis, we concluded that AAL is extremely undervalued. Using our target price of $65, this investment would garner a return of 32.1% over the stock price of $49.22 on March 13. This price is in line with the street target price of $69.53 with 14 analysts with a buy recommendation and 2 with a hold (Exhibit 28). Given AAL’s leading international routing and hub locations, its improving financial quality, and its management team’s prior airline merger experience, AAL is a high quality stock that is greatly undervalued and poised to benefit generously from over $1 billion in expected synergies and $5 billion in fuel savings.

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Appendix(((((((

08!Fall&


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APPENDIX Exhibit 1: Stock Features

Stock Features

Ticker AAL

Exchange NASDAQ

Current Price (March $49.22

Market Cap 33.91 B

IWF Ranking 66

Shares Outstanding 696.65 M

52-Week Range $28.10- $56.20

Dividend Yield 0.82%

Sector Consumer Discretionary

Industry Airlines

Exhibit 2: AAL Stock Price Performance

Source: Bloomberg


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Exhibit 3: Strategy

Source: AAL Investor Presentation Exhibit 4: Flight Paths

Source: AAL Investor Presentation


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Exhibit 5: US Post-Merger Network

Source: AAL Investor Relations Exhibit 6: Fleet Purchases

Source: AAL 10-K


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Exhibit 7: Fleet Size Projections

Source: Flightglobal Ascend Fleets database (August 2014)

Exhibit 8: Average Fleet Age Projections

Source: Flightglobal Ascend Fleets database (August 2014)


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Exhibit 9: Airline Fatalities

Source: FAA

Exhibit 10: JD Power Rank

Source: JD Power


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Exhibit 11: Load Factor and Yield

Source: Factset

Exhibit 12: R/ASM and C/ASM

Source: Factset


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Exhibit 13: Profitability

Source: Factset

Exhibit 14: Profitability vs Peers

Source: Factset

Exhibit 15: Liquidity and Credit Quality

Source: Factset


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Exhibit 16: Debt Coverage

Source: Factset

Exhibit 17: Industry Metrics

Source: Factset


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Exhibit 18: Growth

Source: Factset

Exhibit 19: World Airline Capacity and Passenger Traffic

Source: Factset


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Exhibit 20: US Airline Capacity

Source: Factset

Exhibit 21: Price Momentum

Source: Factset


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Exhibit 22: Price Momentum

Source: Factset

Exhibit 23: Earnings Momentum

Source: Factset

Exhibit 24: Valuation

Source: Factset and Team Analysis


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Exhibit 25: Peer Multiples

Source: Factset

Exhibit 26: Relative Valuation

Source: Factset


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Exhibit 27: Shareholder Return

Source: AAL Investor Relations

Exhibit 28: Street Analysis and Target Prices

Source: Factset

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