American Airlines vs. Southwest: Balance sheet battle

imp

Investment thesis

The airline industry has shown great signs of recovery despite general fears of recession and economic slowdown. American Airlines Group Inc. (NASDAQ: AAL) and Southwest Airlines Co. (NYSE: LUV) dominate the airline with 19.3% and 17.4% market share in 2022. They are the current leaders in the United States in terms of domestic market share and both posted record profits in the second quarter. However, I believe that one of these companies has greater long-term potential and will be able to post a more significant share price increase over the next 2-3 years.

AAL and LUV market share

zippia.com

The financial situation of American Airlines compared to Southwest Airlines

AAL and LUV recognize their income from 4 main sources. Passenger revenue represents the lion’s share of their operating revenue (80% versus 73%). The only major difference is that AAL has a cargo revenue stream that LUV does not, so the US airline’s portfolio is a little more diverse. Investors can see the same diversification in terms of international destinations and flights.

AAL-LUV income

The graphic is created by the author. All figures come from companies’ financial statements.

LUV recognizes 93% of its revenue from domestic flights and only 7% comes from international destinations, while AAL has traditionally focused more on international flights. 84% of their revenue comes from domestic flights and 16% comes from Atlantic-Latin America-Pacific flights. This is why, after the easing of the lockdown in 2021, shares of Southwest Airlines could have recovered more quickly as domestic travel rebounded much faster than international travel (fewer restrictions were also in place). International travel still lags behind and will continue will not fully recover by 2025 according to expectations. At the same time, domestic travel spending will be just 5% below 2019 figures in 2022, and by 2023 spending is expected to exceed pre-pandemic levels.

From a sales and revenue growth perspective, AAL dominates the major airline market and beats LUV. Its passenger revenue per available seat mile (13.93 cents) is 30% higher than Southwest’s 10.66 cents. AAL achieved the highest quarterly revenue in the company’s history and its second quarter schedule was over 25% larger than its closest counterpart. But from a balance sheet perspective, things aren’t too good for AAL at the moment and things are looking up for LUV. Post-pandemic, AAL’s debt situation improved only slightly despite the management plan to reduce the company’s debt by $15 billion by the end of 2025. The company is the most indebted among its peers, totaling more than $36 billion (this is generally noted by many analysts), but keep in mind that AAL has the youngest fleet in the Big 4 of US airlines, which is important during a recovery phase of the industry. Management can slow down the company’s CAPEX and its fleet spending to reduce its debt without hurting its fleet and that’s why I think the $15 billion debt reduction will likely be successful in the years to come without any destruction of shareholder value. Additionally, at the end of the second quarter, the company had a cash balance of nearly $16 billion.

However, in terms of ratios, LUV wins. American’s quick ratio is 0.7 and its debt ratio is -4.4 while Southwest’s quick ratio is 1.6 and its debt ratio is 0.95. I also like to look at ROA metrics because the airline industry’s primary assets (aircraft) generate the bulk of its revenue, and therefore why this metric is an appropriate measure of profitability. Over the last 12 months, AAL had an ROA of -2.8% while LUV had an ROA of 2.7%. This measure of ROA will improve as the airline industry recovers, ticket spending and the number of travelers return to pre-pandemic levels. Return on assets was between 2-3% pre-covid for AAL, so there is plenty of room for improvement. LUV had a higher return on assets, averaging 7-9% before the pandemic. This is partly due to LUV’s aircraft types. Southwest only owns Boeing 737s and no other aircraft types, which saves unnecessary costs. Pilots do not need to be trained for the other types and the same goes for mechanics. At this point, Southwest Airlines has a stronger balance sheet with less debt and can generate better returns than American Airlines. Still, AAL is slightly more undervalued than LUV at the moment. In a DCF model, AAL is about 48% below its fair value while LUV is only 38% below its fair value. I calculated a modest growth rate of 4% due to high labor and fuel costs and with an EPS of 1.33 for AAL and 3.04 for LUV.

Future prospects

The future looks bright for both major carriers due to rising demand and rising ticket prices. U.S. domestic leisure travel spending will exceed pre-pandemic levels by the end of the year and total leisure spending will surpass pre-pandemic numbers by the end of the year. ‘next year. However, the recovery will not be as quick as some analysts previously predicted. Business travel spending is not expected to return to 2019 levels until 2027. The average domestic fare is expected to increase to around $350 and international rates to $800 for Thanksgiving, Christmas and the holiday season.

There are certain risks associated with the airline industry in general and all major carriers face almost the same issues. The majority of costs that any airline has to deal with are fuel prices and labor costs. Over the past 6 months, all major carriers have suffered from extremely high jet fuel prices and struggled to hire new employees after layoffs during the pandemic. In the third quarter, jet fuel prices began to moderate due to lower crude oil prices, but the current price is still 50-60% higher than pre-pandemic prices. In addition, during the holidays, the demand for jet fuel will increase and prices will follow this demand, which will reduce the already thin profit margin of the airlines. This will be particularly harmful for AAL and for the airlines which already have a record debt of high interest charges in addition to other costs such as fuel and high labor costs.

Kerosene price

ustravel.org

LUV also faces some issues, but I think they are much less severe than AAL’s issues. The southwest will only receive 66 Boeing 737 Max planes in 2022 fewer than the 114 originally planned. Southwest plans to add 10,000 net employees by the end of the year, but management has hinted it may slow hiring due to the economic downturn. However, at the same time, the company is adding short-haul flights to capitalize on the growing demand from domestic business travelers.

Conclusion

The airline industry is slowly but gradually recovering from the pandemic and is expected to fully recover within the next few years. This trend will help major carriers reduce their accumulated debt and increase their ROA. However, there are significant differences between the major airlines in terms of future shareholder returns. I think with its lower debt profile, stronger balance sheet and better pricing model, Southwest Airlines will recover faster than American Airlines and that’s why it’s a better asset long term for investors.

Comments are closed.