The airline industry is notoriously cyclical and capital-intensive. This leads many companies in this sector to declare bankruptcy when the economic experiences a downturn.

For this reason, many investors (myself included) were very surprised when Warren Buffett initiated stakes in the ‘big four’ United States airlines, which includes:

• Southwest Airlines (LUV)
• United Airlines (UAL)
• Delta Air Lines (DAL)
• American Airlines (AAL)

These airlines do not have the typical characteristics of a Warren Buffett investment. Berkshire Hathaway’s common stock portfolio is filled with capital-light companies with strong brand names and durable competitive advantages.

You can see Warren Buffett’s comprehensive investment portfolio analyzed in detail here. 

American Airlines is Buffett’s second-smallest airline position behind United. Since United does not pay a dividend, this makes American Airlines his smallest position among dividend-paying airlines stocks.

This article will analyze the investment prospects of American Airlines in detail.

Business Overview & Current Performance

American Airlines is the world’s largest airline when measured on a variety of fundamental industry metrics, including revenues, fleet size, and the number of destinations served.

Before 2013, American Airlines was an operating subsidiary of AMR Corporation. The parent company filed for Chapter 11 bankruptcy and American Airlines was forced to merge with U.S. Airways in 2013 to create today’s American Airlines.

Today, the airline’s performance is far superior to 2013. The company is shareholder-friendly and actively repurchases shares. Further, American Airlines is experiencing fundamental growth on both the top and bottom lines.

Source: American Airlines Presentation at the BoA Merrill Lynch 2017 Transportation Conference

American Airlines’ financial performance has been driven by its strong improvement in a number of airline-specific metrics. This includes metrics such as on-time arrivals, mishandled baggage, and on-time departures.

Source: American Airlines Presentation at the BoA Merrill Lynch 2017 Transportation Conference

Moving on, the next section will discuss the growth prospects of American Airlines in detail.

Growth Prospects

Although American Airlines is already the leader (by size) in the airline industry, it is still investing heavily in its future growth.

Airlines generally grow by investing money in new aircraft and terminals, which allows them to increase their flight revenues and improve the number of locations that their customers may travel to.

With this in mind, consider American Airlines’ capital expenditures relative to its peer group over the past several years.

Source: American Airlines Presentation at the BoA Merrill Lynch 2017 Transportation Conference

The company has devoted substantially more capital to capital expenditures than its peer group since 2014. Even when accounting for American Airlines’ large size relative to its peer gorup, it still appears that the company is the most aggressive in investing in future growth.

American Airlines is also experiencing the highest rate of revenue growth among its ‘big four’ airline peer group, as shown below.

Source: American Airlines Presentation at the BoA Merrill Lynch 2017 Transportation Conferen

American Airlines is driving this growth by focusing on 4 main areas of its business:

• Technology
• Human Capital
• New Destinations
• Fleet Modernization

From a technology perspective, American Airlines is seeking to ease many of the customer paint points that are associated with traditional air travel.

This includes baggage logistics, flight cancellation notifications, and on-the-fly reaccomodations.

These updates will soon be available through an American Airlines mobile app that is expected to be released in the summer of 2017.

Source: American Airlines Presentation at the BoA Merrill Lynch 2017 Transportation Conference

The company is also focusing on improving its talent base.

The airline industry, in general, is notorious for poor customer service and widespread public relations issues. By investing in its team and making American Airlines a great place to work, the company can help to mitigate this risk.

In the last year, American Airlines added 10,000 additional employees and delivered a 38% average pay rate increase per team member.

Source: American Airlines Presentation at the BoA Merrill Lynch 2017 Transportation Conference

American Airlines is also improving its destination base.

More specifically, the airline is expanding into China. Having exposure to this important and growing economy will be a key component to American Airlines’ growth moving forward.

Source: American Airlines Presentation at the BoA Merrill Lynch 2017 Transportation Conference

Lastly, American Airlines is investing heavily into improving its fleet.

The company is aggressively buying 800-class and 900-class aircraft to replace its dated equivalents, which will help improve the number of passengers it transports and its overall fuel efficiency (as measured by available seat miles per gallon).

Source: American Airlines Presentation at the BoA Merrill Lynch 2017 Transportation Conference

American Airlines recent investments into fleet modernization have had a tremendous impact on its average fleet age, particularly when compared to its broader peer group.

In 2012, American Airlines had the 3rd youngest fleet among the ‘big four’. Its fleet modernization efforts have improved this figure so that now American Airlines has the youngest fleet in its industry.

Source: American Airlines Presentation at the BoA Merrill Lynch 2017 Transportation Conference

Competitive Advantage & Recession Performance

The airline industry is full of what Buffett calls ‘commodity businesses’ – companies where the single largest differentiator is price.

As a consumer, this makes sense – the most important aspect of a flight ticket for most travelers is price.

Fortunately, American Airlines has a significant scale-based competitive advantage. As the world’s largest airline based on fleet size and destinations served, the company benefits from slightly better pricing power than many of its peers.

American Airlines’ size also means that it offers more destinations and more flight combinations than many of its smaller competitors. Travelers may be forced into using American Airlines to arrive at certain destinations, which is a win for AAL shareholders.

This size-based competitive advantage does not mean that American Airlines is recession-resistant, however.

Both the old American Airlines and U.S. Airways experienced bankruptcy at some point before their merger to become today’s American Airlines. This is an industry-wide trend. Many other airlines have experienced bankruptcy before emerging as a slightly different entity.

To conclude, American Airlines has a scale-based competitive advantage over its peers but I would still expect this company to perform poorly during a recession.

Valuation & Expected Total Returns

The most attractive investment characteristic of American Airlines right now is the company’s rock-bottom valuation.

American Airlines reported adjusted earnings-per-share of $9.10 in fiscal 2016. The company’s current stock price of $47.35 is trading at a price-to-earnings ratio of 5.2 (using adjusted earnings).

This is a remarkably low valuation. For context, the S&P 500 is currently trading at a price-to-earnings ratio of ~25.

If American Airlines’ valuation were to expand to that level (which is very unlikely, this is just an illustration) then shareholders would realize returns of ~400% before accounting for dividend payments or earnings-per-share growth.

Even better, American Airlines’ management has been taking advantage of the company’s cheap stock price and have bought back stock aggressively.

Since the company’s bankrutpcy-driven merger with U.S. Airways in 2013, the company’s share repurchases have reduced their share count by 34% – tremendously impacting its shareholders’ part ownership.

Source: American Airlines Presentation at the BoA Merrill Lynch 2017 Transportation Conference

The company is trading at a rock-bottom valuation because of fears about its recession resiliency. That does not mean that it will be unable to grow its earnings-per-share through full economic cycles.

I would expect American Airlines to grow its adjusted earnings-per-share by a rate of ~4%-6% over the long run. With that said, a severe recession has the potential to wipe this company out completely, and conservative investors would be best to avoid this stock entirely.

The company is not highly appealing from a dividend perspective, either – it is a low yield dividend stock.

The company recently declared a quarterly dividend of $0.10 per share, equivalent to an annual payout of $0.40. This dividend payment yields 0.8% on the airline’s current stock price of $47.35.

To sum up, American Airlines’ expected total returns are composed of:

• 0.8% dividend yield
• 4%-6% earnings-per-share growth

For expected total returns of 4.8%-6.8% before the effect of valuation changes (which will likely be the largest contributor to future shareholder returns).

Final Thoughts

American Airlines is the largest company in its industry and is a significant holding in Warren Buffett’s investment portfolio.

However, the company is not very recession resistant. Both the old American Airlines and U.S. Airways (which merged to form today’s American Airlines) have experienced bankruptcy in previous recessions.

So why did Buffett buy this stock?

I would guess that Buffett is bullish on the airline industry as a whole, and that is why he initiated a position in each of the ‘big four’.

When Buffett is bullish on a sector, investors ought to pay attention. And, American Airlines has (by far) the lowest valuation among the ‘big four’ airlines.

Thus, value-oriented investors who want to follow Buffett into the airline industry may want to consider American Airlines.