The combined airline (“new American Airlines”) is forecasting pre-tax income of $2.6 billion this year, $3.8 billion next year, and $4.4 billion in 2015. Revenue is projected at $41 billion this year; it is expected to rise 5% in 2014 and another 6% in 2015. However, these figures appear to be best-case-scenario projections. American’s bankruptcy restructuring should allow the new company to be profitable, but it will still face strong competition from its two big rivals, Delta Air Lines, Inc. (NYSE:DAL) and United Continental Holdings Inc (NYSE:UAL), as well as budget carriers like rapidly growing Spirit Airlines Incorporated (NASDAQ:SAVE). This heavy competition will probably keep a lid on the new American’s profitability.
A comparative perspective
Based on the revenue and earnings projections in American’s proxy statement, the carrier will achieve a pre-tax margin of 6.3% this year, 8.9% in 2014, and 9.6% in 2015. Profitability on that scale is not unheard of in the airline industry: Spirit Airlines achieved a pre-tax margin of 13.2% last year. However, it is unrealistic to expect major carriers to achieve a 9.6% profit margin today. An ultra-low-cost carrier like Spirit that competes solely on price can cut unprofitable routes, fly at odd hours, and cram lots of passengers onto each flight to maximize margins. By contrast, legacy carriers make money primarily by winning corporate accounts based on offering large networks, frequent flights, and good business class amenities. This additional complexity of the network airline business model increases the addressable market, but forces carriers to keep flying marginal routes (which dilute margins).
In 1998, when inflation-adjusted oil prices hit an all-time low (with an average nominal price of $11.91 per barrel), American Airlines managed to achieve a 10.3% pre-tax margin. At the time, it was paying $0.55 per gallon for jet fuel. In today’s high fuel price environment, major carrier profitability is much lower. Delta has been the most profitable network carrier recently, but achieved a pre-tax margin (excluding special items) of just 4.4% last year. US Airways Group, Inc. (NYSE:LCC) was a close second at 3.9%, while United Continental Holdings Inc (NYSE:UAL) was much less profitable and American lost money.
Margin pressure remains
Oil prices have pulled back recently, and airlines are on track to benefit from lower jet fuel costs in 2013, which will boost margins somewhat. However, even the highest-performing major carriers are far from the new American’s margin targets, and it stretches credibility to believe that the new American will be able to make such massive improvements in just a year or two.
Moreover, if airline industry profitability improves, lower-cost airlines like Spirit will expand even more quickly and steal traffic from network carriers like American. Spirit has recently been targeting major airline hubs for expansion, and has grown rapidly at American’s home base: Dallas-Fort Worth International Airport. Moreover, as of the end of 2012, Spirit had firm orders for 106 additional aircraft through 2021, compared to just 45 planes in Spirit’s fleet at the end of last year. Spirit clearly plans to grow quickly for many more years, and its low base fares will pressure American and other legacy carriers, keeping economy-class fares in check.
Foolish conclusion
American’s proxy statement includes the usual waivers and disclaimers that investors should not rely upon forward-looking statements. Yet, they seem particularly necessary in this case. Even in a best case scenario, it’s hard to see a pathway to a 9.6% pre-tax margin by 2015. Moreover, United Continental Holdings Inc (NYSE:UAL)’s recent merger integration woes highlight the risks that the new American will face in its first few years. A major computer glitch that led to hundreds of flight cancellations last week points to other risks; for example, American may have underinvested in IT systems in the past decade due to its weak financial position. Investors should be careful to evaluate all of these factors before investing in American or merger partner US Airways Group, Inc. (NYSE:LCC).
The article Will This New Airline Be an Earnings Juggernaut? originally appeared on Fool.com and is written by Adam Levine-Weinberg.
Motley Fool contributor Adam Levine-Weinberg is short shares of United Continental Holdings (NYSE:UAL) and is long Sep 2013 $33 Puts on United Continental Holdings. The Motley Fool owns shares of SPIRIT AIRLINES INC. (NASDAQ:SAVE).
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