The issue for airline stocks like American Airlines Group Inc (NASDAQ:AAL) is whether investors really can trust the sector — at all. The fact that American Airlines shares trade at just 6x forward EPS estimates shows that the market still has quite a bit of skepticism. But a strong run in AAL stock following its 2014 bankruptcy exit shows that there is money to be made in the sector… sometimes.
Coming out of what looks like a disappointing Q1 earnings report on Thursday, the news for AAL, and the sector, still looks mixed. Delta Air Lines, Inc. (NYSE:DAL) and United Continental Holdings Inc (NYSE:UAL) posted strong reports earlier this month. AAL and Southwest Airlines Co (NYSE:LUV), however, both disappointed on Thursday. Rising fuel costs are a near-term concern. Longer-term, the always-fragile competitive situation remains a risk.
Overall, I still see some value in the sector. Indeed, I argued this month that Delta looks like a compelling buy. But coming out of earnings, I think AAL stock doesn’t quite measure up to its peers.
Seeing AAL Earnings Differently
From a headline standpoint, American’s Q1 earnings look reasonably solid. Adjusted EPS of 75 cents came in 3 cents better than Street estimates. Revenue of $10.5 billion fell short of consensus — but by about $20 million, or ~0.2%.
But the market saw the report differently. AAL stock at one point Thursday was down as much as 10%, before trimming losses to 6.4% on the day. And the primary culprit looks to be rising fuel costs. American Airlines cut its full-year guidance to $5-$6 per share, down 50 cents from the previous range. That ~9% cut in guidance was almost exactly mirrored by the initial sell-off — but American Airlines shares have rallied from those lows.
Is AAL Stock Sell-off an Overreaction?
There is a case that a 10% decline was an overreaction — and clearly some investors are putting money behind that case. AAL stock rebounded in afternoon trading on Thursday, and another 2% through the first half of Friday’s session.
After all, fuel costs are an industry-wide problem, as CEO Doug Parker pointed out on the Q1 conference call. American Airlines eventually will be able to push up pricing to compensate. Per the call, fuel costs rose a whopping $441 million year-over-year. Adjusted operating income, however, declined just $232 million.
In other words, had fuel prices held steady, AAL would have increased its operating income roughly 22%. There is some one-time help on the expense front (some expenses shifted in Q2, again per the call). But in terms of what it can control, American Airlines actually had a pretty solid quarter. And while fuel costs are hitting 2018 guidance, their impact should moderate and even reverse by next year even if prices stay as high as they are now.
In the meantime, AAL stock dipped to near a post-election low — and reached its lowest levels of the past year before bouncing. It’s not as if investors were pricing in torrid growth, or as if the market was unaware of the fuel cost issue heading into the report. Q1 shouldn’t be a surprise, necessarily. And with AAL shares already dipping ahead of the report, the sell-off looks like potentially too much.
Two Concerns About American Airlines Stock
Despite a cheap price and a stock near historic lows, there are two concerns for American Airlines stock coming out of earnings. The first is the health of the industry as a whole. It’s true that Warren Buffett’s Berkshire Hathaway Inc. (NYSE:BRK.A,BRK.B) invested in the sector after the Oracle of Omaha himself swore off airlines. But airline stocks haven’t done that well of late in an economy and a market where they should be soaring (pardon the pun).
And the long-term risks cited by Buffett and so many others still persist. As my InvestorPlace colleague James Brumley pointed out ahead of earnings, United’s recent commentary has raised fears of yet another destructive price war. A fatality at Southwest and a ’60 Minutes’ report critical of safety practices at Allegiant Travel Company (NASDAQ:ALGT), combined with higher prices, may add to near-term concerns about demand. I’m not sure long-term investors can quite trust the industry just yet.
The second concern is whether AAL stock is the best play in the sector. And I don’t think that’s the case. LUV stock has matched the decline in AAL shares so far this year, and I’d rather have the discount airline’s business model long-term, even at a higher multiple. DAL looks stronger to me as well.
I don’t think AAL is a bad play by any means. I can see the argument value investors might make both for American Airlines stock and the sector as a whole. AAL’s post-earnings decline indeed might be an overreaction. But in looking for the most compelling play in the sector, amid fuel cost and capacity concerns, I’d go in a different direction than American.
As of this writing, Vince Martin has no positions in any of the aforemen