In the past few years, U.S. airlines' profits have surged due to a combination of moderate oil prices and strong demand. Many airlines have taken advantage of their rising cash flow to buy back lots of stock. This was a particularly attractive option because most airline stocks have been quite cheap in recent years.
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American Airlines (NASDAQ: AAL) and Hawaiian Holdings (NASDAQ: HA) are two of the U.S. airline operators that have implemented share repurchase programs in recent years.
With its earnings at record levels and a very modest debt burden, Hawaiian Holdings should strongly consider accelerating its buybacks. By contrast, American Airlines' profitability is declining and the company has a huge debt load. As a result, American may need to suspend its share repurchases for a while.
Hawaiian Holdings has been timid
Between 2012 and 2014, as other airlines ramped up their share repurchase programs, Hawaiian Holdings didn't buy back any stock. During that period, the company was investing heavily in new aircraft, leaving it with no excess cash to return to shareholders.
However, Hawaiian Holdings has generated a substantial amount of free cash flow since 2015, as its profitability has soared and capital spending has moderated. It has used some cash for share buybacks, repurchasing $40 million of stock in 2015 and another $14 million of stock in 2016. The vast majority of its cash flow has gone to debt reduction, though.
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Today, that's no longer necessary. Hawaiian Holdings ended last quarter with leverage in the lower half of its target range. Yet it continued to buy back very little stock. The company replenished its share repurchase authorization to $100 million in April, but it spent only $4.3 million on buybacks in the second quarter.
As a result, Hawaiian Holdings' cash balance has ballooned, reaching $844 million (including short-term investments) at the end of June. That's well above its target of $500 million.
To be fair, capex is set to rise in the second half of 2017. Hawaiian Holdings is also scheduled to make payments totaling roughly $120 million to reduce its post-retirement liabilities. Even so, the company clearly has excess cash that it could use for share buybacks. With Hawaiian Holdings stock trading for less than eight times earnings, there's no reason to delay.
American Airlines has a debt problem
The situation is very different at American Airlines. Like Hawaiian Holdings, American has spent a fortune on new aircraft since 2011. However, it has financed most of these purchases with debt, freeing up cash for an aggressive share buyback program.
Since mid-2014, American Airlines has spent $10 billion to buy back 250 million shares of stock at an average price of $39.84. This program has dramatically boosted earnings per share. And given that American Airlines stock currently trades for more than $50, these buybacks appear to have increased shareholder value.
American Airlines has already started to reduce its buyback activity. After repurchasing more than $4 billion of stock last year, the company spent just under $1 billion on buybacks in the first half of 2017. However, it may be time to quit cold turkey.
First, profitability has started to sink. In the first half of the year, adjusted pre-tax profit slipped to $2 billion from $2.8 billion a year earlier. Additionally, American Airlines expects to post an adjusted pre-tax margin of 10%-12% this quarter, down from 14% a year earlier.
Second, American Airlines has huge debt payments coming up. From 2018-2021, it has an average of more than $3 billion in scheduled debt repayments annually. This will represent a significant use of cash going forward.
Two extremes; time to meet in the middle?
Hawaiian Holdings and American Airlines represent extremes on the spectrum of capital allocation policies. In recent years, Hawaiian Holdings has paid cash for several of its aircraft deliveries while simultaneously prepaying some of its debt. Meanwhile, American Airlines has financed nearly all of its aircraft purchases and run up a huge debt burden, in order to take advantage of low interest rates.
Hawaiian's policy is too conservative. The company's massive cash balance represents a big drag on its return on invested capital. Given that its stock is cheap and it doesn't have much debt left, Hawaiian Holdings should be buying back more stock.
By contrast, American Airlines has been too aggressive in repurchasing stock. At this point, the company should be paying cash for its new aircraft, in order to gradually whittle down its debt load. Otherwise, the largest U.S. airline could find itself on the ropes if the economy goes into recession just as its debt maturities start ramping up.
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Adam Levine-Weinberg owns shares of Hawaiian Holdings and is long August 2017 $46 calls on Hawaiian Holdings and short October 2017 $50 puts on Hawaiian Holdings. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.