Author: E. Krystal Somaza
Buy Candidate Analysis
American Airlines Group Inc. operates an airline that provides scheduled passenger, freight, and mail service throughout North America, the Caribbean, Latin America, Europe, and the Pacific. The Company also provides connecting service throughout the United States, Canada, and the Caribbean.
After merging with US Airways in late 2013, AAG is one of the largest airlines in the world. The combined airline, together with its third-party regional carriers including Air Wisconsin, Chautauqua, ExpressJet, Mesa, Republic, and SkyWest operate nearly 6,700 daily flights to roughly 340 destinations in more than 50 countries. American and US Airways operate 965 mainline jets, and regional subsidiaries and third-party regional carriers operate nearly 520 regional jets and 40 turboprops. The Company has hubs in Charlotte, Chicago, Dallas/Fort Worth, Los Angeles, Miami, New York City, Philadelphia, Phoenix and Washington, D.C. As of December 31, 2013, it operated a fleet of approximately 903 aircraft. The company’s mainline passengers who travel through the main hubs account for 72% of revenues. The second revenue segment of American Airlines is the regional passengers, this group travels with the company’s third-party carriers and it represents 25% of the revenues. The company also operates as a scheduled air freight carrier providing a range of freight and mail services to shippers which represent 2% of American Airlines revenue. AMR Corporation is the parent company of American Airlines and American Eagle Airlines, which all together form American Airlines Group Inc. The company was founded in 1934 and is headquartered in Fort Worth, Texas.
American Airlines Group has shown steady operating cash flows in the last 3 years regardless of their acquisitions and asset purchase. The company has demonstrated its ability to repay debt outstanding. In 2014 the company repaid $1 billion of senior secured notes, and approximately $1.2 billion of various high cost aircraft debt and lease obligations. The company is generating $42 billion in revenue which is an increase of 59% since 2013. The low oil prices contribute to this intense increase on revenues; however the airline industry is expected to increase its profit by 25% in 2015 compare to last year, assuming the average price in the year will hover around $85 per barrel.
American Airlines has become a sustainable company since its crash in 2009, becoming part of the prestigious S&P 500 this past month. The company has increased its revenue by almost 60% in the last year and it continues to increase since demand for airfare increases. American Airlines is expecting to see this growth in the top line to transfer to the bottom line. Even though the company has pursued a capital expenditure strategy in the last two years to renew its fleet, it has repaid 12% of its debt outstanding in 2014 and is expecting to continue repaying its debt while increasing is cash flows. This makes the bondholder position a more stable one, as the company demonstrates its ability to repay debt. American Airlines has operating margins of 10%, which is above the industry average of 8.79%, which makes them more efficient than its competitors at managing cost, which will reflect in their bottom line after all the investments they made in the past two years. The company has a coverage ratio of 4.79 compare to the industry’s 7.22. Their debt to equity ratio is 20.65. This is due to their debt outstanding, however with their capital expenditures decreasing year over year, and their revenue increasing they will be able to repay their $17.1 billion long term debt outstanding. 2015 is the perfect opportunity to become a bondholder of American Airlines for the following reasons: first, the low oil prices will continue to bring tremendous cash flows to the airline industry and American Airlines group is the largest airline in the United States and the World and has the highest revenue among its peers. Secondly, the company plans an average annual principal repayment of $1.6 billion in the next five years which will be able to satisfy more than half of its current debt. And finally, the company’s has already implemented policies to become more competitive and increase growth which will contribute to the bottom line of American Airlines during our workout period.
American Airlines Group has an S&P credit rating of B+. Considered a junk bond, I decided to analyze different indicators that could potentially describe the movements of AAL bond. I created a graph that represents the yield movements of AAL, ISTAR (my proxy for the PIMCO fund), and the US 10 year treasury. The data utilize for this chart is monthly and goes back almost 3 years. Even though AAL was issued in 2001 I grab this three year range to make it comparable to ISTAR, which was only issued in 2012.
This graph shows that AAL or ISTAR have similar interaction with the 10 year treasury. It seems like both corporate bonds could potentially increase or decrease, while the 10 year treasury is clearly downward sloping. However it is difficult to quantify the relationship between all the yields. In order to analyze the correlation between the 10 year treasury and AAL, I ran statistical models to prove if there is any relationship between the two yields. I also executed a similar process between the AAL bond and the S&P500.
After generating my regression analysis results, I found the US 10 year treasury and the S&P return to have no significant correlation with the American Airlines Group bond. This can be back up with the p-value of both variables, the US treasury with a .73 and the S& P 500 with a .94. Both values are higher than .05 and make them highly insignificant. This analysis proves the graph assumptions made earlier, meaning that AAL is not affected by any changes in the 10 year treasury. Consequently if the Federal Reserve decides to raise rates, it will have a small impact on the AAL yield.
Since the AAL bond is not related to neither variable I utilize historical yield to come up with my most likely scenario of yield movement. As we can see in the previous graph, the AAL yield has been slowly decreasing in the last 2 and half years, however due to the debt issuance in the last four months; the company’s yield has increased. Also in the past week the yield decreased returning to its previous level before the debt issuance. The yield a year ago was below what it currently is, which gives room for it to keep going down. The company’s historical lower yield was 5.37%, while the yield is currently 5.77%. I expect the yield to autocorrect during our portfolio workout period. Due to the company’s increase in cash flows, revenues and its management plan to repay debt, I believe a conservative estimate is a 60 to 40 bps drop.
Taking all of this analysis into consideration, with the AAL yield being uncorrelated to the S&P and the US 10 year treasury, I believe AAL will drop by 40 basis points.
∆AAL yield= – 40 bps
I ran the same analysis on my sell candidate proxy ISTARS Financial and found no significant correlation with the 10 Year treasury or the S&P500.
After performing the same statistical model with the PIMCO proxy, there was no relationship with the 10 year treasury. However when I ran the model with the S&P 500 return, the P-value is 0.09, which is still insignificant, but more likely to react to this variable. At the same time, with a weak negative correlation to the S&P return and the fact that the bond is approaching maturity, I believe the ISTAR yield will decrease. I got this value by using the forecasting formula shown above, where I utilize my intercept and the S&P 500 coefficient, which I multiplied by my expected return in the market. The outlook for the S&P 500 for the upcoming year seems promising. Even though the economy is starting to slow down, the economic factors show no signs of a recession. In previous years, analysts have underestimated the market return while it has consistently beaten expectations since the recession. Because of the uncertainty generated by oil falling prices and fed rising interest rates, I don’t think the return will be as high as it was last year. However, as the economy remains strong and investors become more attracted to the US market, I believe the S&P will have a return of 9%.
By looking at the graph above, we can notice how the ISTAR yield has been decreasing, however in June 2014, the yield increase by almost 100 bps, and has not decreased since. Since the bond is going to reach maturity in the next two years it will most likely go down. Since I expect for interest rates to go down, I believe it would be good to increase the duration of our portfolio, so we can take advantage of interest rate risk. ISTAR matures in 2017, while AAL matures in 2021. While swapping these two, we would increase our portfolio duration by 4.45. under my most anticipated scenario of a decrease of 53 basis points on ISTAR, and a decrease of 40 basis points on ALL, the return pick up will be 245 basis points I added up -20 bps to the -33 bps because I wanted to be more conservative in regards to the yield of ISTAR. (See chart below).
Fair Value ISTAR Financials
When calculating the fair value for the sell candidate, I utilize the Bloomberg Fair value. With a yield spread of -27.2 and a modified duration of 1.967, the bond is overvalued by 53 basis points. Our portfolio will be taking advantage my selling this overvalued bond.
Interest Rate Stress Test
In order to have a better understating of the possible impacts out portfolio could have if AAL and ISTAR bonds had interest rate movements, I conducted a sensitivity analysis. In this test I change the different interest rates each bond could face and receive various combinations of possible basis point pickups. I increase the yield up to 80 basis points but only decrease it 60 basis points to a have more conservative scenarios.
Fair Value for American Airlines Group
To calculate the fair value of AAL I found similar bonds: Bombardier and Teekay Corp. These two bonds average out have a duration of 4.39, which is similar to the duration of American Airline Group of 4.88. With the comparable bonds having similar maturities, within the same duration range, and sector, I calculated the spread between the two bonds. Finally I multiplied this interest rate change by the negative value of the duration of AAL’s bond to give me a mispricing of 280 bps. This is shown in the values and table below.
In order to estimate the financials for the PIMCO High yield fund, I took the top six holdings of the fund and average all of the items below in order to come with the financial ratios of the whole fund. I repeated the same process for American Airlines group utilizing the 2014 financial statements.
Since the total debt to equity ratio was just positive in 2014, it was not a good measure of the stable financials of the company in the last three years. In order to account for the profitability and the efforts of the company to reduce debt, I calculated the debt to assets in the last three years. The table below, shows how year over year American Airlines Group was been reducing its total debt and has increased its total assets.
The table below shows the position of American Airlines group compare to the largest airlines in the world. This company is not only the largest airline because of its destinations and main hubs, but it also has the highest revenue and profit in the industry.
By swapping from our position in the PIMCO fund for American Airlines Group bond our portfolio would benefit. ISTAR’s yield has high chances of decreasing as It approaches maturity, while AAL will decrease due to their company initiatives to repay debt and their strong company performance. Also we would not be picking up basis points by switching credit ratings, optionality, or sector, since AAL is safer compare to ISTAR. Most of the pickup comes from interest rate risk and mispricing. American Airlines as shown before is not even correlated to the 10 year treasury which in reality would not affect our portfolio. The PIMCO H/Y 0 – 5 year bond fund, are not generating as much return as AAL could bring to our portfolio. American Airlines’ bond will diversify our portfolio; it has a longer duration with lower risk. The company itself has shown strong financials and overall stability showing it can repay its debt as soon as expected. Taking into account all of this reasons, I will like to recommend the Roland George Investment program to purchase $100,000 worth of AAL bond.