Why You Should Be Terrified of the American Airlines Euphoria

Euphoria is the best word to describe what's happened to American Airlines stock since the company's merger with US Airways. In just three months, American Airlines shares have soared more than 50%, reaching a new high just short of $40 earlier this week.

American Airlines Stock Chart, data by YCharts.

This came after the company's valuation had already risen more than 50% between when the merger was announced in early 2013 and when the merger closed near the end of the year. All in all, American's market value has grown from an estimate of $11 billion last February to $28 billion today.

While this has happened, analysts and investors have continually increased their expectations for the new American Airlines' earnings. This cycle of rising expectations and a rising stock price is unsustainable. American Airlines stock is likely to correct sharply lower later this year as reality sets in again.

Expecting a record profit
Last year, American Airlines reported a solid profit of $1.95 billion before special items. That was vastly higher than the company's 2012 adjusted profit of $407 million, primarily due to cost savings related to American's bankruptcy filing, as well as profit growth at US Airways. (All of these figures combine the results of American Airlines and US Airways.)

American Airlines earned a solid profit of nearly $2 billion last year. Photo: American Airlines.

American should be able to build on that profit in 2014 as it realizes additional cost savings from the bankruptcy process, replaces inefficient aircraft with better planes, and reaps early revenue synergies from its expanded network.

However, many analysts and investors are now looking for a lot more than "earnings growth." Analysts surveyed by Bloomberg projected on average that American Airlines will nearly double its profit this year to $3.5 billion! These bullish estimates seem out of control.

First signs of trouble
To some extent, the rapid rise in investor expectations was driven by the strong Q1 guidance that American provided in late January. At that time, the company projected a 6%-8% Q1 operating margin.

Earlier this week, American Airlines released its February traffic statistics, and the company noted that it had canceled 28,000 flights in the first two months of the year. American reiterated its unit revenue guidance but cautioned that costs would come in higher than expected. Despite this disclosure, the average analyst EPS estimate has barely budged, dropping just $0.01.

Four specific headwinds
Looking ahead, American Airlines faces four particular demand-side headwinds that will hit in the next year or two -- leaving aside the risk of integration problems. These all involve increased competition in markets where American is particularly strong.

1. A real competitor in London
First, since creating a joint venture with British Airways several years ago, the American Airlines/British Airways alliance has dominated travel between the U.S. and London's Heathrow Airport. Most notably, the two partners offer 17 daily nonstops between New York and London, including 12 nonstops on the JFK-Heathrow route. This is by far the most important international route for business travelers from the U.S.

Delta is boosting its presence on the New York-London route through a joint venture with Virgin Atlantic.

However, Delta Air Lines recently received antitrust approval for its joint venture with Virgin Atlantic. Later this month, the two carriers are implementing a coordinated schedule consisting of nine daily roundtrips between New York and London.

Delta still can't match the presence of American and British Airways on this route. However, its new joint venture makes Delta a lot more competitive. Combine this with Delta's brand-new terminal at JFK Airport and a leading position in the New York air travel market, and Delta is in a position to win market share among profitable business travelers.

2. A new threat in the transcontinental market
Second, American is the clear market leader on the busy transcontinental route from JFK Airport to Los Angeles, as well as a major player on the route from JFK to San Francisco. These routes have very high fares, and American is deploying its brand-new A321T aircraft on both routes. With 10 first class seats and 20 business class seats on these planes, American needs very high fares to be profitable.

However, JetBlue Airways is upping its game in the transcontinental market beginning this summer. Not only is it boosting its economy class capacity by 33% from JFK to Los Angeles and by 59% from JFK to San Francisco, but it's also deploying flat-bed premium seats on those routes for the first time ever.

JetBlue plans to undercut American on price for flat-bed business class seats. Photo: JetBlue.

JetBlue and American will both be using the A321 aircraft on these routes, yet JetBlue outfits them with 159 seats, compared to just 102 seats for American. If rising premium cabin seat inventory on these routes cuts into premium fares, American Airlines could face margin pressure due to its focus on high-fare traffic for the transcontinental routes.

3. New competition in Dallas
American Airlines has also benefited from its dominant position in the Dallas-Fort Worth area ever since Delta closed its rival hub there in 2005. Southwest Airlines operates a focus city at Love Field in Dallas, but it has been banned from offering nonstop long-haul flights at Love Field. This limited its ability to compete with American's massive hub at Dallas-Fort Worth International Airport.

Southwest is adding lots of long-haul flights in Dallas this fall and in 2015. Photo: Southwest Airlines.

However, Southwest will be allowed to fly from Dallas to anywhere in the U.S. starting in October. Within the next year or so, Southwest will start service to 20 new cities from Love Field -- and if it gets access to additional gate space at Love Field, it will add 12 more new destinations.

American Airlines currently has the only nonstop service on many of these routes. It holds a dominant seat share on many of the others. New competing service on Southwest will drive down fares on many of these routes starting in Q4 and ramping up next year.

4. Low-cost carriers arrive in D.C.
Lastly, American will see margin pressure at its highly profitable Reagan Airport hub near Washington, D.C., starting later this year. US Airways has held a dominant share of Reagan Airport slots, and faced very little competition on most of its routes from the legacy carriers that held most of the other slots.

As part of the American Airlines-US Airways merger, the companies had to sell off dozens of Reagan Airport slots to low-cost carriers. JetBlue, Southwest, and Virgin America will all be expanding at Reagan Airport later this year, and most of their new flights will attack American Airlines-dominated routes. More competitors and more capacity will inevitably drive fares lower.

Foolish bottom line
I have great respect for American Airlines CEO Doug Parker and the rest of his leadership team. However, good management cannot change the fact that the airline business is ultra-competitive and has few barriers to entry.

Several artificial barriers to entry that have protected American Airlines are falling this year. Delta and Virgin Atlantic were given antitrust immunity to coordinate schedules, Southwest's base at Love Field in Dallas is opening to long-haul flights, and American was forced to divest slots at Reagan Airport to competitors.

Some of these three big changes -- as well as JetBlue's unrelated decision to introduce a premium cabin on transcontinental flights -- will start impacting American next quarter. However, the biggest impacts will come at the end of this year and through 2015. Investors should steer clear of American Airlines stock until the euphoria wears off and the market starts to rationally weigh the merger benefits against headwinds like these.