Shareholders of American Airlines would probably like to forget the past six months even happened. The stock dropped 33.2% and now trades at $12.21. This was partly driven by its softer quarterly results and may have investors wondering how to approach the situation.

Is there a buying opportunity in American Airlines, or does it present a risk to your portfolio? Check out our in-depth research report to see what our analysts have to say, it’s free.

Why Do We Think American Airlines Will Underperform?

Even with the cheaper entry price, we're cautious about American Airlines. Here are three reasons why AAL doesn't excite us and a stock we'd rather own.

1. Weak Growth in Revenue Passenger Miles Points to Soft Demand

Revenue growth can be broken down into changes in price and volume (for companies like American Airlines, our preferred volume metric is revenue passenger miles). While both are important, the latter is the most critical to analyze because prices have a ceiling.

American Airlines’s revenue passenger miles came in at 56.36 billion in the latest quarter, and over the last two years, averaged 5.3% year-on-year growth. This performance was underwhelming and suggests it might have to lower prices or invest in product improvements to accelerate growth, factors that can hinder near-term profitability.

2. Previous Growth Initiatives Haven’t Paid Off Yet

Growth gives us insight into a company’s long-term potential, but how capital-efficient was that growth? A company’s ROIC explains this by showing how much operating profit it makes compared to the money it has raised (debt and equity).

American Airlines historically did a mediocre job investing in profitable growth initiatives. Its five-year average ROIC was 0.8%, lower than the typical cost of capital (how much it costs to raise money) for consumer discretionary companies.

3. High Debt Levels Increase Risk

As long-term investors, the risk we care about most is the permanent loss of capital, which can happen when a company goes bankrupt or raises money from a disadvantaged position. This is separate from short-term stock price volatility, something we are much less bothered by.

American Airlines’s $35.5 billion of debt exceeds the $7.47 billion of cash on its balance sheet. Furthermore, its 6× net-debt-to-EBITDA ratio (based on its EBITDA of $4.90 billion over the last 12 months) shows the company is overleveraged.

At this level of debt, incremental borrowing becomes increasingly expensive and credit agencies could downgrade the company’s rating if profitability falls. American Airlines could also be backed into a corner if the market turns unexpectedly – a situation we seek to avoid as investors in high-quality companies.

We hope American Airlines can improve its balance sheet and remain cautious until it increases its profitability or pays down its debt.

Final Judgment

We cheer for all companies serving everyday consumers, but in the case of American Airlines, we’ll be cheering from the sidelines. Following the recent decline, the stock trades at 8.4× forward P/E (or $12.21 per share). While this valuation is optically cheap, the potential downside is huge given its shaky fundamentals. There are more exciting stocks to buy at the moment. We’d suggest looking at our favorite semiconductor picks and shovels play.

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