Wednesday, November 03, 2010

AMR Corp (NYSE:AMR): Headwinds Shifting to Tailwinds; Our Top Idea - J.P. Morgan

AMR Corp (NYSE:AMR) is getting very positive comments from two Tier-1 firms this morning:

- J.P. Morgan's Jamie Baker, the Axe in the Airline space highlight AMR as his Top Idea with a $13.50 price target.

JPM expects AMR to turn a significant margin corner in 2011, as alliance immunity, rising industry labor costs, and a shifting Latin/Pacific supply dynamic reverse its multiyear relative margin decline. Based on our theoretical analysis, if AMR relative margins can perform in line with the industry from here, upside equity potential is expected to exceed that of all other U.S. names they cover. If relative margins can narrow their gap to the industry, potential equity upside is still great. Thus, AMR emerges as our top equity pick among U.S. airlines.

Recent margin performance hasn’t been pretty – AMR relative margins have suffered for years, given stubborn labor costs, uncompetitive alliance immunity, a limited Pacific footprint, and superior cost management elsewhere (particularly at United). In 3Q, AMR’s operating margins trailed the industry by ~700 bps.

Headwinds are expected to become tailwinds – JPM expects industry labor costs to migrate toward AMR levels, starting with United and followed by US Airways. AMR’s recently immunized alliance partners should drive RASM momentum in 2011. And 10% Latin supply growth is moderating while Pacific supply is worsening, suggesting RASM relief for AMR and pressure for DAL/UAL.

There’s significant leverage in AMR’s model – Firm sees several outcomes to our theoretical margin analysis. In our best case, industry and AMR operating margins return to prior peaks (~11% EBIT). Mid case, industry gets to prior peak but AMR margins trail by 300-400 bps. Worst case, industry margins suffer and AMR’s relative position gets even worse. Across this range of outcomes, they can envision AMR equity value of between zero and nearly $40, versus a $7.85 current price. As they aren’t modeling for industry strain, AMR emerges as their top equity pick.

And of course, they gravitate toward the underdog – AMR has the highest percentage of Sell & Hold broker ratings of any U.S. legacy. Its year-to-date equity performance has been woefully weak (+2% vs. +46% XAL & +7% S&P). Investors tend to identify labor as an overhang, despite greater risk of cost escalation elsewhere. While the lack of company aggression in pursuing alternative strategies has been disappointing, in JPM's view, that doesn’t stop them from identifying where potential equity upside is greatest. They think they’ve found it.

- Barclays comes out reiterating Overweight and $18 price target on AMR saying the share could rally into year-end.

Firm believes concern about the possibility of a pension expense headwind, among other things, is creating apprehension among investors about performance in AMR shares. Their focus for AMR is on relative margin expansion across the cycle and cash generation during 2011 that they believe will encourage investors to re-think current valuation. As year-end approaches, with a relatively benign current outlook on pension expense for 2011, firm sees opportunity in AMR and believes the shares could rally into year-end as investors anticipate better things to come in 2011.

AMR has dramatically underperformed the sector year to date despite our view that margin upside across the cycle will exceed industry averages. Barclays believes concerns about escalating pension expense in 2011 have contributed to this underperformance, especially as year-end approaches.

AMR is heavily exposed to pension expense and has suffered material margin pressure as a result, but the firm expects a relatively minor amount of headwind in 2011; barring strong market movements in the next two months, they believe the pension impact for 2011 will be around $40mm, which, in their view, is relatively minor.

Cash flows ultimately rule and AMR’s cash generation has lagged with heavy CapEx in 2010. However, current CapEx projections suggest a sharp turn in that dynamic for 2011, when they believe AMR’s free cash flow will approach 35% of its current market capitalization on more normalized levels of CapEx; Barclays expect AMR to screen best in the industry on this metric in 2011.

They believe this level of cash generation will drive AMR shares to a better performance outcome in the year ahead and the market may look to discount these prospects for AMR before the calendar year turns.

Notablecalls: Must say I was pretty surprised to find two Tier-1 firms out so very positive on AMR this morning. JPM's Baker is the Axe in the space which probably means the call will not fall on entirely deaf ears.

Like the chart.

PS: Just remember, my recent performance is trumped by this guy.

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