Rothschild upgrades American Airlines to buy on fare strength

Rothschild and Co. Redburn upgraded American Airlines Group to buy from neutral with a $17.50 price target, implying nearly 24% upside from Monday’s close, CNBC reported.

Analyst Gavin Tennant argued that American’s re-established network and investments in key hubs, combined with a high-fare environment, give the airline room to expand revenue and pay down debt, according to CNBC’s analyst calls coverage. The upgrade is notable because American’s stock has shed nearly 8% year to date as higher jet fuel costs from the Iran war have pressured profit margins and led to increased fares.

The investment bank’s call is that the fare increases will stick even if fuel costs moderate. “We expect airlines will hold onto higher pricing points if jet fuel costs recede, providing a tailwind to margin expansion,” Tennant wrote in a note to clients. The thesis treats the fare hikes as a pricing floor, not a temporary response to fuel costs, and it is the basis for the upgrade.

The case for American

Tennant’s argument has several components. First, American has re-established its network and invested in key hubs, which gives it the route structure to capture demand at higher fares. Second, U.S. travel demand is strong, and capacity growth across the industry is rational, meaning airlines are not adding seats fast enough to undercut pricing. Third, fuel cost volatility is keeping fares elevated, and even if fuel recedes, airlines have no incentive to cut prices back to pre-war levels.

The combination of those factors is what Tennant calls “room to expand revenues, return to deleveraging the balance sheet and generate sustainable margin expansion in outer years.” The phrase “sustainable margin expansion” is the key claim. Airline margins are notoriously cyclical, and the industry has a history of destroying value during downturns by adding capacity and cutting prices. Tennant is arguing that this cycle is different because capacity discipline is holding and demand is strong enough to support higher fares.

American has also reduced the size of its fleet and curtailed service at some airports to cut costs and simplify operations. The capacity discipline is partly voluntary and partly forced by the fuel cost environment, but the effect is the same: fewer seats in the market, which supports pricing. If fuel costs moderate and American does not rush to add back capacity, the fare increases hold, and margins expand.

The stock is relatively inexpensive, which Tennant described as “an attractive entry point for an improving business.” American trades at a discount to Delta and United, partly because of its weaker balance sheet and partly because of its history of operational challenges. The upgrade is a bet that the discount is too wide given the improving revenue environment.

The balance sheet problem

American’s balance sheet is the reason the stock trades at a discount to its peers. The airline carries more debt than Delta or United, a legacy of the pandemic and the years of heavy aircraft investment that preceded it. The debt load is the constraint on the stock, because it limits American’s ability to return cash to shareholders and creates risk in a downturn.

Tennant’s upgrade addresses the balance sheet issue by arguing that higher fares will let American resume deleveraging. The logic is straightforward: if revenue grows and costs do not rise proportionally, the surplus cash flow goes to debt paydown, and the balance sheet improves over time. The $17.50 price target assumes that American can generate enough free cash flow at the higher fare levels to make meaningful progress on debt reduction.

The risk is that fuel costs do not moderate, and the fare increases are not enough to offset the higher fuel bill. In that scenario, margins do not expand, free cash flow is limited, and the balance sheet does not improve. American is stuck with high debt, high fuel costs, and a stock that continues to underperform. The Rothschild thesis requires fuel to at least stabilize, and the Iran war makes that assumption uncertain.

The stock’s recent performance offers some support for the call. Shares are 11% higher in the past month, suggesting that the market is already starting to price in the fare-stickiness thesis. The year-to-date decline of 8% means the stock is coming off a low base, and the upgrade could accelerate the recovery if other analysts follow Rothschild’s lead.

Wall Street’s split view

Analysts on Wall Street are divided on American. Of 26 analysts covering the stock, only 12 rate it buy or strong buy, while 13 call it no more than a hold, according to LSEG data cited by CNBC. The split reflects the tension between the improving revenue environment and the balance sheet risk, and Rothschild’s upgrade moves the consensus slightly toward the bullish camp without resolving the debate.

The divided opinion is itself a signal. When analysts are split on a stock, the upside case and the downside case are both well-articulated, and the stock’s direction depends on which set of assumptions the market decides to price. Rothschild is making the case that the fare-stickiness assumption is the one that will drive the stock, and the upgrade is an invitation for investors to take that side of the trade.

What I think

The fare-stickiness thesis is the strongest part of the call, and it is probably correct. Airlines have historically been slow to cut prices after fuel costs rise, because the pricing is set by capacity and demand, not by fuel costs directly. Fuel costs determine margins, but fares are set by what the market will bear, and the market is bearing higher prices right now because demand is strong and capacity is disciplined. If fuel recedes, the airlines have no reason to cut fares unless they add capacity, and American has explicitly reduced its fleet. The fare floor is real.

The balance sheet is the weakness, and Rothschild’s upgrade does not fully address it. American carries more debt than its peers, and the debt is the reason the stock trades at a discount. Higher fares and stable fuel costs would let the company pay down debt over time, but the timeline is long, and any downturn in travel demand or spike in fuel costs would interrupt the deleveraging. The upgrade is a bet on a smooth path to debt reduction, and the airline industry does not provide smooth paths.

The $17.50 price target is a 24% upside from Monday’s close, which is a meaningful move for an upgrade on a stock that is already up 11% in the past month. The target prices in the upside scenario, but it does not fully account for the downside risk if fuel costs stay elevated or demand weakens. The risk-reward is favorable if the Rothschild thesis plays out, but the stock is not cheap enough to offer a margin of safety if it does not.

The contrarian nature of the call is what makes it interesting. American is the least loved of the major U.S. airlines, and upgrading it to buy requires arguing that the market is wrong about the balance sheet risk. Rothschild is making that argument, and the fare-stickiness thesis is a reasonable basis for it. But the market’s skepticism about American is based on years of underperformance and balance sheet problems, and a single analyst upgrade does not change that history. The stock will need several quarters of deleveraging and margin expansion to convince the skeptics, and the upgrade is the beginning of that process, not the end.

The broader question is whether the airline industry’s capacity discipline will hold. The fare-stickiness thesis depends on airlines not adding back capacity if fuel costs moderate, and the industry’s history is not encouraging on that front. Every cycle, airlines promise discipline, and every cycle, at least one carrier breaks ranks and adds capacity to gain market share. If that happens in this cycle, the fare floor breaks, and the Rothschild thesis unwinds. The upgrade is a good call if the industry holds the line on capacity. It is a premature call if it does not.