Last Monday, Bloomberg reported that the top five U.S. airlines -- American Airlines (NASDAQ:AAL), Delta Air Lines (NYSE:DAL), United Airlines (NASDAQ:UAL), Southwest Airlines (NYSE:LUV), and Alaska Air -- spent a whopping 96% of their free cash flow (FCF) on share buybacks over the past decade. Numerous other media outlets picked up on this statistic, which became a rallying cry for people opposed to government financial support for the airline industry in the midst of the COVID-19 pandemic.

However, while this statistic is accurate, it's also a bit misleading. First, for people unfamiliar with financial terminology like free cash flow, it might appear that airlines were buying back stock hand over fist while neglecting to invest in their businesses. Second, the headline doesn't capture the fact that the high spending on buybacks relative to FCF was distorted by a single outlier: American Airlines.

Free cash flow vs. operating cash flow

Operating cash flow (OCF) is the amount of cash a business generates in a given period (i.e., a quarter or a year) before accounting for capital investments. One of the big decisions corporate leaders must make is how to allocate this cash flow. Some must be reinvested in the business in the form of capital expenditures, or capex. FCF is whatever is left after capex. This FCF can be used for several purposes: most notably, dividends, share buybacks, acquisitions, and balance sheet improvements. (For U.S. airlines, acquisitions are mostly off the table at this point because of antitrust concerns.)

Calculating the percentage of FCF spent on share buybacks, or dividends and buybacks combined, can tell you how a company is prioritizing returning capital to shareholders compared to improving its balance sheet. However, it's only a partial view of capital allocation, as it excludes the arguably more important decision about how much to reinvest in the business.

For example, in 2019, Delta Air Lines generated $3.5 billion of FCF, based on the standard calculation methodology. It spent $2 billion on share buybacks and $980 million on dividends, so 58% of FCF went toward buybacks and 86% went toward all forms of capital returns. Yet operating cash flow was $8.4 billion. Thus, Delta devoted just 24% of its operating cash flow to buybacks; a substantial majority of the airline's cash from operations was reinvested in the business rather than being converted into FCF.

In short, even if airlines spend most of their FCF on buybacks, buybacks may still account for a relatively small percentage of their operating cash flow. Indeed, most U.S. airlines have been investing heavily in their businesses in recent years, pressuring FCF.

One airline stands out for high buybacks

The even more misleading aspect of Bloomberg's headline is that American Airlines has led the industry in spending on share buybacks since its late 2013 merger with US Airways, despite not producing positive FCF on a cumulative basis.

Over the past five years, American Airlines spent $11.9 billion on buybacks. The vast majority of that share repurchase activity came in 2015 and 2016, when fuel prices were low and it seemed to many that airlines had entered a period of sustained high margins. American Airlines has also paid out over $1 billion of dividends over the past five years, for total capital returns of nearly $13 billion.

American Airlines returned this cash to shareholders despite poor FCF generation. On a cumulative basis, the airline generated operating cash flow of $24.9 billion and spent $25.9 billion on capex as part of an aggressive fleet renewal initiative over the past five years, putting FCF in negative territory.

American paid for most of this capex by issuing debt and entering sale-leaseback transactions. Meanwhile, it returned a little more than half of its operating cash flow to shareholders over this period, mainly through buybacks. This led to a huge increase in the company's leverage. CEO Doug Parker justified this policy based on the low interest rates available for financing aircraft and his belief that the airline industry would be consistently profitable.

In a case of "famous last words," Parker stated at American Airlines' 2016 annual meeting: "We have gotten to the point where we like other businesses will have good years and bad years, but the bad years will not be cataclysmic. They will just be less good than the good years."

Now, airlines are facing an even more cataclysmic year than they experienced during the biggest downturns of the past few decades. Most U.S. airlines have manageable debt loads, so they should be able to take their lumps in 2020 and eventually recover. By contrast, American Airlines entered 2020 with $33.4 billion of debt and lease liabilities and can ill afford to incur any additional debt due to short-term losses.

How have the top airlines used their cash flow?

Of course, even excluding American Airlines' outlier position, there's a wide range of capital allocation frameworks in the airline industry. But once American Airlines is excluded, the rest of the industry's use of cash flow seems quite reasonable.

The following table shows how much of their operating cash flow the top four U.S. airlines (which together account for the vast majority of the U.S. airline industry) reinvested in their businesses between 2015 and 2019, and how that affected FCF.

Airline OCF (Cumulative) Capex (Cumulative) Cumulative Capex as % of Operating Cash Flow FCF (Cumulative) American Airlines $24.9 billion $25.9 billion 104% ($1 billion) Delta Air Lines $35.6 billion $20.3 billion 57% $15.3 billion United Airlines $28.1 billion $21.3 billion 76% $6.8 billion Southwest Airlines $20.3 billion $9.2 billion 45% $11.2 billion

All of the top U.S. airlines spent heavily on capex over the past five years. Thanks to their strong profitability, Delta Air Lines and Southwest Airlines were able to make these investments while still limiting capex to about half of their operating cash flow. United Airlines is similar in size to Delta and spent a similar amount on capex, but because of its lower profitability, that represented 76% of its operating cash flow. American Airlines was the outlier, spending the most on capex despite being the least profitable. This led to its negative FCF.

The next table compares the four airlines' spending on dividends and buybacks to their operating cash flow and FCF. While all four have returned close to, or even more than, 100% of their FCF to shareholders, their capital returns look far more modest when compared with their operating cash flow.

Airline OCF (Cumulative) FCF (Cumulative) Dividends Plus Buybacks (Cumulative) Cumulative Dividends Plus Buybacks as % of OCF Cumulative Dividends Plus Buybacks as % of FCF American Airlines $24.9 billion ($1 billion) $13 billion 52% N/A Delta Air Lines $35.6 billion $15.3 billion $13.6 billion 38% 89% United Airlines $28.1 billion $6.8 billion $8.6 billion 31% 126% Southwest Airlines $20.3 billion $11.2 billion $9.9 billion 49% 88%

This table reveals that the four top airlines together generated about $32.3 billion of FCF over the past five years but spent $45.1 billion on dividends and buybacks (140% of their combined cumulative FCF). That said, this spending represented just 41% of their combined cumulative operating cash flow.

It's not an airline problem; it's an American Airlines problem

Companies returning more than 100% of their FCF to shareholders over long periods have only themselves to blame if they get into financial trouble. On the other hand, for a company with an investment-grade balance sheet -- like Southwest Airlines and, until recently, Delta Air Lines -- to return close to 100% of FCF through dividends and buybacks is entirely reasonable. After all, the only significant alternative is putting additional cash on an already-solid balance sheet indefinitely.

American Airlines has been rather irresponsible with its capital allocation in recent years. As shown in the tables above, it spent the highest proportion of its operating cash flow (52%) on dividends and buybacks, despite also spending more on capex than any of its peers.

By contrast, the other three top U.S. airlines spent 96% of their FCF and just 38% of their operating cash flow on dividends and buybacks over the past five years. (If we excluded dividends, as the Bloomberg analysis did, these percentages would be lower.) In other words, they reinvested more than half of their operating cash flow in their businesses and returned most of the leftover cash to investors. American Airlines was the only major airline that adopted a blatantly reckless financial policy. Other airlines shouldn't be blamed for American's mistakes.