Airlines Hit Hard by Bevy of Factors

The airlines have been hit hard by the recession. Unemployed people do not take as many airplane trips. Employed people with less job security do not take as many airplane trips. Businessmen and women are operating on more restricted budgets during this period of economic recession / slow down. They take fewer airplane trips. The Swine Flu, its pandemic designation, and the predictions for a huge percentage of the populations of many countries contracting the Swine Flu have put a big dent in airplane traffic. For instance, Russia has issued warnings about travelling to the UK. The US is probably on a lot of countries “avoid if possible” lists.

The price of oil has more than doubled since earlier in the year. Predictions are for the price of oil to go up even further next year. All of these conditions are likely to persist or worsen in the next two years. Moody’s (MCO) estimates that the credit card charge off rate will peak in mid 2010. This will likely mark the bottom for the amount of individuals’ airplane travel. It will likely be close to the bottom for business travel. The Swine Flu is supposed to be prevalent for two years. The unemployment rate is supposed to remain above 9% well into 2011 (and possibly further). Dr. Roubini has predicted slow economic growth in the US (1% approx. in 2010 and 2011) and Europe. The Fed has predicted slow economic growth in the US in 2010 and 2011. Both think there is a good possibility of a double dip recession.

Many of the airlines were given upgrades at the tail end of the last rally. The stocks climbed rapidly. The reasons for the upgrades were twofold. First the credit markets have eased recently. This has apparently led the banks to re-evaluate their position vis-à-vis lending to airlines. Since a number of the airlines have substantial debt, this has helped them in particular. Some heavily indebted major airlines (using the debt to capital ratio) are UAUA (150%), AMR (142%), CAL (96%), and DAL (94%).

The change in attitude on the part of the banks is very tenuous. If the economy struggles further, the banks will struggle. They will no longer want to take any extra chances. They will not want to make commercial loans to airlines that owe more than they are worth (or close to it). Commercial loans are predicted to default at higher and higher rates over the next year. This is predicted to cause higher numbers of bank failures. It is likely banks will tighten their lending practices with regard to heavily indebted airlines in the very near future. Analysts' upgrades based on banks’ attitude easing are a highly questionable reason to invest in these stocks.

The second reason for the upgrades was the increased ridership last month (a little over +2%). This was the first increase in many months. It was seemingly great news. However, on closer inspection, it was not such great news. CAL reported a 19% decrease in per unit (seat) revenue that month. Given that the planes were flying over 2% fuller during that time, the airlines had to have discounted the tickets considerably to increase the ridership by even the slight amount that they did. Those discounts clearly did not help them earn money. In fact they had to lose more (I haven’t seen the exact figures yet). The table below contains some of the relevant financial data for CAL.

Stock Name	Continental Airlines (CAL)
Price at close 10/2/09	$16.07
P/E (TTM)	NA – negative earnings
2009 PE	NA – negative earnings
2010 PE	11.01 (likely to increase, if not disappear)
Beta	1.3
% Held by Institutions	87%
Short Interest	13.6%
Price to Cash Flow	NA – negative cash flow from operations
Price to Book	8.32
Debt to Capital Ratio	96%
Quick Ratio	0.84 – trouble paying debts
Return on Equity	-86.7%
Return on Investment	-10.2%
EPS Growth (MRQ)	-3300%
EPS Growth (TTM)	-2283%
Revenue Growth (MRQ)	-22.7%
Revenue Growth (TTM)	-8.3%
Dividend Yield	0
Net Profit Margin	-6.2%

As you can see from the above information, nothing good has happened with this company in the recent past. It is hugely in debt. Its debt is growing, not shrinking. It is predicted to be profitable in 2010, but those predictions are highly questionable. Some people have based predictions on 3-4% GDP growth throughout the 2010 year. This is highly unlikely. If Meredith Whitney’s predictions bear fruit (a 25% decline in real estate values), it is more likely that CAL will lose even more money in 2010 than it will in 2009. The unemployment figures are still increasing. Higher unemployment can only mean decreased ridership and decreased margins for airlines. I am not sure where the 2010 figures have come from, but they are extremely likely to fall. In fact I will be very surprised if they are not negative for 2010 as well when all is said and done.

This being the case, CAL will likely go down dramatically as its estimates fall. A 19% decrease in per unit revenue last month is a very hard and cold fact that testifies to this likelihood. Airlines can only be buoyed by analysts’ comments so long. Then they are likely to fall on fundamentals. It is even possible that banks have been upgrading them recently in their own self interest. The banks do not want to see their current investments in these airlines go bad. They want the airlines to be able to raise money through stock offerings (better to have a higher stock price for this) and bond offerings (better to have a higher credit rating for this). Then their huge investments in these airlines will be safer.

The problem is the numbers will eventually catch up to these airlines. Next year’s results will soon become next quarter’s results. The visibility will become clearer the closer we approach 2010. When the picture becomes sufficiently clear, the reality will be painfully obvious. The heavily indebted airlines will be in a lot of trouble. CAL is the one I like best as a short. It has the highest stock price of the four I listed above. It is predicted to make money next year. However, this prediction is likely a mistaken one. As the prediction gets downgraded over time, CAL should fall dramatically.

The 3-month chart shows a shallow down trend over the last 2 weeks. The stock is trading well above its 50-day, 100-day, and 200-day SMA’s. It should return to these relatively quickly. The 50-day SMA is a little below $14. The 100-day and the 200-day SMA’s are close to intersecting at approx. $12. CAL probably won’t approach its recent low ($6.44) in the near term. However, money is generally flowing out of the stock. This looks like a good short on a technical basis.

Along with the fundamental reasons cited above, the latest petroleum stocks data provides one more reason.

Tuesday the API reported Petroleum Inventories numbers that were significantly worse than was expected. API gave the following figures:

Crude Oil Inventories = -254,000 (expected +2.2M barrels)

Gasoline Inventories = +544,000 (expected +1.0M barrels)

Distillates Inventories = -2.9M (expected +.3M barrels)

Total Decrease in Inventories = -2.61M barrels

Total Expectations Miss = 6.12M barrels of inventory less than expected

This latter number is a huge amount. If the EIA numbers agree with it this morning at approx. 10:30am ET, the market should bid up the price of oil in response.

The other factor at work is the fall in the USD recently. This has led directly to investors bidding up commodities and commodity stocks. Higher oil is bad for airlines. The USD has been going down all week so far. It may steady tomorrow after the last few days. However, commodities may still continue to rise after good Q3 results data so far. This should push airline stocks downward. CAL should outperform to the downside. It has better reason than most to fall.

If all this was not enough, consider technological reasons. Video Conferencing is now coming of age. Networks are fast enough. Holographic images to talk to may not be far off. If you can pay for all the video conferencing equipment you need to support a several hundred person business with just the cost of 10 plane flights and hotel bills, it might seem like a great cost saver. It’s also healthier. It wastes less time in travel, etc. Some may scoff, but video conferencing will likely cut into business air travel over the next several years. In fact, the recessionary environment may give it a jump start. It is cheaper than flying everywhere.

CAL is both a short term and a long term play. If you enter this trade, keep your stops fairly tight on entry. The market could send it up short term, especially if the general market keeps rising. However, the negative fundamentals are too strong for it not to go down longer term. If you get stopped out, you can re-enter at a later time with most of your money intact. It should work. After you are profitable, you can widen your stops (or trailing stops).

Disclosure: I have a small short position in CAL.

Comments

[David White:]

CAL was down early today as this article expected. However, it was buoyed later by the announcement of new routes to Hawaii. Investors need a reality check here. Are vacation routes going to be big money makers in a slow economy? Most estimates are for high unemployment and very slow growth for the next 2+ years. Instead of a plus, these new routes may be an opportunity for CAL to lose more money.

Oct 07 11:15 AM

[David White:]

If Geithner says Americans will be saving more (and low growth predicted), why does CAL management think more vacations routes are needed? SNAFU!! This really lowers my opinion of the CAL managment.

CAL should fade today as the announcement euphoria of new routes announcement dwindles with the reality of the losses they may bring in the next two years.

Oct 07 12:01 PM

[David White:]

Supporting a CAL short, the FAA ETF looks like it topped out about 2 weeks ago. Its next support is 12% - 20% lower than its current price. If CAL just follows its sector trend, it should go down nicely. Of course, some of those airlines are actually making money, so CAL should outperform them to the downside.

Oct 07 01:25 PM

[igggy:]

At some point I looked at monthly performance of airline stocks and CAL on average goes up some 7% in October. Could be data mining but other airlines perform well in October too.
To the author: who said 'investors' own airline stocks? Maybe as a bet against oil. I'd rather own refiners for that.

Oct 07 05:19 PM

[DrBenway:]

Wow...I first thought Debt-To-Capital ratio above 100% was a typo. You almost never see that in a solvent company. I was wrong! UAUA is -18 per share of negative equity, a quick ratio of 0.6, and a negative cash flow.

So it can't borrow and can't meet its short-term obligations within a year. I am just thinking of a plausible scenario (short of the goverment bailout) where it will not go bankrupt.

Any comments?

Oct 07 06:08 PM

[David White:]

igggy: interesting comment about the average 7% gain in October by airlines. However, CAL did report 19% lower revenue last month. The airlines have had a huge run up. The FAA chart fairly clearly indicates a down trend in the sector. The overall market is still due for a retracement. Plus the Beta of CAL is 1.3. Cal is still losing money, and its debt is huge. It may soon be underwater. With the credit card charge off rate predicted to peak in mid 2010 and the unemployment rate still rising, it is likely the current 2010 estimates for CAL are much too high. If the market goes down CAL should out perform it to the down side. Most October's we are not at the tail end of a 50+% upswing over the last 6 months. The markets are not priced by roughly 20% over fair value as they are now. Meredith Whitney is not calling for a 25% drop in real estate prices. The commercial mortgage market is not imploding. The unemployment rate is not in the process of rising to over 10% (although some are now saying the real rate is in the 15% to 20% range). I could go one. This trade is not just dependent on oil. I merely cited oil as a likely contributor to the downside for CAL today after the API data reported yesterday. That particular thesis did not play out as EIA reported substantially different results.

As for the trade today, CAL announced the additon of new routes from Orange County to Hawaii. This "growth" action seemed to push the stock up immediately after the announcement. However, I think this move falls more into the SNAFU category. Geithner is saying Americans will be saving more. Both the Fed and Roubini are agreeing on very slow growth for 2010 and 2011. How are new "vacation" routes going to pay in that type of environment? The per unit revenue was down 19% last month. If CAL is losing more money than it expected, are the estimates for 2010 reasonable? It looks like a good short to me.

Oct 07 06:15 PM

[David White:]

DrBenway: No its not a typo. Yes, all of the above named airlines are in danger of going bankrupt in the next year or two. One of the reasons for the recent rally has been that banks have recently relaxed their lending attitude toward these airlines. That meant that the airlines did not have to worry as immediately about facing bankruptcy. However, that does not mean they are out of trouble. They are still in very serious trouble. Also the euphoria from the better lending atmosphere is waning as you can clearly see from the FAA 3 or 6 month chart. This makes CAL a good short.

In fairness I should point out that the market value of the airplanes owned by many of these companies is likely at a low. If there is a substantial recovery in the next few years, the plane values might go up enough to push UAUA's head above water again. Still the planes are getting older with time. Plus the recovery is supposed to be long and drawn out. This likely means a lot more time spent losing money by these airlines. This is trouble. CAL for example has a big cash flow problem. Others too. As 2010 rolls around, talk of bankruptcy for all of the 4 airlines listed above will likely return. Stock prices will likely fall. From the FAA chart it looks like airline stock prices should fall 12% to 20% from their current values near term before the FAA ETF hits good technical support. Since all of the companies listed above are currently losing money, this seems like a strong possibility, especially with an overall market retracement likely in the works.

Oct 07 06:30 PM

[DrBenway:]

I am just curious why you are not short some way UAUA and AMR. I am also curious about your take on JBLU, which in my humble opinion, should be a big beneficiary of the "majors" trouble.

On Oct 07 06:30 PM David White wrote:

> DrBenway: No its not a typo. Yes, all of the above named airlines
> are in danger of going bankrupt in the next year or two. One of the
> reasons for the recent rally has been that banks have recently relaxed
> their lending attitude toward these airlines. That meant that the
> airlines did not have to worry as immediately about facing bankruptcy.
> However, that does not mean they are out of trouble. They are still
> in very serious trouble. Also the euphoria from the better lending
> atmosphere is waning as you can clearly see from the FAA 3 or 6 month
> chart. This makes CAL a good short.
>
> In fairness I should point out that the market value of the airplanes
> owned by many of these companies is likely at a low. If there is
> a substantial recovery in the next few years, the plane values might
> go up enough to push UAUA's head above water again. Still the planes
> are getting older with time. Plus the recovery is supposed to be
> long and drawn out. This likely means a lot more time spent losing
> money by these airlines. This is trouble. CAL for example has a big
> cash flow problem. Others too. As 2010 rolls around, talk of bankruptcy
> for all of the 4 airlines listed above will likely return. Stock
> prices will likely fall. From the FAA chart it looks like airline
> stock prices should fall 12% to 20% from their current values near
> term before the FAA ETF hits good technical support. Since all of
> the companies listed above are currently losing money, this seems
> like a strong possibility, especially with an overall market retracement
> likely in the works.

Oct 07 06:39 PM

[David White:]

Reassuring news for me: The Motley Fool agrees with my assessment. The Motley Fool wrote their own article about CAL, "One Star Stocks Poised to Plunge". It was published Oct. 8, 2009. This should also help my thesis to come true. Still a lot will be based on overall market behavior. Please use reasonably tight stops.

Oct 09 09:43 AM