With rising fuel prices already in motion and rising labor inputs just over the horizon for airlines, we’ve identified good candidates for a potential short. The industry is likely to undergo further consolidation, and as a consequence, ticket prices should continue to firm. We think these risks are outweighed by the unprofitability that plagues this cyclical sector. High speed rail projects, spillover risk from unrest overseas, and burdensome security procedures prior to boarding should keep a lid on the upside for most airlines.
Within the individual airline companies, here is what we found:
Alaska Air Group (ALK): This airline has a 20% market share of the coveted Alaskan area market. We expect the company to continue to destroy capital for shareholders, however, with margins closer to 7% and capital spending eating up 10% of revenues over the next several years. Revenue growth will remain in the mid-single digits as more travelers seek Alaska as a favorite getaway destination. We think shares are worth $15 apiece.
JetBlue (JBLU): This national carrier should be able to control fuel costs better than its peers and increase revenues from complementary services to passengers. Volatility in fuel prices will still cramp future earnings and cash flow to the company. JetBlue faces extra risks not borne by other airlines due to its expansion into new markets. It also faces the prospect of full-scale unionization of employees. We value shares at $3.50 apiece given its high debt-to-capital ratio around 2:3.
AMR Corporation (AMR): This airline faces fuel costs accounting for 25-30% of its operating budget. Most of its stateside employees are unionized and locked into two year contracts which tend to result in wage spikes at each interim. New entrants into the airline industry peel away valuable revenues to AMR. The company’s pension plan is also underfunded. Shares are worth $7 apiece assuming 5.5% margins and mid- to high-single digit revenue growth over the next few years.
Copa Holdings SA (CPA): This Panama hub airline should benefit from increasing economic growth in the markets it serves. The company’s shareholders could be diluted due to a Panama law, which requires a minimum ownership stake in Panama-based airlines by its own citizens. Shares are worth $50 apiece given that legacy competition is nipping at Copa’s heels and new airlines are likely to spring from central America to compete on price. Copa is also likely to be squeezed by rising fuel prices. We use a 13% cost of equity for this airline.
US Airways Group (LCC): This airline should be able to grow revenue in the mid-single digits and cost-cutting at US Airways should produce margins of 4-5% over the next few years. Fuel costs, already above 20% of expenses, will likely compress margins and deplete the impact of cost-cutting measures. Also, 90% of company workers are unionized and will create a substantial burden on the company’s ability to return any cash to shareholders. Shares are worth $8 apiece using a 12% discount rate.
Southwest Airlines (LUV): Despite a successful hedging program in the past, Southwest is likely to be hampered by fuel costs. At 30% of expenses, fuel, coupled to an 80% share of unionized workers, should cost Southwest its ability to produce a return on invested capital in excess of its cost of capital. Shares are worth $11 apiece using a 12% discount rate.
Airtran (AII): Ths company’s shares reflect the purchase price from Southwest Airlines. We expect the merger to go through but not result in any positive impact for Southwest over the long-haul. Airtran demonstrates that a new, low-cost carrier can spring into the industry and take significant capacity from larger players at a rapid pace.
Delta Airlines (DAL): Delta should be able to grow revenues at a 7% clip and keep margins around 6%. Fuel prices will hamper any real growth for the company, however. Periodic battles for market share with other established and newer players in the industry will keep a lid on Delta. We value shares at $10 apiece using a 12% discount rate.
Ryan Air (RYAAY): Like Southwest, Ryan Air has done a good job of keeping ticket prices low and building out its network. Fuel prices and potential unionization of the airlines workers are persistent threats to the company’s bottom line. We think margins can be maintained in the teens, but we also anticipate unfavorable exchange rates for U.S. investors in this ADR. Shares are worth $22 apiece using an 11% discount rate.
United Continental (UAL): United overpaid for Continental Airlines, and the company will face a tough job continuing to integrate the airline over the next few years. Competitors, both established and new, as well as significant fuel price increases will hamper this company. UAL can grow revenues with higher ticket prices and we expect mid margin expansion due to synergies developing, albeit at half the $1 billion figure offered by management. We value shares at $23 apiece using a 12% discount rate.
For more short opportunities, view our list of Cramer shorts.