3 Legacy Airlines, 3 Strong Investment Rationales

 |  Includes: AAL, DAL, UAL
by: Adam Levine-Weinberg

2011 was a difficult year for most airline stocks. The six largest US carriers each lost at least 20% over the course of the year. Only smaller carriers like Alaska (NYSE:ALK) and Allegiant (NASDAQ:ALGT) gained ground.

However, 2012 is likely to see much stronger results from the airlines, as jet fuel price increases are likely to moderate while disciplined capacity decisions lead to continued price strengthening. With the exception of bankrupt AMR (AAMRQ.PK), the legacy carriers (United Continental (NYSE:UAL), Delta (NYSE:DAL), and US Airways (LCC)) are each poised for strong gains this year. All are trading at exceptionally low forward P/E ratios (less than 5). Each of these carriers has a unique advantage and investment rationale, but all will benefit from this year's improved industry fundamentals.

United Continental: United Continental has been the weakest performer lately. The company issued a downbeat investor update last month, and then announced that December PRASM (passenger revenue per available seat mile) increased by only 4-5%. This represented a significant slowdown compared to other recent months. While I still expect the company to report a Q4 profit, it is likely to be significantly lower than last year's. It is not all that surprising that United has been underperforming recently. It is widely understood that integrating two airlines is a very difficult task, and that near-term performance may suffer while management's attention is captured by the integration process.

However, from recent chatter, I expect PRASM growth to pick up again in the next few months in light of lower industry capacity, route cuts at American in some of United's major markets, and easier comparable revenue figures. Furthermore, the company will see easier year over year comparable numbers on the cost side in future quarters. United paid $2.46/gallon for jet fuel in Q4 2010, but $2.78 in Q1 2011 and $3.09 in Q2 2011. Additionally, United is making progress on integrating the two carriers; for example, the company recently reached an agreement with the United subsidiary flight attendant union. Lastly (and most importantly, in my opinion), United has a pristine balance sheet by airline standards. At the end of Q3, the company had $8.4 billion in cash and short term investments against $11.8 billion in long-term debt. If the company can put up strong results over the next 18-24 months, it will be able to bring its debt burden down to a level where its debt could regain investment-grade status (a milestone that seems out of reach for the other legacy carriers). Of the three legacy carriers, United is the most likely to start returning cash to shareholders within the medium-term.

Delta: Delta is in many ways the opposite of United from an investor perspective, but also represents a strong investment opportunity. At the end of Q3, Delta had slightly more debt than United, but less than half as much cash. On the other hand, the company has successfully integrated with the former Northwest and has been showing strong results recently. At its investor meeting last month, Delta raised its guidance to an adjusted profit of $1.1 billion for 2011, and also forecast a profit for 2012.

One piece of good news for Delta is that it is becoming far more reliable and customer-friendly, which will likely increase customer loyalty over time. The company ranked last among U.S. airlines in customer service in 2010, but came in second for 2011. This was a very impressive increase, driven by investments in technology and personnel to minimize canceled flights, missed connections, lost bags, etc. Delta's improvement seems to be the result of process improvements more than luck, so there is good reason to believe it will continue to post good results this year.

Delta has also been the most vigilant airline on the capacity front. By cutting capacity, the airline is able to better match supply to demand and increase fares to ensure more consistent profitability. Delta projected capacity cuts of 2-3% for 2012. Meanwhile, the company has also been busy cutting fixed costs in order to match the slimmed-down network, and to focus on the most profitable markets. On the latter front, Delta finally completed a slot-swap deal with US Airways, allowing it to acquire 132 slot-pairs at LaGuardia Airport in New York. Delta will be able to consolidate its position as a leading airline in the busy New York market with a domestic hub at LaGuardia to complement its international hub at JFK. This should generate significant incremental revenue opportunities. Meanwhile, Delta is cutting back in smaller hub markets like Memphis and Cincinnati, which are less profitable.

US Airways: US Airways is much smaller than United and Delta, but has been able to compete very effectively in spite of its small size. US Airways does not have the global scale needed to draw as many high-paying business customers as its larger competitors. However, the airline makes up for that through extreme discipline on the cost side. For example, US Airways has some of the lowest labor costs in the industry. In addition, the company does not engage in fuel hedging, which insulated it from this year's wild swings in petroleum markets.

Even more importantly, US Airways has made a commitment to concentrate its resources in the markets where it is strongest: Philadelphia, Charlotte, Phoenix, and Washington (Reagan Airport). By the middle of this year, 99% of US Airways capacity will begin or end at one of these four airports. This focus has allowed the company to post very strong revenue results in recent quarters. In December, US Airways reported a PRASM gain of 11%, far outstripping United (one of the few other carriers to report this figure on a monthly basis). Furthermore, US Airways has been one of the few airlines able to go head to head against Southwest (NYSE:LUV) and win. Southwest is drastically scaling back its Philadelphia schedule this year, thus ceding a monopoly position to US Airways on several additional routes. This should further bolster revenue performance this year.

Lastly, as noted above, US Airways finally completed a long-sought slot swap agreement with Delta. The company will gain 42 slot pairs at Reagan airport, allowing it to consolidate its focus city operation there. US Airways had long been serving LaGuardia with tiny regional aircraft that were unprofitable under current jet fuel prices. By eliminating that service over the course of the next six months, and replacing it with more profitable routes from Washington, US Airways should achieve additional profit improvement this year. (The company also got a nice cash incentive of $66 million from Delta to bolster the balance sheet.)

Altogether, each of the legacy carriers is a worthwhile investment opportunity at this point in time. The choice is yours!

Disclosure: I am long UAL, DAL.