The Airline Industry is widely known to be highly cyclical in nature. Despite the global economic outlook being sluggish in the wake of a looming debt crisis spilling over from Europe, there are still several airlines that have positioned themselves to benefit from this prevailing scenario. After a detailed analysis, we have come up with few actionable investment opportunities for our investors. Depending on individual stock drivers and their expected movement, we advise long positions in Delta Airline (DAL) and US Airways Group, Inc. (LCC), while maintaining a neutral stance on JetBlue (JBLU). Additionally, we recommend investors to take a short position in Southwest Airlines CO. (LUV). A detailed analysis of the industry and key individual players is given below.
The U.S. Passenger Airline Industry is a hyper-competitive industry and is susceptible to the tide of both the U.S., as well as the global economy. An industry that carries one-third of the world's passengers is subject to intense regulation. It is for this purpose that the Federal Aviation Administration (FAA) is made responsible to oversee all aspects of the industry. Dominated traditionally by major U.S. airlines like United Continental Holdings (UAL), DAL, LUV and LCC, the industry can be classified into network, low-cost and regional airlines.
In the wake of the recent global economic downturn, threats of terrorism, war, and disease, as well as increased competition from low-cost carriers, many incumbent U.S. airlines have been attempting a fundamental re-structuring of their operations.
Three significant mergers in the past three years have changed the landscape of the Airline Industry. DAL and Northwest Airlines merged in 2009; United Airlines and Continental Airlines merged in 2010 to make United Continental Holdings , and Southwest Airlines merged with AirTran Airways in 2011. Most recently, American Airlines (formerly AMR) filed for bankruptcy protection in November 2011. The profit of U.S. carriers in 2011 of $390mn remained much lower in comparison to the expected profit of $2bn. It was also 86% below the profit recorded in 2010.
With anticipated current year profits of $3bn and $900mn for the global and the U.S. airline industries respectively, analysts maintain a fragile outlook. In the wake of the debt crisis spilling over from Europe, cargo traffic might take a hit. Cargo from Asia bound for Europe is already down by 5%, and analysts view a moderate global passenger growth of 4.2% in 2012. However, global airlines are expected to invest an enormous $3.5 trillion in the purchase of 27,800 new airplanes over the next 20 years (2011-2030). Passenger demand in the U.S., according to estimates, is expected to grow at a rate of 2% in 2013.
- The industry is highly competitive, and the behavior of low-cost carriers and their airfare has the ability to re-shape its future significantly.
- Since it is a cyclical industry, it is highly correlated with the general economic climate of the country, as well as the world.
- Mergers and acquisitions continue to alter the landscape of the Airline Industry. These mergers and acquisitions have an impact on the overall industry.
- The industry is subject to stringent government regulation through the FAA.
- Jet fuel costs have risen significantly, surpassing labor costs, to become the largest expense for airlines. Fuel costs now represent 35% of total expenses for airlines. The effect of rising oil prices on airline stock could run in either direction, depending on whether oil prices are representing economic activity or a supply side issue, and how much fuel each airline hedges.
- The labor force in the U.S. Airline Industry is highly unionized. Collective bargaining arrangements set the cost of labor so high that it limits the ability of air carriers to be competitive.
- Yields and Revenue per available seat mile (RASM) have been on the rise for all major U.S. airlines in recent years.
- Airlines tend to show strong performance in the holiday season. Significant variation in the industry's performance is witnessed when comparing peak and off peak seasons.
- After 9/11, insurers withdrew coverage for terrorism. Since then, the U.S. government assists airlines in insuring war risks, which results in higher costs of insurance.
- Random threats, such as a rapid spread of contagious illnesses or acts of terrorism, shake the entire industry's profitability.
Major U.S. Air Carriers
PEG (5-year expected)
Our outlook for DAL is positive. Despite a sluggish U.S. economy, DAL's ability to reduce capacity by cutting flights, its strong liquidity position, favourable relative valuations and expectation for growth makes it a potential investment opportunity.
Serving more than 160mn passengers at 61 destinations in 61 countries worldwide, DAL has the second largest market share in the U.S. Airline Industry. DAL and Northwest airlines, the two companies with the minimal network overlap, merged a few years ago. The new comprehensive route network continues to serve as a competitive advantage.
Labor unions are not much of a concern for DAL, since it only has one unionized workgroup of pilots consisting of 16% of the workforce.
DAL generates a strong cash flow and has around $5.4bn in cash and short term investments to cover its short term needs and draw down its debt. Further, the company is restricted by its credit covenants to pay dividends. A concern for the company, however, is its pension liability, which is underfunded by 60%. The company expects to make payments of $700mn in 2012.
Standard and Poor's estimates that both revenue and costs per available seat mile will grow by 5% in 2012 for DAL along with a 10.4% rise in average crude oil price from $95.15 to $105 from 2011 to 2012. DAL posted a current revenue and cost per available seat mile of 12.89c and 14.12c respectively. Going ahead with these estimates and using UBS's sensitivity model, we see an EPS estimate of $1.04, assuming a tax rate of 38% for 2012.
According to DAL's EV/EBTIDAR, its stock is trading at a premium of 3.17% to the industry. When comparing DAL's price-to-earnings ratio to that of the industry, we see that DAL is trading at a significant discount of 61%. Its projected price-to-earnings ratio is at a 70% discount to that of the industry. The price/earning to growth ratio of 0.22 is below the industry average of 0.33. Based on the above analysis, the stock appears to be undervalued, and we recommend a long position in it.
United Continental Holdings
UAL's strengths are visible in its revenue growth and notable return on equity. However, unimpressive losses in the bottom line and concerns regarding profit margins and labor unions act as a counter to these strengths. Based on these aspects, our outlook for UAL is negative.
Being the largest U.S. carrier, UAL serves more than 148mn people to reach 370 destinations in 62 countries by operating 5,800 flights every day. 80% of UAL's workforce is represented by various labor unions.
UAL reported a 5% increase in its Passenger Revenue per Available Seat Mile (PRASM), coupled with an 8% increase in Cost per Available Seat Mile (CASM) from 1Q2011. The company is less sensitive to any adverse impacts on the global air cargo business due to the European debt crisis, since only 3% of UAL's revenue is generated from cargo. UAL generates a strong cash flow and has around $7.3bn in cash and short term investments to cover its needs. Cash from operations decreased by a significant 88% compared to the same period last year. This was largely attributed to losses YoY, working capital cash flow impact and increases in cash collateral from fuel hedges.
Even though UAL was able to increase its turnover for 1Q2012 by around 5% YoY, its losses witnessed an increase when compared to 1Q2011. This resulted in a decrease in the net worth of the company. UAL, in line with its industry peers, has a significant 89% proportion of debt in its capital structure, of which $1.1bn is due in the coming 12 months.
Owing to rising fuel prices, the company intends to cut down its full-year capacity by 0.5% to 1.5% YoY, by indefinitely postponing the start of flights to new destinations as well as less profitable existing markets. The management is also considering getting rid of fuel inefficient aircraft.
UAL's EV/EBTIDAR is at a discount of 13% to the industry average; however, the stock is trading a 215% premium to its peers based on price-to-earnings ratio. It's price/earnings to growth ratio of 0.42x is also above the industry average of 0.33x. Based on the above analysis the stock is overpriced. Therefore, we recommend a short position.
LCC, with a fleet of 640 jet aircraft, connects 200 destinations in 31 countries by operating 3,208 flights daily. With hubs in smaller cities, and a few international routes, LCC's network is not as robust as its legacy peers, limiting its ability to increase the share of business travelers over time. However, LCC commands top market positions with a dominating share in its local markets, which enables the carrier to be the best option for many corporate accounts. Long-term EPS growth is expected to be at 38.5%, and it is currently offering a notable ROE of 275.3%. LCC is one of the only large air carriers in the U.S. that does not hedge its fuel needs. Its stock has been trading at a 125% YTD owing largely to declining fuel prices and rumors of a takeover of American Airlines. LCC can take advantage of American Airline's robust network and expand its own network exponentially.
LCC's EV/EBTIDAR is trading at a premium of 3.17% from the industry. When comparing LCC's price-to-earnings ratio to the industry, we see that LCC is trading at a significant discount of 51%. Its projected price-to-earnings ratio is at a 70% discount to that of the industry. The company is also trading at a price-to-sales ratio that is at an 82% discount with respect to its peers. The price/earning to growth ratio of 0.09 is significantly below the industry average of 0.33. Based on the above analysis it appears that the growth potential in the stock has not been fully realized by the market. We recommend a long position.
JetBlue is one of the most dominant low-cost carriers in the U.S. It serves 71 destinations in 21 states, and twelve countries. JBLU's EV/EBTIDAR is trading at a premium of 11.1% from the industry. When comparing JBLU's price-to-earnings to the industry, we see that JBLU is trading at a discount of 2.1%. Its projected price-to-earnings ratio is at a 40% discount to that of the industry. The company is also trading at a price-to-sales ratio that is at a 60% discount with respect to its peers. The price/earning to growth ratio of 0.44 is above the industry average of 0.33. Based on the above analysis it appears that the company does not have enough growth potential, which is why we maintain a neutral outlook.
Considered to be the largest low-cost air carrier, Southwest Airlines has a fleet size of 710 aircrafts and serves at 97 destinations.
LUV maintains an EV/EBITDAR of 7x, which is at an 11% premium when compared to the industry average. Its trailing price-to-earnings ratio is also trading at a significant premium of 81%. Based on these valuations, we recommend a short position.
Investors can also short sell Guggenheim Airline ETF as a hedge against the long positions in DAL, LCC and JBLU.