On Thursday morning, Goldman Sachs (GS) initiated coverage of United Continental (UAL), the parent of United Airlines, with a sell rating. Delta (DAL) also received a sell rating from Goldman. The investment bank stated that it expects both companies to underperform the broader market in both the short term and long term due to weak economic growth and high fuel prices. While these are both reasonable concerns, the airline industry has been very proactive in matching capacity (supply) to meet demand over the past 2-3 years. I expect this trend to continue, and think both companies (but particularly United) are well-positioned for the next few years.
For one thing, while jet fuel prices have moved upward over the past few weeks from their June lows, prices still sit more than 10% below the highs seen in late April. Barring a major supply disruption from a hurricane or geopolitical tensions, I expect fuel prices to trend lower for the remainder of the summer and into the fall. A strong dollar and widespread economic weakness will continue to dampen demand. As petroleum stockpiles grow, prices will fall, particularly as the end of the peak summer season approaches. While oil prices spiked Wednesday on a higher-than-expected draw of nearly 4.7 million barrels of crude oil last week, most news reports (and the market as a whole) seemed to overlook the fact that total petroleum product inventories actually increased by 3 million barrels. The draw down in crude stockpiles was due to higher refinery activity, which led to increases in stocks of most finished products, such as gasoline, distillates, jet fuel, and propane.
Additionally, Enbridge (ENB) stated last month that it expects to expand the Seaway pipeline's capacity by 250,000 barrels per day by year end (a few months earlier than initially planned). This will effectively expand global supply by 250,000 bpd, as landlocked crude will be able to reach Gulf Coast refineries rather than building up in the Cushing storage hub. Lastly, a tightening of the "crack spread" is likely to begin when Delta's recently purchased refinery restarts production in September. With an additional 185,000 bpd of East Coast refinery capacity, almost one-third of which will be devoted to jet fuel, jet fuel refining margins are likely to decline. All airlines (not just Delta) would benefit from this potential tightening of the crack spread, as the result would be lower market prices for jet fuel.
As analyst Jamie Baker opined a few weeks ago, United is likely to beat current earnings estimates even with lower revenue gains. Baker is modeling RASM gains just above 2% for United in the second half. I think Baker's revenue estimates are unduly conservative, though. United has been facing fairly strong comparable figures in the first half of the year, whereas it will face easier comps after September. Furthermore, capacity cuts will eliminate underperforming routes and support pricing overall. Given the company's target for a roughly 1% capacity reduction for the full year, and the 0.2% reduction year to date, it follows that second-half capacity is planned down by nearly 2%. A third factor in United's favor is that the progression of its merger is likely to show increasing benefits this fall. After the company reported Q1 earnings in April, CEO Jeff Smisek stated, "We are now on the steep back slope of our integration." With the full integration of United and Continental, the company can now deploy its aircraft anywhere across its network. The bulk of these changes will come into effect with the fall schedule.
Additionally, United is poised to renew its fleet in the coming years in order to improve fuel efficiency and reduce maintenance costs. As Justin Loiseau recently pointed out, the fuel efficiency of United's fleet (as measured by ASMs per gallon) has increased noticeably in the last few years. On Thursday, United announced an order for 150 new Boeing 737 aircraft, which will primarily replace older and less fuel efficient planes. While the bulk of these aircraft will not arrive until 2018 and thereafter, this order complements the company's existing commitments for next generation widebodies (the Boeing 787 and the Airbus A350). Fuel efficiency gains from these new aircraft will lower costs and improve profitability even in the high fuel-cost environment expected by Goldman Sachs.
While competitor US Airways (LCC) has seen its shares nearly triple this year, United and Delta have risen by much more modest percentages. I think United is a better long-term play than Delta, because of the impending merger-related revenue improvements, a stronger balance sheet, and a more fuel-efficient fleet. By contrast, I think US Airways may be overbought at current levels, given uncertainty surrounding its potential merger with American Airlines (AAMRQ.PK) and higher vulnerability to a potential spike in oil prices.