As excess capacity for US domestic air travelClick to enlarge continues to shrink, the US carriers [FAA] will begin to see a more optimal pricing environment. This could make some of the airlines attractive investments moving forward.
In my last article, I examined the factors driving this trend. In this article, we'll examine some of the downsides to investing in the air carriers, with a specific focus on financial risk, pensions, and valuation. We'll focus on seven major US carriers: Delta (NYSE:DAL), United Continental (NYSE:UAL), US Airways (LCC), Southwest (NYSE:LUV), JetBlue (NASDAQ:JBLU), Spirit (NASDAQ:SAVE) and Alaska Airlines (NYSE:ALK).
Pension Problems and Financial Risk
Airlines and financial risk go together like peanut butter and jelly. With the exception of upstart Spirit, all of the carriers we will examine have significant liabilities. This can be problematic, but it can also provide an opportunity for very high returns.
The legacy carriers (i.e. DAL, UAL and LCC) in particular have high debt loads and significant pension / post-retirement liabilities for employees. The chart below lays out several metrics to assess financial risk. There is an abbreviation key below in case any of the terms are not clear.
There are several interesting takeaways from the above chart. US Airways has the highest long-term debt of the group, when you examine debt as a percentage of total assets; it is followed, surprisingly, by JetBlue on this metric. However, this measure is somewhat misleading. Once you begin to factor in pensions and post-retirement obligations with long-term debt ("Adjusted LTD" in the chart above), the picture begins to change quickly. It's also important to strip out intangible assets, as you can see in column 3 ("Adjusted LTD / Tangible Assets").
With these adjustments in place, Delta clearly has the most significant liabilities, followed by US Airways and United Continental. Yet, while we should have some worries about the debt loads of UAL and LCC, they are not even in the same ballpark as Delta. This is largely because Delta's pension and post-retirement obligations ["PROs"] make up 32.6% of their total assets (as you can see in column 4). If you adjust this to only factor in tangible assets, pensions and PROs this accounts for somewhere in the range of 47% of Delta's total asset base; a shockingly high figure.
What could potentially make things even more problematic is that David Trainer of New Constructs argues that Delta's pension liabilities are understated. I won't assess the validity of those arguments right now, but needless to say, it's clear that Delta has a lot of financial risks. We'll have to see whether those risks are offset by positives in upcoming articles.
The next chart provides stock price, net tangible assets per share, and my own rating of financial risk for all seven carriers.
I'd put particular emphasis on the airlines with negative equity (you can see this in the "NTA per Share" column), which once again, includes our three main legacy carriers: UAL, DAL and LCC. It's important to note that if these companies earn large enough profits, they might still make worthwhile investments, in spite of the negative equity, high debt, and pension problems, so I wouldn't dismiss them just yet. Let's also remember that direct equity investments aren't the only option here; long-dated call options might be an attractive way to play these types of high-risk / high-reward stocks.
Operating Margins and Expenses
Next, I want to take a look at is historical operating margins and expenses, which I view as a reasonable measure of operating performance over the past decade. Note that I only have a few years of data here for US Airways and Spirit, but the data stretches back to 2000 for the rest of the carriers. Here is a chart showcasing the operating margins:
Here are the 3-, 5-, and 10-year averages
JetBlue comes out looking the best from these figures over the entire 10-year horizon; however, Alaska Airlines also looks excellent over the past 5 years, and Southwest is reasonably impressive, given the environment.
The three legacy carriers (DAL, UAL and LCC) all fare poorly comparatively. Still, the trend appears positive, and the real question is whether consolidation and less excess capacity allow the legacy carriers to compete more effectively and produce better operating margins in the future. There's some evidence that a shift towards more sustainable profit margins is already occurring.
The chart below gives the compounded average growth rate [CAGR] for revenue over a variety of different timeframes for our seven carriers.
These figures are all over the place. The only obvious takeaway is that all the airlines have significant revenue growth over the past decade, in spite of other shortcomings. Much of this growth can be attributed to consolidation in the industry.
JetBlue and Alaska Airlines appear to have more organic growth than the rest of the bunch. JBLU, LUV, and ALK also tend to be the most shareholder friendly of the bunch, having significantly less dilution than the legacy carriers. This is, of course, important because anyone can purchase revenue growth through dilutive mergers; it's more impressive to grow revenues without issuing new shares.
Valuation Risk: Price to Net Tangible Assets
Let's take a look at a few "quick valuations." Another term for these might be "mindless valuations." The point in this exercise is just to get a quick feel about what a valuation might look like for each of these firms. The actual valuation will depend on a host of complex factors that we will examine much more specifically in future articles. But for now, let's get a taste of things.
First off, let's look at Price to Net Tangible Assets [NTA] ratios. I view this as the best "safety valuation" metric; or that is to say, you're least likely to "go wrong" by using this metric, as opposed to other quick valuation metrics such as P/E.
From this, Delta, United, and US Airways fare poorly due to their negative equity positions, implying high risk, but we've already established that, so this is not exactly news. Spirit has the highest P/NTA ratio at 3.71, but SAVE's business model is also radically different from the other six airlines here, so it's not really a comparable metric in any meaningful sense. Finally, Jet Blue, Alaska, and Southwest are all in the 0.9 to 1.25 range, which I would view as ideal.
Analyst Projections and Implied Valuations
Now, let's take a look at some earnings projections from the banks, and try to piece together some quick valuations based on these. As I said, these are more or less, "mindless valuations", and I wouldn't take them seriously. Rather, the main reason for this exercise is that these quick valuations help provide some degree of understanding of how valuation is impacted due to the operating and financial leverage of these firms.
This chart may be somewhat difficult to read, but the main points:
(1) Column 3 contains consensus analyst forecasts for earnings in FY 2013. Whether we believe those estimates to be accurate or not, or indicative of a future trend, is a completely different matter altogether. For this exercise, we will assume they are accurate.
(2) The fourth column ("Implied Valuation at 15 P/E") is my estimate of how these firms should be valued if the consensus analyst estimates are correct, we see a continuation of that trend, and moderate future growth is expected.
(3) The final column ("Implied Under-(Over-) Valuation") shows whether the stock is undervalued or overvalued based on this model. For instance, at -13.5%, this model suggests that Delta is 13.5% overvalued. Whereas, at +99.2%, US Airways is 99.2% undervalued.
From this data, US Airways and Spirit would appear the most attractive, while JetBlue and Alaskan would look the least attractive. Delta, United, and Southwest would appear slightly overvalued based on this.
I have very little faith in this methodology for this group of stocks, for a variety of reasons. For one, financial and operating leverage is moderate to high for almost all of these carriers, making the valuations very sensitive to minor changes in earnings projections, growth rates, costs of capital projections, etc. Still, the numbers here are intriguing enough to keep looking at the airlines in greater depth, which is exactly what we'll do in my upcoming articles.
For now, the data in this article is primarily meant to help guide us in analyzing the airlines individually. We can see that Delta has the most significant risk of the bunch, and we should analyze it with an expectation of earning a higher return to compensate for that risk. We can also see that UAL and LCC have some significant risks, while JBLU and LUV have moderate risks. With an understanding of risks, growth and margins, we can better analyze the carriers in relation to one another.
With my next article, I begin looking at some of the carriers individually, starting with a focus on JetBlue.
Disclosure: I am long (LUV).