The airline industry of today is not what it was even a few short years ago. Most companies in this sector are still being punished for their past transgressions. However, for long-term investors, this is creating a great opportunity to invest in the sector. We have written about several airlines in the past, including Delta (DAL) and Hawaiian (HA). And today we would like to highlight another airline, one that we believe is still a buy, even with a sizable rally so far this year. And that airline is US Airways (LCC).
On the surface, US Airways seems like a poor investment choice. After all, it seems to be the weakest of the Tier 1 airlines (Delta, United (UAL), American, Southwest (LUV), and US Airways), and it has the dubious honor of being the only one of those airlines to file for bankruptcy not just once, but twice. But, when it comes to investing, things are never as simple as they seem. US Airways has more than doubled so far in 2012, rallying largely due to hopes of a merger with American Airlines (something we will address at length later on).
(click to enlarge)However, US Airways' share price remains a shadow of its former self. Shares traded at over $60 back in 2006. While we are not suggesting that they can quickly rally back from under $11 to $60, we do believe that at a price of under $11, shares of US Airways are undervalued. For the record, unless otherwise noted, financial figures and management commentary will be sourced from one of 3 places: US Airways' Q2 2012 conference call, its Q2 2012 earnings release, or its latest 10-Q filing with the SEC.
US Airways reported its Q2 earnings on July 25, and they were a record for the company in terms of both earnings and revenue. US Airways posted GAAP EPS of $1.54 and non-GAAP EPS of $1.61 on revenue of $3.754 billion. The PRASM (passenger revenue per available seat mile) came in at 16.3 cents, up 6.1% from Q2 2011 and was also a record for the company. Operating margins came in at 10.761%, up from 5.053% in Q2 2011. This increase was driven by strong cost controls across the entire company. Fuel expenses dropped by 2% (more on this later), rent and landing fees dropped by 9.1%, and maintenance costs dropped by 4.6%.
US Airways' earnings call was a bit awkward at times, for analysts didn't really care that much about asking anything other than questions relating to American Airlines, and company executives made clear that they didn't want to talk about the issue beyond the standard company line that this merger will benefit everyone involved. However, there was one particularly useful insight on this conference call, and it has to do with the very sustainability of US Airways. Analysts pressed the company on whether or not it can even compete on a standalone basis against Delta and United. We were pleased with how CEO William Parker responded to these questions. He stated that,
I just will tell you what we always have as planned, what we said consistently for a long period of time, which is we have an airline that works and a model that works. And these results prove it better than anything else I can say. So I think we all know that, and we've established that. We're -- we can continue to do or do it on a standalone basis. That model is different than others. It's a model that works with a network that is very, very strong but not quite as strong as -- not as strong as United and Delta's. And therefore, it doesn't generate the same revenue per ASM as they do. So we offset that me having a cost per ASM that's lower than theirs, and we do that with a labor cost structure that is lower than theirs. And that results in -- sometimes some extended labor negotiations, but we get them done, because we know that's the only way the model works, and our employees know it's the only way the model works and as do those that regulate labor negotiations. So all those things come together, and that's how it works. It doesn't mean we can't have nice pay increases for our people. It doesn't mean it can't be great place to work. It can be all those things, and it will be. So that model works but that's the model. There is another model that might work even better and that would be -- that may be better for our shareholders and better for our employees and that would be to combine our existing strong network with another strong network and getting our revenue-generating capabilities up to those similar to United and Delta's. So that -- you know you'd have strong revenue-generating capabilities, and you also would, therefore, allow some of the benefits of that to accrue to employees and the shareholders as well. So we look at those opportunities all the time. We always look at those opportunities and those opportunities I think would exist with any other 3 network airlines other than US Airways.
While Parker made clear that he wants US Airways to merge with "another strong network," he also made clear that US Airways has a model that works for it, and a model that can work on a standalone basis. We agree with that assessment. US Airways' latest quarter showed that the company can thrive on its own, and that it is not an absolute requirement.
Analysts noted that the company has been building a strong cash pile, which currently stands at $2.515 billion, which is more than the company market capitalization of $1,731,157,414 as of this writing (that is a gross amount), and US Airways has $4.483 billion of debt on the balance sheet. US Airways has net debt of $1.968 billion, which the company is slowly but surely paying down, even if it is not with the same speed and focus as Delta. On the call, CFO Derek Kerr said that while US Airways will drain cash in the second half of the year, this is due largely to seasonality, and the company's plan is to continue to build its cash pile, and not accelerate debt repayments. In the first two quarters of 2012, US Airways paid down $263 million of debt.
The company also stands ready to refinance a large chunk of its debt. US Airways has $1.12 billion of debt due to Citigroup (C) in March 2014, as well as another several hundred million in other debt due that year. CFO Derek Kerr said on the call that the company is working with banks to refinance this debt, but that it is waiting to find the right proposal and will not simply jump at the earliest opportunity.
CEO William Parker also jumped in after this question, laying out his views on the cash issue. Parker said that his primary focus is to generate cash at this point, and that he regularly evaluates whether or not to begin paying down debt. Parker said that, in his view, the issue of cash is directly related to the issue of investor confidence (given the fact that US Airways has been through bankruptcy twice, this is especially important). Every airline industry observer knows how bad things have been in the past, and no airline wants to be left without a cash cushion in the middle of an economic crisis. But, Parker did also add that he thinks simply holding cash is inefficient in the long term.
Specifically, he stated that,
it certainly is inefficient to hold as much cash as the industry is holding and gain the returns on that cash we're getting. But given what we've all been through in the past, I think we all are trying to be extremely prudent to make sure we don't get our -- we don't put our companies at risk until we're absolutely certain that the industry's restructured in a way that we won't have those kind of changes in the past.
The onus is on airlines to prove that they are not the same companies of even a few years ago. And strong cash positions go a long way toward achieving that goal. However, we do think that US Airways needs to find a proper balance between cash generation and debt reductions. Debt reductions have a clear benefit on an airline's bottom line. For example, Delta's interest expense dropped by 11.16% in its latest quarter. And United's dropped by 14.8%. Interest expenses at US Airways, however, rose by 7.2% this quarter. While we do think that cash generation is important, US Airways must not ignore rising interest costs. We will be watching this trend closely in the next several quarters.
Hedging: Frankly, It's All a Wash
Each airline deals with fuel costs in a different way. Delta uses complex swaps to lock in the cash costs of its fuel (the airline's GAAP fuel expense included adjustments related to its hedges). Delta trades potential cost savings in a low-price environment for certainty. Hawaiian favors call options. While they may be more expensive, they give Hawaiian a ceiling price for its fuel while still allowing it to benefit should fuel prices fall. Because Hawaiian is primarily a leisure airline, this allows it to weather economic stress better than other airlines. Much of the impact from a drop in passenger yields can be offset by lower fuel costs. And what about US Airways? What does it do to hedge fuel costs? The answer is nothing at all.
CFO Derek Kerr has consistently argued that hedging fuel costs is far too expensive relative to the benefits it provides. Investors need to understand that there is no perfect approach to controlling fuel costs. Each approach has its own set of costs and benefits. For US Airways, embracing the spot market for fuel means that it shares in both the ups and downs. In this latest quarter, fuel expense at US Airways dropped by 4.4%. Delta's fuel costs rose by 24.108%. United's rose by 5.609%. And Hawaiian's rose by 11.068%. But, it is important to remember that fuel expenses at US Airways can rise much easier than at most other airlines, as there is nothing in place to prevent it. Everyone who applauds US Airways for not hedging today may criticize the company for not hedging when oil prices rise. In our view, investment decisions in this sector should not hinge on hedging practices (or a lack thereof). We believe that it's all a wash in the end.
American Airlines: Progress Toward a Deal
The courtship of American Airlines by US Airways has been done in the open since Day 1. US Airways has made no secret of its desire to see a merger with American Airlines, and the markets have made no secret of their desires as well. US Airways opened its latest conference call by making the case that a merger will benefit everyone involved, including employees, passengers, and investors. US Airways has been aggressive in courting the support of American's unions and creditors, for it is anxious to avoid a repeat of what happened when it tried to take over Delta when it was in bankruptcy. US Airways made it clear that while it does not need a merger, it certainly wants one.
CEO William Parker stated that,
as evidenced by our record second quarter results and how well they compare to the other airlines, it's quite clear that US Airways has a great business model that works and we certainly don't need to merge with another airline. However, we do believe a combination of US Airways and AMR is in the best interest of both -- of AMR and its stakeholders, US Airways and its shareholders and the employees of all companies. All 3 of Americans unions, representing over 55,000 employees agree and support a merger of AMR and US Airways. And last week, APFA joined APA and TWU in sending AMR's offer to its union members for a vote. So if, as the 3 unions, and we have been advised, those labor agreements are a prerequisite for the AMR's strategic alternative process to move forward. We welcome those efforts.
While US Airways may not need a merger, a combined US Airways/American Airlines would instantly be stronger, and join the ranks of Delta and United as one of the leading carriers. US Airways will bring its cost discipline, while American will bring major international exposure and the leading position in its alliance. While US Airways is currently a part of the Star Alliance, no one will dispute that it is in the second tier of this alliance. The top tier is held firmly by United, which is the flagship carrier of this alliance, just as Delta is the flagship carrier of the SkyTeam alliance. American, however, is the flagship of oneworld, and a merger with it will make US Airways a flagship carrier equal in standing to United and Delta.
And in recent days, it seems that merger talks have intensified. On August 31, US Airways and American Airlines signed a non-disclosure agreement so that they can move forward in evaluating a merger. Investors will need to have patience, but so far, we are optimistic that a merger will indeed take place. US Airways has made it clear that it wants a deal, and American has warmed up to the idea. While we do believe that a deal with American will make US Airways stronger, we still believe that the company has potential even if it remains a standalone entity.
Valuation: The Future Seems Bright
Like almost every airline, US Airways trades at a substantial discount to the broader market, due in large part to the "haircut" it receives on its multiple due to the fact that it is an airline. However, we believe that in the long run, US Airways and the broader airline sector will see multiples expand as they prove that they can post consistent profits and avoid the mistakes of the past. And until that day, investors can take comfort in the fact that valuations in this sector are not stretched. As of this writing, shares of US Airways are trading at $10.66, giving the company a multiple of 3.74x estimated 2012 EPS, and 3.11x estimated 2013 EPS.
Earnings per share at US Airways are set to soar by over 319% in 2012, and are set to grow by 20.35% in 2013. Revenues, however, are set to grow just 6.15% in 2012, and 3.62% in 2013. This disparity is a testament to US Airways' ability to control costs, and further highlights the benefits of a merger with American Airlines, for a combination of those cost skills with American's international presence would be a powerful combination.
The US Airways of today and the US Airways of tomorrow are far different than the US Airways of even a few years ago. The company's latest quarter was a record in terms of both revenue and profits, and we believe that the company is stronger than ever. Even without American Airlines, US Airways will thrive, for it has a proven model. And if the company does indeed combine with American, the future will be even brighter. For long-term investors, the US Airways pullback from its July high of over $14 presents a good entry point, and we believe that shareholders who keep their faith with US Airways will be rewarded.