United Airlines (UAL) Short Thesis

Summary

• Increase Spikes in COVID-19 will force other countries to continue their travel bans and quarantine measures against the US.
• The extended travel bans and quarantine measures will decimate airline's international Revenue. UAL is the most over exposed US airline to international flights.
• Price Target $23.69 per shares. Time horizon of 1-6 months.

Summary

This paper is a top-down analysis of the airline industry as of June 24, 2020, that will conclude with a short thesis for UAL. Increase spikes in COVID-19 in the US will force other countries to continue to enforce travel bans against the US. As a result, International Revenue for airline flights will continue to be decimated into Q1-Q2 2021 which is not priced into the stock. According to my analysis, UAL should be valued at approximately $24.00 per share.

Macro Outlook

For the last few months, the FED has introduced massive amounts of liquidity into the markets inflating equities asset prices. This combined with the significant increase of retail buying into airlines with the expectations that the airline industry will return to ATH within the next year, has created a bubble within the airline industry that is ripe for shorting. In the figure below, that is the price of UAL shown with the number of Robinhood retail traders that own UAL.

This demonstrates the dash-to-trash phenomenon that is often associated with market crashes: retail traders pile into garbage stocks that have dropped 60-80% from ATH with the expectations that the stock will recover. However, it is my belief that UAL is not one of those stocks that will return to ATH anytime soon.

Furthermore, the May 2020 Manufacturing and Non-manufacturing index (ISM and NMI) have shown that the transportation industry has continued to contract for the month of May. Despite this fact, airlines have doubled in price since their lows in April, demonstrating mispricing in the market.

Sector Analysis

Based on my Macro analysis, we are seeking a US company with heavy International Revenue exposure and significant earnings deterioration. In the figure below, you can see that out of the 3 US airline companies that do release domestic vs international revenue, UAL has the highest exposure to international revenue (column J). Furthermore, they are expected to have the 3rd largest earnings deterioration out of all airline companies, making UAL a prime short candidate (column I).

UAL in relation to COVID

As mentioned before, UAL has the highest international flight exposure with available data at slightly under 40%. Due to COVID-19, travel demand has been decimated to the point where UAL has decreased their international flights by 85% and domestic flights by 42% and even then UAL could not fill their planes. It is my thesis that COVID-19 will continue this trend of significantly reduced travel demand into Q2 2021. This is because of 2 reasons: COVID-19 2nd wave and 0 political incentive of other countries to remove travel bans from the USA. It is my prediction that due to political pressure in the US and high unemployment rates, the US will be forced to reopen the economy which will cause a massive spike in COVID-19 cases. As a result, other countries will extend their travel bans and quarantine measures against US travelers, and as a side effect, decimate international airline revenues. It is very likely that all other industries will be allowed to reopen due to internal political pressure; however, that pressure has no effect outside the US. New Zealand is a country that demonstrates this example. As of June 24, 2020, New Zealand has completely eliminated COVID-19 cases from their country; however, they have continued to enact their travel restrictions for fear of reintroducing COVID-19 back into their country.

Following China’s timeline, we can expect the 2nd wave of COVID to hit the US around September. As a matter of fact, we are currently seeing significant COVID-19 spikes in June which lowers other countries' confidence in relation to the US. With these facts in mind, I believe it is a fair assumption that countries will continue to enact travel restrictions against the US until at least Q2 2021, and will force UAL to continue with their 85% reduction in international flights. Furthermore, certain states in the US are considering quarantine measures against other states in the US with high levels of COVID-19 infections, causing a significant decrease in domestic revenue as well as international revenue.

UAL response to COVID-19

In response to COVID-19, UAL has raised $7.85B from loans, aircraft financing, and equity offerings. In addition to that, they raised an additional $3.5B grant and $1.5B 10 year equity loan from the CARES Act. In total, UAL has $7.9B in cash after accounting for Q1 2020 net loss. Furthermore, UAL has greatly slashed Capital Expenditures from $4.5B to $2.5B with an average of $40-45M cash burn per day for Q2. Due to the increasing price of crude oil since April 2020, CapEx will probably be on the high end of estimates since fuel is the second highest CapEx after salaries.

UAL Demand and Revenue Analysis

A quick analysis of UAL domestic and international load factors will highlight the lack of demand for airline travel.

In the figure above are the seat reservations for the domestic flight of Seattle to San Francisco. UAL has blocked the purchases of all middle row seats in order to maintain social distancing. As a result, only 59.14% of the seats are filled.

In the figure above are the seat reservations for international flights from San Francisco, US to Tokyo, Japan. Similar to their domestic flight policy, UAL has blocked all middle aisle seats. As a result, this flight is only filled at 30% capacity.

Extrapolating these statistics and assuming that UAL will continue to reduce international flights by 85% and domestic flights by 40%, we can estimate Q2 revenue:

Q2 Revenue = International Revenue + Domestic Revenue = Q2 2019 Total Revenue * Domestic revenue % * % of domestic flights + Q2 2019 Total Revenue * International revenue % * % of total international flights = 11,402 * 0.38 *0.5914 + 11,402 * 0.15 * 0.30 = $3.075B for estimated Q2 Revenue. Assuming similar Revenue results due to COVID restrictions for the rest of the year and $7.979B revenue for Q1, we get 7.979 + 3 * 3.075 = $17.204B revenue for fiscal year 2020.

Price Targets using Sales multiples

Since EPS is expected to be negative, we will use annual sales multiple to determine price targets. UAL yearly sales multiple hovers around 0.5. 0.5 * $17.204B = $8,602B market cap for UAL. Divide that by the number of shares outstanding (290.430M), we get a price target of $29.61 per share.

However, since the earnings outlook for UAL has been decimated, I believe that the sales multiple for UAL should be smaller than the normal sales multiple of 0.5. Using a conservative estimate of -20% decrease in sales multiple and using the same calculations as before, we derive a price target of $23.69 per share.

Catalysts

There are multiple catalysts that can move UAL in either direction. Potential catalysts over the next 3 months are but not limited to COVID-19 news, UAL new bond issues, Earnings, Extension of lockdowns, Extension of shutdowns for any travel industry (etc), 2nd stimulus check.

Historical and Implied Volatility Analysis

I analyzed historical volatility using the Average True Range method as depicted in the chart below.

This shows that on average, UAL has moved a total of 11.27% since the start of COVID per day, and 52% per month. In the next figure below, this is the implied volatility and expected move of the 40.00 put in the given time frames.

Given the high historical and implied volatility, UAL is a very volatile stock and that fact will need to be taken into consideration in the best possible way to express this trade idea.

Trade Structures

I recommend two potential trade structures to express a UAL short position: a pairs trade with another airline company, or a Horizontal put option spread.

For the pairs trade, I recommend shorting UAL and going long on an airline company with low international revenue exposure such as LUV. The purpose of the pairs trade is to hedge out market and airline sector risk.

For the Horizontal spread, I recommend selling one 7/31 28 put at the current price of $240 per contract and buying two 8/21 33 put at $555 per contract. The total cost of this spread will be $315.00 per spread. In this ratioed spread, the best-case scenario is if UAL stays above $28 until 7/31 and then drops to our price target of $20 at the 8/21 expiration. For this scenario, we will earn $985.00 per spread or a risk-reward of 3.13 to 1 ratio. Worst case scenario, the price of UAL stays above $33 per share and we lose the entire premium. If the stock price plummets to $20 before 7/31 expiration, then we would make $85 per spread.