Based on past performance, airline stocks deserve their reputation as terrible investments. All three of the major full-service carriers operating today–American Airlines Group (AAL), Delta Air Lines (DAL) and United Continental Holdings (UAL)–have declared bankruptcy at least once.
However, investors shouldn’t overlook fundamental changes in the airline industry that have transformed these perennial losers into big winners.
The New York Stock Exchange ARCA Airlines Index trades at about 10 times forward earnings estimates; this multiple could expand to between 13 and 15 times 2014 consensus earnings expectations, thanks to improving profitability, rising dividends and a wave of stock buybacks.
We foresee additional upside for shares of our favorite U.S. air carriers, due to:
American Energy Liberty = Lower Fuel Costs. U.S. oil production has surged from about 5 million barrels per day in 2008 to almost 8 million barrels per day by the end of 2013.
Demand for Travel. Trends in business travel historically have tracked corporate profits and economic activity. Not only did third-quarter corporate earnings climb by 5.7% from year-ago levels, but the Purchasing Managers Index for manufacturing also came in at 57 in December 2013–one of its strongest readings since early 2011.
Supply: Less Capacity, Higher Profits. The industry has concentrated efforts to address long-standing capacity problems by retiring older planes and cutting unprofitable routes. A wave of consolidation has also improved the industry’s fortunes.
Rising Demand + Shrinking Supply = Higher Profits. The post-recession recovery in air travel, coupled with reduced capacity, translates into fewer empty seats on each flight.
Airline Valuations. We continue to prefer the full-service airlines over the low-cost carriers due to improving yields and profitability. Of the three major carriers, American Airlines and Delta Air Lines offer the best upside potential.
Delta Air Lines’ (DAL) partnerships with leading European carriers Alitalia and Air France-KLM (Paris: AF, OTC: AFLYY) give it access to hubs in Amsterdam, Paris and Rome. All told, Delta and its partners account for about one-quarter of the airline industry’s total trans-Atlantic capacity.
Delta’s joint venture with Virgin Atlantic Airways is expected to benefit the company to the tune of $120 million, and gives Delta better access to Heathrow, where some 85% of all passengers on the 10 most traveled U.S.-Europe routes pass through.
Management also deserves plaudits for Delta Air Lines’ acquisition of the Trainer refinery in Pennsylvania.
Delta Air Lines continues to deliver on plans to reduce debt and return capital to shareholders, paying off $1.5 billion in borrowings and allocating $700 million to its dividend and stock repurchases.
Delta Air Lines rates a buy up to $34.00 per share.
Based on the Bloomberg consensus estimate for 2014, shares of American Airlines Group (AAL) trade at 7.9 times forward earnings, compared to multiples of 10.2 for United Continental Holdings and 11.1 for Delta Air Lines.
This discount likely reflects concerns that the integration process may encounter some of the same technical difficulties and performance challenges that have plagued United Continental Holdings.
These risks appear overblown. The new management team, led by former US Airways CEO Doug Parker, has considerable experience integrating complex mergers, including the successful merger of America West Holdings and US Airways in 2005.
American will remain in One World, an alliance that includes British Airways, Cathay Pacific Airways (Hong Kong: 0293, OTC: CPCAY) and Japan Airlines (Tokyo: 9201), giving American an impressive network of Asian and European connections for its international passengers.
At a minimum, American should bridge the valuation gap between itself and Delta, implying a stock price of about $38.00 rates a buy on any pullback to less than $33.00 per share.
Elliott Gue & Roger Conrad, Capitalist Times, www.capitalisttimes.com, 888-960-2759, Jan. 31, 2014
