9/27/2011 5:00 PM ET|
Bluer skies ahead for airlines
After a weak first quarter, battered airline stocks seem poised to soar. Five stocks in particular seem most likely to take off.
The managers of U.S. airlines finally have become "more concerned about profits than market share," says Ray Neidl, a senior aerospace analyst at Maxim Group in New York. And that's great news for investors.
The industry broke even in the seasonally weak first quarter, was profitable in the second and probably will earn more than $1 billion in the third quarter. The respectable results have come despite a 40% jump in jet-fuel prices in the second quarter from the year-earlier level, to more than $3 a gallon.
The improved outlook isn't evident in airline stocks, most of which have been pummeled this year on concerns about those fuel costs and the economy, plus memories of the bankruptcies of carriers including United Airlines, Delta Air Lines (DAL), US Airways Group (LCC) and Northwest Airlines over the past decade.
An emphasis on profitability, rather than market share, is lifting the prospects of U.S. airlines. This, in turn, should lift the stocks of the best-run carriers.
Indeed, despite their healthier prospects, airline stocks remain best suited for risk-tolerant investors. "They're the ultimate high-beta, economically sensitive stocks," says Michael Linenberg, the airline analyst at Deutsche Bank. "They're the first stocks that people get out of." High-beta stocks are more volatile than the overall market.
Adding to the potential volatility: Airline earnings estimates for 2011 have fallen since the start of the year, in part on worries that business travel, which accounts for an estimated 65% of carriers' revenue, may be weak. But airline-stock valuations look compelling. And they'll look even more so if fuel costs stabilize -- a distinct possibility, given the likely resumption of Libyan oil exports by year's end -- and the U.S. economy doesn't slide back into recession.
AMR, parent of American Airlines, is down more than 50% this year to about $3.50, not much above its 2009 low. Delta is off by a third; United Continental (UAL) has fallen about 25%; Southwest Airlines (LUV) has dropped about 35%; and JetBlue (JBLU) is off about 35%.
Some of the better plays are United Continental, Delta, Alaska Air (ALK), Southwest Airlines and JetBlue. All are expected to operate in the black this year. United Continental has an excellent network, including hubs in Newark, N.J., San Francisco and Chicago, plus lucrative Pacific routes. Delta is benefiting from the integration of its merger with Northwest. And United and Delta trade at just four times projected 2012 profits.
Alaska Air has industry-high profit margins of 13% and a solid niche on the West Coast. Southwest has the best balance sheet and a history of making money in good times and bad, while JetBlue has one of the newest fleets, loyal fliers and a growth strategy keyed to Boston and the Caribbean.
Since the Sept. 11, 2001, terrorist attacks, which disrupted airline travel around the world, the industry has chalked up big cumulative losses.
AMR, parent of American Airlines, is the group's riskiest stock, because it's losing money, owing to a high cost structure. US Airways Group has good management but a relatively weak route network, limited international exposure and near break-even results.
Overall, says Gary Chase, the airline analyst at Barclays Capital: "I don't think the fundamentals are as bad as what the stocks are suggesting. The market is discounting some probability of a global financial crisis."
It's understandable that investors are down on airlines, because most have significant debt, and their profits are acutely sensitive to changes in revenue. While most industry executives sounded upbeat on second-quarter conference calls, Southwest CEO Gary Kelly was cautious: "I am concerned about the U.S. economy. I have concerns about fuel prices."
Given their volatile history, airline stocks scare many long-term holders. But they're frequently trading vehicles for hedge funds and others seeking high-octane plays on energy prices and the economy.
Institutions often avoid stocks with negative profit revisions. United Continental now is expected to earn $3.30 a share in 2011, down from a forecast around $5 per share at the end of 2010. AMR is expected to lose almost $4 a share this year, versus a profit projection of 23 cents per share at year-end 2010.
Barclays analyst Chase is encouraged that airlines are doing a better job of aligning supply and demand, with the major carriers reducing domestic capacity as they retire older, less-fuel-efficient planes.
Comments Deutsche Bank's Linenberg: "The industry is reaping the benefits of a significant restructuring and greater concentration. For the first time in history, it is deleveraging its balance sheet." It's also consolidating. Pairings in recent years include Delta and Northwest, Continental and United Airlines, and USAir and America West.
United, Delta, Northwest and USAir used bankruptcy to restructure labor agreements, aircraft-leasing obligations and pension plans, to become competitive with low-cost carriers like Southwest and JetBlue.
While debt levels remain high, several airlines are reducing leverage. Delta has cut net debt by $3.2 billion, to $13.8 billion, in recent years. In the second quarter alone, it slashed its obligations by $700 million, and its goal is to trim debt to $10 billion.
One big positive: Airlines have a lot of cash. At the end of the second quarter, United Continental had more than $8 billion; AMR, $5.2 billion; and Delta, $3.8 billion. JPMorgan analyst Jamie Baker noted recently that airlines' enterprise values (stock market value, plus net debt) had returned to 2009 lows. Equity values may be higher, but debt levels are down. Baker wrote that while he was "frightened" for the industry in 2009, during the financial crisis, he's "merely concerned" now, arguing that the "risk-reward appears highly attractive" for investors willing to take a mildly optimistic industry view. The combined market value of the seven major carriers is only $25 billion, while their combined enterprise value exceeds $80 billion.
The bear case is that airlines are too unpredictable and too vulnerable to changes in demand and the price of jet fuel, which may cost the industry $54 billion this year, up from $39 billion in 2010. Every $1 move in crude affects industry profits by $400 million. And, unfortunately for airlines, jet-fuel costs are based on international oil prices, recently above $110 a barrel, not U.S. benchmark crude, around $90.
Trailing the market
The volatile industry, which has suffered multiple bankruptcies in the past decade, has flown well below the Standard & Poor's 500 Index ($INX).
Many investors hate industries like airlines because of their strong unions; it's hard to get labor concessions in bad times, and the unions tend to push for a greater share of profits in good times. However, airlines probably are now managed better than ever, remaining profitable despite a weak economy and high fuel costs -- something unthinkable a few years ago. And most are determined to deal with their unions.
Despite complaints from travelers, the industry delivers a valuable service at a price that's usually reasonable. The average domestic round-trip ticket cost $316 in 2010, little changed over a decade. In fact, adjusted for inflation, ticket prices are down more than 40% since airline deregulation took hold in 1979. Travelers usually can still fly coast to coast for $500 or less, round-trip.
Airlines have shrewdly gotten creative about charging for things that formerly were free, such as transporting baggage and providing meals. Bag-check fees alone totaled $3.4 billion last year, up from $500 million in 2007. So-called change fees to modify reservations generated an additional $2.3 billion last year. Pay American a fee, and you can get expedited clearance through security and access to airport lounges. United and others offer seats with extra legroom in coach for an additional charge.
Airlines reaped $5.7 billion last year from fees on checked baggage and reservation changes. These fees are helping airlines offset much higher fuel costs this year.
Starting from the top
A brief look at seven airlines, ranked in order of their appeal:
United Continental: It's emerging as the class of the industry, after the 2010 merger of the two carriers created the largest domestic airline, with projected revenue of $37 billion this year.
Even without much financial benefit from the deal, the carrier had an operating margin of almost 9% in the second quarter, behind only Alaska Air. The merger savings ultimately could total $1 billion a year, hinging in part on greater cooperation from United's historically difficult unions. That's a key risk. At around $18, the stock recently traded at under six times projected 2011 profit of $3.30 a share, and just four times 2012's estimated $4.75. Deutsche Bank's Linenberg sees United generating $2.1 billion of free cash this year. His 12-month price target is $31.
Delta: That it has largely completed its integration with Northwest has helped Delta greatly. The stock, recently around $7, is a favorite of Maxim Group's Neidl, who wrote that it's "reaping the benefits of its new powerful route system and worldwide alliance." The consensus earnings estimate of nearly $1 a share for 2011 and $1.75 for 2012 "could be light" if the economy avoids recession and global oil prices hold. Linenberg carries a price target of $16.
Alaska Air: It has been the top-performing domestic airline stock this year, mostly because 2011 profit estimates have increased, and now stand at $7.64 a share. Alaska Air had its fifth straight record quarterly profit in the June period, and it's paying down debt and buying back small amounts of stock. Analysts credit veteran management, good labor relations, an underappreciated West Coast network and popularity with leisure travelers. Much of its growth is coming from West Coast-to-Hawaii routes, with the company avoiding competitive San Francisco and Los Angeles airports and flying such routes as San Diego to Honolulu. Linenberg's target: $80.
JetBlue: An investor favorite after its hot 2002 initial public offering, JetBlue now sells for about half its IPO price and a fraction its 2003 peak. It continues to grow, largely in Boston and the Caribbean, but its margins are under pressure, as are its profit estimates. Analysts now expect the airline to earn about 20 cents a share this year, versus 44 cents at the start of this year and 60 cents when Barron's wrote favorably about the company a year ago.
The stock may have bottomed. JetBlue is trading below its book value of $6 share, has a good balance sheet, a young jetliner fleet and a strong reputation among leisure travelers who like its free satellite TV, ample legroom, comfortable leather seats and employees' irreverent attitude.
Southwest: The longtime industry financial leader has seen its status erode, as rivals narrow cost advantages. After second-quarter profit missed Street estimates, analysts cut their 2011 forecasts to an average of 36 cents a share, from 60 cents, and also trimmed 2012 projections. Southwest stock, recently at about $8, may find support now, because it trades below its book value, about $9 a share. The airline has both a strong management and balance sheet, as well as fuel hedges that should offer protection if oil prices rise. While Delta and United Continental may be better values, Southwest probably would have the most staying power in an extended downturn.
US Airways: It has the worst route system of any major carrier, the weakest financial performance except for AMR, and virtually no fuel hedges. The airline is seeking to improve its competitive position by swapping gates with Delta to secure a larger presence at Reagan National, near Washington, in return for slots at New York's LaGuardia. Profit estimates for 2011 and 2012 came down after second-quarter results fell short of expectations. US Airways is expected to operate around break-even this year and earn just over $1 per share in 2012. There's plenty of upside in the stock if fuel prices drop and profits turn higher.
AMR: The stock, recently around $3.50, amounts to an option on the carrier's ability to return to profitability. AMR lost 85 cents a share from operations in the second quarter, by far the industry's worst performance, and is expected to lose almost $4 a share this year. Management is betting on a turnaround keyed to new airplanes; the company has announced that it will order 460 new Boeing (BA) and Airbus jets over the summer. It also is seeking labor concessions and may spin off its regional-jet business. While justifiably proud of being the only major carrier to avoid bankruptcy, AMR couldn't restructure labor agreements, as the bankruptcy crowd did.
Maxim Group's Neidl writes that AMR is "only for those" who believe that it can make major changes and return to consistent profitability. If current trends continue, AMR may be forced into a financial restructuring, which would be bad news for shareholders.
Given the risks in the airline industry, investors probably should stick to its strongest, most profitable members. Right now, those are United Continental, Delta, Alaska Air, Southwest and JetBlue.
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