Despite strong performances from 2013 and early 2014, most airline stocks still trade well below the S&P average and the transportation sector as a whole. While airline stocks do carry their own risks, two airlines offer valuations that are extremely difficult to find in this market.
The world's largest
Late last year, American Airlines and US Airways got the go-ahead to begin the process of creating the world's largest airline. The new airline company, American Airlines Group (AAL 1.51%), has taken the title of the world's largest airline and is likely to hold on to that title since United Continental Holdings (UAL 1.59%), Delta Air Lines (DAL 4.05%), and Southwest Airlines (LUV -6.96%) are all products of megamergers themselves, and mergers between these megaairlines would have a tough time passing antitrust scrutiny.
Source: American Airlines Group.
Using estimates from Nasdaq, American Airlines Group shares trade at less than six times FY2015 earnings and only 5.3 times FY2016 earnings. From a valuation perspective, this appears highly favorable compared with the S&P 500 at 16.3 times forward earnings and the Dow Transportation Index at 18.5 times forward earnings.
If American Airlines Group can meet analyst expectations and earn a valuation of 10 times earnings, a level still well below the market average, shares could nearly double by 2016. This scenario requires a lot of things to go right for the airline but does help show the potential bullish outcome.
On the risk side, American Airlines Group carries a higher level of integration risk than its peers, since it still has to do the heavy lifting of integrating American Airlines and US Airways. While the integration of Delta Air Lines and Northwest Airlines went fairly smoothly, the integration of United Airlines and Continental Airlines encountered more turbulence, resulting in annoyed passengers and prolonged inefficiencies. So far, the integration at American is progressing along without any major hiccups, but all eyes will be on labor contracts and the integration of the frequent flyer and reservation systems.
From a valuation perspective, American Airlines Group is one of the best candidates in the industry today. However, because of a massive fleet modernization program, the airline will have limited free cash flow, and investors should look for gains through a rising stock price rather than dividends.
Canada's largest airline
The past few years have been volatile for Air Canada (TSX: AC.B), with the airline brushing close to insolvency in 2012 before its shares rallied hard in 2013 and early 2014. Despite providing multibagger gains for shareholders, Air Canada shares still trade at only 3.7 times FY2015 earnings, using estimates from Nasdaq.
Source: Air Canada.
At this valuation, I view Air Canada shares as highly attractive and could see shares producing another double over the next few years as earnings grow and the stock sees multiple expansion.
That's not to say Air Canada is a risk-free investment. The airline is still exposed to the Canadian dollar's value, since much of its debt is U.S. dollar denominated. Additionally, oil and most types of aircraft are priced in U.S. dollars.
Air Canada is also relying on international flights for much of its growth. While this should help the airline grow capacity without saturating the domestic Canadian market, it does mean Air Canada could face additional risks from slower foreign economies. This international expansion through mainline Air Canada and its discount subsidiary, Air Canada rouge, is something all airline industry investors should watch.
What about Ebola?
The Ebola outbreak in West Africa has been on investors' minds as more cases are reported in West Africa and a select few in the United States and Europe. However, airlines seem to be feeling little financial damage from the outbreak, with American Airlines Group noting only a short dip in bookings before a quick recovery.
Air Canada still has yet to report earnings, but I see any major effect from Ebola on this airline as unlikely, considering none of the four major U.S. airlines had any significant impact to bookings. Additionally, Canada has advanced health care infrastructure and the resources to counter Ebola at home.
While Ebola is still worth keeping an eye on from an investment perspective, the financial losses for airlines are dwarfed by the humanitarian losses in West Africa.
Industry turnaround
While airlines still do face elevated risks compared to most other transportation companies, they have made major progress over the past several years in stabilizing their operations. Capacity discipline and consolidation have gone hand in hand for carriers, leading to fuller planes and higher fares.
Unlike the old market share strategies where capacity was used as a weapon, today's U.S. legacy carriers are growing their capacity at rates close to GDP growth. Air Canada is looking for faster capacity growth but is doing so mostly on international routes; many of which it does not currently serve. While this does expose Air Canada to more foreign economies, its provides the airline with a way to grow capacity without saturating the domestic Canada market.
Although oil prices could remain volatile, airlines are also benefiting from a strong tailwind in the form of lower fuel costs. Considering Delta, American, and United Continental each expect to use around 4 billion gallons of jet fuel in 2014, the drop-off in oil prices should be a big earnings booster as long as oil remains cheap.
Airline sale
American Airlines Group and Air Canada each carry their own risks, but I think both stocks could be attractive for value investors with a moderate amount of risk tolerance. Lower jet fuel prices could also act as a major tailwind for Q4 earnings and possibly beyond. While nothing is guaranteed in the market, this combination of growth and value make American Airlines Group and Air Canada worth looking at for risk-tolerant investors.
