1-Star Stocks Poised to Plunge: UAL?

• Report this Comment On June 09, 2010, at 2:56 PM, 50percentreturns wrote:

  You fools never cease to amaze me. You fools have been saying the same thing when this stock was $3.50. It's now over $20. You fools know nothing about the airline business. It's obvious that your foolish experts got burned on this stock, probably after bankruptcy. Get over it. This stock is heading for $30 by years end. Do the math.

• Report this Comment On June 09, 2010, at 4:05 PM, PAQuaker wrote:

  UAL should not plunge, it should climb, and it's due to capacity, modest GDP growth, and forecasted oil price...

  Today’s Airline Economics: It’s the Intersection that Matters

  Recommendations:

  Strong Buy: USAirways, United Airlines (UAL)

  Buy: Continental Airlines (CAL), Delta Airlines (DAL)

  Hold: American Airlines (AA)

  America’s bankruptcy courts are littered with the corpses of business men and women who thought they could make money in the airline industry. Ah…high fixed costs, low marginal costs, capital intensive, perishable inventory, commodity product, government regulation, unionized environment, and terrorists love the attention the airline industry brings. And I didn’t even mention oil price volatility. I mean, from an investor’s point of view, what’s not to love? Even Warren Buffet has sworn off airlines.

  While I wouldn’t be foolish enough to encourage long-term investing in the airline industry, at least on the equity side, now may be a good time to look at airline stocks if you are seeking some sizeable returns, albeit for a relatively short time period of 6-12 months.

  Airlines in 2010 and 2011

  You can’t forecast 2010 without looking at both 2008 and 2009. Because oil went crazy in 2008 and yield plummeted in 2009, it’s best to actually look at revenue from 2008 and expenses from 2009, without including fuel hedge gains or losses. When you combine the two years, you can see that 2010 should be a fairly healthy year for the airlines. While fuel expense will be higher in 2010 vs. 2009, Passenger Revenue per Available Seat Mile (PRASM – or airline revenue divided by seat supply) will be higher in 2010 vs. 2008.

  In the first quarter, PRASM was up between 10-20%, depending on which airline you examine. April PRASM improvement, year-over-year, was even better, as much as 13% higher at USAirways and 23% higher at United. While this improvement may seem unrealistically high, the bottom of the PRASM trough in 2009 was in May/June, so I expect 2nd Q PRASM improvement to exceed April, by an average of 3-7%. While forecasting a 28% (the highest among the airlines) PRASM improvement for UAL may seem a bit aggressive, the PRASM drop off in the 2nd quarter of 2009 was just as aggressive. PRASM in 2010 is simply 4-7% higher than 2008, to help keep perspective. If we assume capacity discipline will continue (a pipe dream for some), I expect PRASM to improve a further 2-5% in 2011 vs. 2010 given modest GDP growth.* This PRASM growth will be determined by capacity growth vs. GDP growth. I expect PRASM growth to meet or exceed expected increases in non-fuel expenses, driven mainly from wage increases at UAL, CAL, USAirways, and possibly AA. This should improve operating margins.

  *6/5/10 Update: US job report released June 4th was weak, which is actually a good sign for 2011. If the major airlines have been able to generate significant increases in PRASM with a weak jobs report, I suspect 2011 will be an even better year, improving PRASM an additional 2-4% from previous forecast to 4-9%.

  If any single airline talks about growing capacity in excess of 3-4%, watch out! That creaking you hear is the breakdown of profitable yield curves.

  When you put it all together you get some very interesting numbers:

  *Estimate

  While airline stocks performed extremely well over the past year, some airline stocks still have room to grow. USAirways, UAL, and, to some extent, CAL are trading at bargain prices. Risk of a liquidity squeeze has dissipated as airlines are carrying healthy cash balances and have learned a few lessons in fuel hedging. Recent legislation should also help damper the oil price elevator of 2008. Net Operating Losses should carry forward for the next 2-3 years as well. With low single digit P/E ratios for forecast 2010 earnings (and this does not even factor in an assumed improved 2011), airlines (UAL and USAirways) may be a steal, at least looking at the next 6-12 months. While DAL may have more downside risk since it is already priced near 8x 2010 projected earnings, cost synergies and improved yields should boost the stock modestly. USAirways may provide the highest upside potential with its low P/E ratio and the possibility it still may merge, although at this point, a merger with troubled American Airlines may create more short-term problems than solutions. Of all the major airlines, American is the only one that should not be profitable in 2010. This leads me to believe American may be staring at a significant restructuring in the next few years.

  A successful restructuring is not only important for AA but for the entire industry. A weakened major carrier, in a liquidity squeeze and facing bankruptcy (at least with our current laws), will inject downward pricing pressure, hurting everyone’s interest. (The public’s interest is not served with airlines passing through the bankruptcy revolving door every decade.)

  With most airlines carrying healthy cash balances and expecting improved cash flows, 2010 and 2011 should bring retirement of debt (improved credit ratings, lower borrowing costs, and improved bottom lines) along with a return of cash to shareholders. It’s important to understand the importance of oil prices since airlines cannot make significant capacity changes quickly. Oil at $150/barrel and everyone is looking at a liquidity squeeze. Oil at $40/barrel and everyone’s a winner! (For further discussion on oil prices and profitability, read below.)

  USAirways (Strong Buy) – This airline has the greatest potential upside (significant PRASM improvement) matched with some real fuel price risk. Expected yields and cash on hand should prevent any liquidity squeeze. It still has open labor contracts which actually help keep wages low, but the day of reckoning will eventually arrive – a merger with AA may drastically increase wages. If a merger with AA does not happen, it may have to develop a creative merger strategy. The likelihood of USAirways remaining “single” over the next decade is not high. I forecast a stock price in the $15-$20 range by January 2011. No hedge position – get ready to ride the roller coaster, although right now its fuel position is riding high with oil near $70/barrel.

  UAL (Strong Buy) – Business traffic coming back should boost PRASM, while cost synergies with CAL should eventually cut operating costs by approximately $1B annually…at least that’s the plan. Much of the ground work for the merger has already been accomplished with steps taken for CAL’s inclusion into the STAR Alliance (i.e. IT platform and gate relocation), so I expect lower merger costs than what Delta faced, assuming management deftly combines the two distinct cultures. (A big IF!) Merger cost savings should help negate expected wage increases. While the merger with CAL will create the best domestic route structure and global alliance, be careful about believing all the talk about revenue synergies. If all the airlines merge into three carriers, they can’t all generate revenue gains in a zero-sum-gain situation. If the stock trades at 8x expected 2010 net income (i.e. Delta), it should trade above $36 (Fully diluted). Successful merger cost savings should drive the stock eventually over $50 by fall 2011. Fuel hedge position is better than average, although slightly above current market prices. An eventual approval nod from the Justice Department will provide a nice short-term bump for the stock.

  CAL (Buy, risk of merger cancellation hurts rating) – The stock is trading below where it should and it should rise and fall with UAL. Delta is looking to take over New York, and with AA not lying down, CAL can expect a real fight with Delta and AA, although the battle will probably focus more on service (Whew!), rather than pure pricing, for those returning business travelers. Fuel hedge position is slightly below average. Merger with UAL will help Newark hub.

  DAL (Buy) – With the full integration almost complete, Delta has generated impressive cost savings. Individual wages are slightly higher than the other majors (merger synergies have hidden this), but expect these labor costs to improve vs. industry as other open contracts are finalized. PRASM is recovering nicely. The only issue is that the stock is already trading near 8x expected 2010 earnings, so I wouldn’t expect a huge run. DAL is highly leveraged with significant near-term maturities [$11.6B through the end of 2014, compared to $4.4B(UAL), $7.4B(AA), $3.2B(USAirways)]. Delta should generate significant cash flow in 2010 and 2011 to pay down this debt level, improving its credit rating and lowering interest payments. DAL’s Enterprise Value is already 40% greater than a combined UAL/CAL. The already high market cap and relative enterprise value could pressure this stock from generating any significant returns. Fuel hedge position is better than average. Future wages advantage vs. new industry labor contracts along with good merger management may bump up stock 20% by the end of the year. I expect unit labor expenses to be lower than at the new UAL.

  AA (Hold) – AA has some real issues – it should be the only major airline not to earn a profit in 2010. It avoided bankruptcy (to its credit) but in avoiding bankruptcy it was unable to dump some legacy costs other airlines were able to cut. Wages are significantly higher at AA on a unit cost basis and there will be some tough negotiating. There is a chance AA will have labor problems this summer which may temporarily spill revenue to other airlines. (Flight Attendants are poised to strike, but until they walk, it’s all talk. Pilots are not happy either.) I wouldn’t be surprised to see the underfunded defined benefit pensions frozen and exchanged for improved defined contribution pensions. Anyone in the industry relying on a defined benefit pension is walking on very thin ice. If AA cannot deal with its cost issues appropriately, any PRASM improvement will not solve their problems. Even if AA were able to cut wages $600M annually ($150M per Q, CEO Arpey’s number, not mine), it still is underperforming both Delta and United. PRASM improvement will help, but with an existing market cap just below that of UAL, combined with some real uncertainty, AA may be one stock to watch from the sidelines. Fuel hedge position is below average. Why buy AA when UAL and USAirways are much cheaper? In 2010, if Delta earns $1.5B and UAL earns $1B, I can’t see how a new management team is not brought in.

  The Past Decade and How it Impacts Today

  Post 9/11

  While I’m sure multiple thesis have been written about the airline industry after 9/11, the important point is that by 2006, airlines started recognizing that oil was not going to retreat to $30/barrel and that capacity was going to have to be reduced. This was the plan – oil between $45-$55 per barrel, and airlines planned for capacity that would yield prices, at this cost structure, to create reasonable margins. That was the plan. Looking at the previous 10 years, there was no reason to believe this oil price forecast was a bad assumption. The problem is that this ended up being a bad assumption, as oil has averaged over $75 per barrel since the beginning of 2006.

  2008 & 2009

  It’s tough to look back across the past two years at the airlines and not gasp. In 2008 oil skyrocketed to an all-time high and just devastated the airlines. Oil came back down to earth in 2009, partly due to the great recession, but this fuel price easing was met by yield reduction of equal devastation. The real whammy occurred when oil dropped below expected pricing levels and airlines were caught upside down on their fuel hedges. At the beginning of 2009, there was real liquidity risk associated with most airlines. In 2010, oil has crept back up, but recent legislation, lessons in fuel hedging, and the development of synthetic fuels should help the airlines keep fuel costs under some form of control.

  Outlook Going Forward – It’s the Capacity, Stupid!

  Recently some very knowledgeable people have disagreed as to where capacity needs to be to earn reasonable returns…for the entire business cycle. Airline Forecasts, LLC believe that capacity needs to be reduced an additional 7% based on the airlines’ performance in the past decade. Robert Crandall believes that excess capacity does not exist since load factors are high, hovering in the low-mid 80s, 8-10% higher than where they were just 15 years ago.

  I’m somewhere in between in that Airline Forecasts is looking at the past decade, in its entirety, while Mr. Crandall is looking at today, although his view, based purely on load factors, has confounded me. Any revenue management VP at a major airline can provide any load factor by adjusting prices. Full airplanes don’t necessarily mean profitable flying. It just means high load factors. To simply talk about capacity without regard to demand, and hence price, is a little ridiculous, since airline ticket pricing plays in the ultimate supply/demand arena. Since short-term marginal costs approach zero and changing near-term (3-6 months) capacity is next to impossible, capacity, relative to demand, will determine pricing, and hence profitability. (Oil prices have an obvious impact on profitability, but in the long-run, oil prices are beyond an airline’s control. You can’t hedge correctly and win big all the time, just ask Southwest.) An airline can’t simply raise its ticket prices if sufficient demand does not exist.

  Airline Forecasts is correct when it talks about excess capacity for the past decade destroying pricing required to yield reasonable returns. However, between 2007 and 2009 (the end of the decade), the major airlines stripped out capacity by 15%. This is why, with a somewhat normal economy, the airlines, sans AA, will generate profits in 2010. The capacity that Airline Forecasts feels must be reduced has been reduced in the past two years, or at least a significant percentage has. The key question that lingers is how will capacity be managed over the next 5 years. If the airlines grow capacity just below the rate of GDP growth, this will have the effect of a net capacity reduction, which should yield better operating margins. If the airlines return to their old ways, where each airline executive team really believes it is smarter than the other 5 airline teams and tries to become market share kings, then each airline may try to outmaneuver (aka, outgrow) the others – the ultimate prisoner’s dilemma. This eagerness to become king will destroy value throughout the industry. Consolidation may place a damper on this hubris, but it won’t wipe it out altogether – treatment vs. cure.

  Looking at the airline hedge positions, it appears that airlines are now planning for oil prices to range between $75-$90 per barrel, perhaps even a little higher, for the near future (3-5 years). This assumption is critical since expected costs are going to determine where capacity must lie in order for the supply and demand curves to intersect at a price that will support reasonable operating margins, and again, for the entire business cycle! This is the intersection that matters. A temporary dip in oil prices that produces improved bottom lines for a quarter should be taken for what it is…temporary.

  Airline executives have been talking more recently about capacity discipline, finally! Airline orders are below historic levels and many aircraft taken out of service have been sold or cannibalized for parts rather than kept at the ready for sudden capacity additions. Domestic capacity growth will be between 0-1% for 2010, and near 1-3% for 2011. This is where capacity needs to be to support pricing that will yield reasonable margins with oil between $75-90 per barrel. If we assume we are entering the beginning of a global recovery, then 2011 should be an even better year for the airlines, albeit slightly, than 2010. Before we get too excited, remember that the airline industry is cyclical and will, at some point, enter a downhill slide. How capacity is managed will determine how steep and deep this slide is. Excess capacity, a modest increase in the price of oil, combined with a GDP slip and the airlines might be staring down another liquidity crisis, something everyone should want to avoid.

  Disclaimer: The author is a commercial airline pilot for a major US airline and presently has a long position in United Airlines.

• Report this Comment On June 09, 2010, at 7:04 PM, raodyssey wrote:

  UAUA ran from $3 in late JUL08 to $23 in April of this year. Was it in immediate danger of slipping into bankruptcy at that $3 price, most likely not and was indeed oversold. The stock returned to the low teens by mid DEC and remained in a narrow range until MAR when analysts began coming out with estimates in the $30 range with no real facts to support it. Why were they so confident this stock would double in a year, did they know more than everyone else? Chances are they did and it wasn't long before the parade of "unnamed sources" began spilling the news of an imminent merger, first with US Airways and then Continental. As a stand alone carrier UA was not going to be worth $30 so fast after just losing $650M last year. Besides the red ink there was and still is dysfunctional employee/ management relations no doubt cause by the very large pay cuts taken by labor, high debt load , and all the other uncertainties that continually bring volatility to the airline sector. The real game changer is the deal with CAL. So why would one of the best run airlines want to merge with one of the worst? That doesn't matter anymore since the deal was made and the parties with the most power want the deal to happen. So how will this thing end up? It will be harder to get government approval than Delta/Northwest but not enough to be a deal breaker. Expect the post merger United to be around 10% smaller than the two separate airlines due to approval restrictions, the need to cut costs, and the one thing that makes this deal attractive to the whole industry: taking seats off the market. What about the synergies? United labor will be bring bad blood and sour grapes that will no doubt poison the well at Continental. This plus the usual merger difficulties will require minimum 10% raises for labor and likely more. This deal will not go as smoothly as DAL but has a good chance of getting done. It will be at least 2 years for merger benefits to kick in and that's if no unseen problems pop up (good luck on that in the airline biz). As for their main competitor, the merged DAL is still the largest carrier and will likely remain so as it is just starting to reap merger benefits now, not two years from now. Rev for DAL LFY was $28.1B, 3% less than then combining CAL and UAUA. This head start plus shrinkage will keep the merged United in the number two spot (don't forget NWA/DAL emerged significantly smaller ). DAL's current market cap is $10.5B and one would expect it to be around $12B after a couple of profitable quarters. UA and CAL have a combined market cap of $6.7B. It would be reasonable to think post merger UA with have a similar market value, but that's at least 2 years down the road. By the end of this year expect United to be facing its biggest hurdles with government approval and how much money it will take to make this deal fly with the unions.

• Report this Comment On June 09, 2010, at 8:33 PM, PAQuaker wrote:

  When the deal was announced, I was under the impression that CAL had the better business model and that UAL would ride it's coattails. After doing some analysis, I don't believe this anymore. Businesses are set up to make money. UAL actually looks better than CAL, at this time. I think UAL will earn almost $1B and CAL $500M in 2010. USAir may have the best upside potential of the bunch. Debt (UAL and CAL) loads are more or less the same (proportionally) and less than DAL. DAL's debt and maturation is a little scary if there is any hiccup in the economy/oil. However, Delta's management team appears to be doing a decent job.

  Looking at full year projected earnings, referencing Jan-May numbers, I was shocked to see UAL positioned as well as it is. I can't figure out what happened to AA. This is why I went long on UAL and almost USAir (didn't because no fuel hedge scared me). USAir and UAL were so oversold "culturally" that few wanted to believe the stocks are good deals. Long-term they are not, but short term there is just so much cash in there compared to market cap. Delta should make a pile of cash, but with UAL's market cap so far below DAL, UAL offers the better investment return.

  As for the airlines' liquidity, they were running on fumes by late 2009. 2008 and 2009 took everything out of them and returns to bankruptcy were real.

  I don't believe UAL and CAL will shrink by 10% simply because both airlines shrank significantly in the few years prior. I see the combined carrier shrinking by less than 5% and then simply constraining capacity going forward.

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