Last week, airline giant United Continental (NASDAQ:UAL) announced that it is on track to complete its current $2 billion share repurchase authorization by the end of this month. The company's board has also authorized a new $3 billion share buyback program.
Share repurchases have become very popular among airlines in recent years, as low fuel prices and a more rational competitive environment have led to higher industry profitability. However, like fellow major airline American Airlines (NASDAQ:AAL), United is spending beyond its means on buybacks. This move could be dangerous for investors in the long run.
Returning lots of cash to shareholders
United Continental has been actively returning cash to shareholders through share repurchases since 2014. However, it really ramped up its capital return program in 2015, as falling fuel prices caused free cash flow to surge. United spent about $1.2 billion on share buybacks in 2015 and $2.6 billion in 2016. If United completes its current share repurchase authorization by year-end as planned, it will have spent another $1.8 billion on buybacks in 2017.
Buybacks have reduced United's share count dramatically over the past few years. In the second quarter of 2014, United Continental had a diluted share count of 396 million. That fell to 301 million as of last quarter and will decline further in the fourth quarter.
This 24% reduction in the share count means that United Continental's earnings per share is more than 30% higher than it otherwise would have been. The new authorization would allow United to reduce its share count by another 17%, based on the recent stock price.
American Airlines has repurchased stock at an even faster rate. The 37% reduction in its share count over the past four years represents an EPS tailwind of more than 50%, all else equal.
The case for more buybacks
Share repurchases can be a good tool for a company with an undervalued stock. They also allow management to signal confidence in the business.
Bulls would argue that United Continental stock is significantly undervalued today, having fallen 24% from its all-time high. Furthermore, United Continental stock trades for just 10 times earnings, and United's earnings would move significantly higher if a corporate tax cut goes into effect. From this perspective, a robust share buyback program is warranted.
Where's the cash?
On the other hand, while United Continental remains solidly profitable, its profit margin is receding. In 2015 and 2016, the company produced adjusted pre-tax margins of about 12%. By contrast, it is on track to record a pre-tax margin of 8% this year, because of a combination of higher non-fuel unit costs, higher fuel prices, and stagnant unit revenue.
The picture is even worse when you focus on free cash flow. United Continental was producing as much as $3 billion of free cash flow annually during the "good old days" of 2015 and 2016. However, free cash flow has actually turned negative this year.
This means that United Continental has borrowed every dollar it has returned to shareholders this year. Free cash flow may improve somewhat next year, as capex is set to decline after peaking at $4.6 billion-$4.8 billion in 2017. Still, free cash flow is likely to remain far below the peak levels of 2015 and 2016.
Is the outlook really that rosy?
United's sudden lack of free cash flow is one reason for investors to be suspicious of its share repurchase program. That said, American Airlines has bought back a lot of stock even in years when it didn't produce any free cash flow. Low interest rates have allowed both American and United to pay for most of their aircraft purchases with debt, freeing up cash for buybacks.
It's also far from clear that the stock is undervalued. While United Continental recently raised its fourth-quarter revenue outlook, it still expects unit revenue to decline 0%-2% year over year. In the long run, it is likely to face higher competition from low-fare carriers in many markets. The company hopes to offset these headwinds through better segmentation and revenue management, but those efforts aren't guaranteed to succeed.
Moreover, jet fuel prices have moved significantly higher in the past few months. As a result, United Continental may need full-year unit revenue growth of 3%-4% in 2018 just to keep its profit margin stable.
If United's profitability will continue to fall in 2018, 10 times earnings might be a very generous valuation. Meanwhile, adding debt to fund share buybacks boosts EPS, but it could also get the company into trouble during the next recession. United Continental shareholders may eventually come to regret management's current love affair with share buybacks.