Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...
United Continental Holdings (NYSE:UAL) stock is taking wing. Up 9% Wednesday after reporting Q2 earnings numbers on Tuesday, United stock tacked on a further 2% in Thursday trading when the earnings beat won it an upgrade from analysts at Australian investment bank Macquarie -- and that's just the start of the good news.
Here's what you need to know.
United reported its earnings after close of trading on Tuesday. Profits for the fiscal second quarter 2018 declined 7% to $2.48 per share on sales of $10.8 billion -- up 8%. That sounds like a bad result, but Wall Street wasn't necessarily focused on these numbers.
Going into the quarter, analysts had expected United would report adjusted earnings of just $3.07 per share. United says that accounting for things like "special charges and mark-to-market adjustments," which it considers one-time items, its earnings were actually $3.23 per share, which worked out to a 17% improvement by this pro forma yardstick. Helping United achieve this was the fact that adjusted pre-tax profit margin on its sales came in at 10.4%. That was down nearly 3 percentage points from last year's Q2, but slightly ahead of the midpoint of United's promised range of between 9% and 11% -- hence another mark in United's favor.
Also going into the quarter, investors were looking to see where United would land on passenger revenue per available seat mile (PRASM). United had predicted it would show a 1% to 3% improvement year over year. In actual fact, it maxed out that prediction with 3% improvement.
Finally, adding to the enthusiasm, United supplemented its earnings beat with a guidance increase, telling investors that when all's said and done, it expects to earn between $7.25 and $8.75 per share this year. Admittedly, this was only a pro forma prediction -- but it was still the company's second hike to guidance so far this year.
What's more, United lent confidence that it will continue meeting and beating targets by reining in plans to increase capacity (i.e., to buy planes and thus create expensive seats that need to be filled) this year. Instead of its prior forecast for a 4.5% to 5.5% increase in capacity, United now expects to grow its fleet by only 4.5% to 5% this year.
Also, United is promising to fill more of those new seats with paying customers. Passenger revenue per available seat mile (PRASM) for Q3, for example, is now predicted to grow 4% to 6%, which would be faster growth even than United achieved in Q2. All of this adds up to United adding less supply to the airplane supply-demand equation, and thus helping to preserve pricing power for itself and other airlines.
How Wall Street reacted
Wall Street liked this news. Macquarie commented that United's "commercial and operational initiatives are kicking in and management is demonstrating a more consistent and thoughtful approach," as quoted in a write-up on StreetInsider.com (subscription required). The analyst further observed that it sees United adopting an "EPS-centric focus" (albeit a pro forma one) that "will resonate well with investors," and raised its price target to $95 a share at the same time as it upgraded United shares to outperform.
Other analysts are even more optimistic. For example, TheFly.com notes that both Citigroup and Buckingham Research have raised their price targets on United stock in response to earnings -- to $99 and $106, respectively.
Citi called United stock its top pick in the airlines sector, and said that the company's decision to roll back its capacity expansion helps to create the possibility for "compelling upside" in this $80 stock.
Buckingham noted that United is working toward a goal of earning between $11 and $13 a share by 2020, which could work out to as much as a 50% improvement in profits over what it hopes to earn this year. Nor is Buckingham worrying overmuch about United's plans to grow capacity. Overall, the airline industry worldwide has expanded capacity less than 3% this year, notes Buckingham, and with "demand on the rise," United should have room to grab greater market share by growing capacity faster than its competitors.
How you should react
With so much enthusiasm visible on Wall Street, it's easy for investors to get carried away -- and some might argue investors did get carried away on Wednesday, based on the 9% bump in share price we saw. But is this mere irrational exuberance?
I don't think so, and I'll tell you why not.
So far this year, United Continental has reported net income of only $831 million, which is down 10% from what it earned in last year's first half. That's bad.
However, trailing earnings are now at $2 billion for the past 12 months, giving the stock a trailing P/E ratio of 10.8 even though its projected long-term earnings growth rate is approaching 22% (according to S&P Global Market Intelligence data). That's good -- United stock looks cheap price on its face.
Even better, though, is the fact that United generated free cash flow of more than $2.4 billion in its first six months this year, a figure three times as large as its reported net profit.
Granted, market cap divided by earnings or free cash flow doesn't give you the whole picture at United. There's still the company's $12.5 billion debt load to consider, which gives United a significantly larger enterprise value than its market cap alone might suggest. Still, by and large I like the valuations I'm seeing in this one. Macquarie is right to recommend it.