At first, it would seem absurd to compare Micron Technology (MU +4.04%), a memory maker in the technology sector, to the airline industry. But this comparison has more in common than the industries' lack of similarities implies, and with airline stocks among the biggest gainers in 2013, examining these similarities is at least worth a look.
Troubled pasts
Neither airlines nor memory makers have much of a long-term record with investors in terms of capital preservation. While airlines are well known for a history of labor tensions, economic risk, and oil price exposure, memory manufacturers have gone through similar boom and bust cycles, sinking some manufacturers and causing turbulence for the entire industry.
Airlines and memory manufacturers have similar problems in that their products are commoditized, making conditions ripe for intense price competition. In the airline industry, this meant fare wars as carriers fought for market share, driving tickets into ranges where margins were thin or even negative. Memory manufacturers also overexpanded capacity similar to how airlines made too many seats available in each market. Following basic supply and demand laws, its pretty clear why this model ended badly.
For airlines, these pressures meant bankruptcy, with United Airlines, now part of United Continental Holdings (UAL +6.80%), declaring bankruptcy in 2002 and Delta Air Lines (DAL +3.46%) seeking protection in 2005. While both of these airlines survived bankruptcy, aviation history is full of carriers that were liquidated after becoming insolvent, and shareholders were wiped out in both these cases.
Although Micron Technology is a survivor in the memory industry, even this company has undergone extreme volatility. Shares of the memory maker shot from the $10 level to over $40 in 1995, only to be back in the single digits by mid-1996. The dot-com bubble was another boom and bust for Micron, as shares started below $20, spiked above $80, and fell back below the $20 level by 2002.
Consolidation control
For airlines and memory makers, all-out price wars are looking to become less likely as the number of competitors is reduced. Today's airlines are combinations of former competing carriers, with United Continental being the merger of United Airlines and Continental Airlines, Delta Air Lines being the merger of Delta Air Lines and Northwest Airlines, and American Airlines Group (AAL +4.49%) being the combination of American Airlines, US Airways, America West Airlines, and some of the TWA remnants.
Micron's portion of the memory industry is also now more limited in competition. Helping to increase consolidation efforts, Micron acquired bankrupt Japanese memory maker Elpida in a transaction that both boosted Micron's total capacity and removed a competitor from the field.
When only a few competitors remain, each competitor has a higher degree of pricing control and, already having a sizable market share, may be less likely to engage in scorched-earth price wars to increase market share. This oligopolistic setup is highly beneficial to shareholders, since greater pricing control brings more stable prices and less volatile earnings. Although company officials are not allowed to fix prices, oligopolistic industries do give greater flexibility in raising prices and keeping supply at reasonable levels, since fewer competitors need to get on board for the actions to be effective and not just result in market share loss.
Valuation, skepticism, and risks
Despite runs of over 200% in the past couple of years, shares of airlines and Micron continue to have low valuations when looked at alone or in relation to the broader market. Per estimates from Yahoo! Finance, Micron trades at under 10 times estimated 2014 earnings -- a good value on its own, and even better when looked at in comparison with the market as a whole.
Some airlines carry even lower valuations, with American Airlines Group and United Continental trading at 6.9 times and 8.7 times estimated 2014 earnings, respectively. Delta Air Lines trades just under 12 times estimated 2014 earnings, reflecting the airline's debt reduction and capital return plan but still well below the market average.
So why are valuations so low in these oligopolistic industries? Part of the discount comes from increased risks that remain present at these companies, including the (much diminished) threat of a price war, the fact that their products still remain largely commoditized, and energy price risks for airlines.
However, both industries have ugly histories, keeping some investors away as they wait for further evidence of industry change and stability. Since the primary reason for greater earnings and stability comes from consolidation, a complete return to the old model would require the breakup of existing companies or significant penetration by new competitors in industries with high setup costs. While the risks mentioned earlier do remain and may keep these companies' valuations below market averages, shares do have a good chance of rising, as skepticism connected to old industry practices fades away and these investors consider buying shares.
Consolidation opportunity
Micron Technology surged higher in 2013, but based on its valuation, lingering investor skepticism, and a shift in how the industry competes, I believe there is more upside ahead as earnings grow and the company proves itself in more investors' minds.
I remain bullish on airlines for similar reasons (although I do like some airlines more than others), but I acknowledge that above average risks do remain in their industries because of the commoditization of their products and, in the case of airlines, exposure to energy prices. But for investors looking for low valuation stocks in today's market and are willing to accept some risk, Micron Technology, American Airlines Group, United Continental Holdings, and Delta Air Lines are definitely worth a look.
