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This Just In: Analysts Upgrade Southwest Airlines -- and American Airlines, Too

By Rich Smith - Jan 7, 2016 at 12:30PM

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It's amazing what a $3 hike in airfare can do for an airline stock.

Delta Air Lines (DAL -2.26%) announced on Tuesday that it's hiking airfares around the country by an average of $3 one-way. Two days later, shares of Southwest Airlines (LUV -2.33%) and American Airlines (AAL -3.48%) both received upgrades.

Coincidence? I think not.

The news
Airline price hikes are funny things. The way it usually works is, one brave airliner will raise its rates, then wait and see if its rivals follow suit. If they don't, the leader quickly tucks tail and rolls back the price hike. But if the rivals do choose to imitate -- that's more than just flattery. It means the market is strong enough that everyone can charge more than they used to.

And that's good news for airlines stocks.

The upgrades
Recognizing this, two separate analysts decided on Thursday to upgrade the stocks of two airlines that followed Delta's lead and hiked their prices: Southwest Airlines and American. Morgan Stanley was the more conservative actor, removing its underweight rating on Southwest and upgrading to equalweight with a $51 price target -- but telling us little more than that it was upgrading, period.

The more interesting upgrade came from Credit Suisse. Not only did CS do a much more significant upgrade, from neutral to outperform, and not only did it give a more sizable hike to price target, from $52 to $57 -- Credit Suisse also gave us a lot more detail about why it thinks American Airlines is a buy.

And this story is about more than just a higher ticket price.

Let's go to the tape
Before I get into those details, let's take a quick look at Credit Suisse's record. (Because to be blunt, if Credit Suisse has shown itself to be a lousy stock picker -- we probably wouldn't care what it thinks about American Airlines in any case.)

Instead, our data on Motley Fool CAPS shows that over the past decade Credit Suisse has been a pretty stellar stock picker, getting a lot of airline picks right, and generally speaking, outperforming about 93% of the investors we track on CAPS. A few examples:

Company

 

Credit Suisse Said:

CAPS Says:

Credit Suisse's Picks Beating (Lagging) S&P By:

American Airlines

Outperform

***

351 points

Delta Air Lines

Outperform

***

333 points

Southwest Airlines

Outperform

****

149 points

I'll risk stating the obvious here: This is a pretty good record, and a good reason to read further and find out what Credit Suisse thinks about American Airlines.

Without further ado -- what Credit Suisse thinks about American Airlines
According to our friends at StreetInsider.com, the situation at American has improved a lot since 2015. "Integration challenges are largely behind" it after the US Airways merger. "Competitive capacity trends are moderating, expectations are low, & the buyback is sizable."

Credit Suisse still worries that American carries "higher leverage" (about $11.7 billion in debt on a $25.5 billion market cap debt) than its peers, and has "lower FCF." Nonetheless, Credit Suisse says American Airlines is among its four top airline picks for 2016 (the others being the aforementioned Southwest and Delta, with United Continental (UAL -3.30%) thrown in for good measure).

Is it right to discount these worries, though, even in light of the "moderating" competition (a fact confirmed by Delta's price hike sticking)? Well, let's see:

Pricing the competition
Priced at just 5.8 times earnings, American Airlines stock certainly looks cheap enough for a company that, according to Yahoo! Finance, is expected to grow its earnings at better than 8% annually over the next five years. For comparison, Delta and Southwest cost 13.8 times earnings and 15.6 times earnings, respectively.

On the other hand, United Continental is priced at just over three times trailing earnings. And all three of these American Airlines rivals are pegged for earnings growth in excess of 20% annualized by Yahoo! Finance.

Free cash flow-wise, American Airlines looks bottom-of-the-heap with less than $900 million in trailing cash profits (versus more than $4.9 billion in reported net income). According to data from S&P Capital IQ, Southwest ($1.3 billion in free cash flow), United Continental ($2.1 billion FCF), and Delta ($5.3 billion) all beat that with a stick.

What it means to investors
A low P/E and a respectable growth rate -- plus an endorsement from Credit Suisse -- make three great reasons to like American Airlines stock. That said, the company's weak free cash flow and consequent price-to-free-cash-flow ratio of more than 28 still give me pause.

Considering how much more undervalued the alternatives look, I'd probably be inclined to buy any of Credit Suisse's other top recommendations -- again, those are Delta, United Continental, and Southwest, and roughly in that order -- before adding American Airlines to my collection.

Because bargain shopping is fine. But if you're shopping for bargains, why not buy the best?

Fool contributor Rich Smith does not own shares of, nor is he short, any company named above. You can find him on Motley Fool CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 298 out of more than 75,000 rated members.

The Motley Fool has the following options: long January 2017 $35 calls on American Airlines Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Southwest Airlines Co. Stock Quote
Southwest Airlines Co.
LUV
$38.94 (-2.33%) $0.93
United Airlines Holdings, Inc. Stock Quote
United Airlines Holdings, Inc.
UAL
$38.96 (-3.30%) $-1.33
Delta Air Lines, Inc. Stock Quote
Delta Air Lines, Inc.
DAL
$34.54 (-2.26%) $0.80
American Airlines Group Inc. Stock Quote
American Airlines Group Inc.
AAL
$14.96 (-3.48%) $0.54

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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