Related Articles
4 high-value airlines investors ignore
The next wave of airline bankruptcies
40 companies sitting on pension timebombs
Company Focus
Recent articles:
• Is BUD still the king of beer stocks?, 10/13/2004
• 5 more sub-$5 stock picks with outsize prospects, 10/6/2004
• 3 'green' stocks that don't care who's president, 9/29/2004
More...
| | Company Focus
Follow the dinosaurs to airline profits
As the big carriers sink into the ooze, their smaller cousins are poised to benefit greatly -- if the big guys' trouble doesn't pull them under, too.
By Michael Brush
For years, investing in the airline sector was easy. All you had to do was consider that in its entire history, the U.S. commercial airline business has never made money -- then move on to other groups with better prospects.
Now, though, with oil at $54 a barrel, much of the industry on the verge of bankruptcy and a big bang of change apparently about to rip through the sector, many airline stocks look enticingly cheap.
Should you buy them? To figure this out, we talked with airline sector analysts, money managers who own these stocks and experts at a credit analysis outfit called CreditSights, an independent research group that pores over corporate balance sheets and industry fundamentals to come up with recommendations on stocks and bonds.
The airline sector has lots of moving parts, but heres the bottom line. Most of the legacy carriers such as US Airways (UAIRQ, news, msgs) or Delta Air Lines (DAL, news, msgs) may be excellent trading vehicles as they bounce around on the ups and downs that play out in their complex stories. But as long-term investments, its better to take a pass, even if they are trading at 52-week lows.
Some of their regional partners look like buys, and others look pricey, creating some interesting pairs trades in which you short one stock but go long another in the same sector.
Low-cost carriers such as JetBlue Airways (JBLU, news, msgs) or Southwest Airlines (LUV, news, msgs) look like the real potential winners in the ongoing shakeout in the sector. But youd do well to be patient and buy these stocks on dips because they look pretty fully valued.
Heres a closer look.
The dinosaurs
Our country has six legacy carriers whose roots and cost structures trace back to the grand old days of airline travel: Delta Air Lines, US Airways, Northwest Airlines (NWAC, news, msgs), Continental Airlines (CAL, news, msgs) and the parents of United and American airlines, UAL Corp. (UALAQ, news, msgs) and AMR Corp. (AMR, news, msgs).
These airlines are saddled with high labor costs, unions fighting to protect pay and benefit levels, huge pension obligations they might not be able to meet and too much capacity. Sky-high fuel costs mean even more turbulence. Two of these airlines -- US Airways and United -- are in bankruptcy proceedings. A third, Delta, may be on the courthouse steps any time.
Their stocks are at or near 52-week lows, which makes them look attractive. To be sure, these stocks can make great trading vehicles for the swift and the nimble. For example, if Delta wrests concessions from its pilots on pay, its stock may get a needed bounce. Or, if the terror premium in oil -- which could be as high as $10 per barrel -- backs off after the election, the dinosaurs benefit.
But as long-term investments, youd be better off avoiding these dinosaurs. First off, its crucial to remember that the shares of a company going into bankruptcy just about always end up getting diluted -- or wiped out altogether.
Dinosaurs that emerge from bankruptcy will look leaner and meaner. But they wont be as lean and mean as low-cost carriers like JetBlue or Southwest, which continue to claim victories over the dinosaurs.
And heres a big problem for the airlines that look safe. The dinosaurs in or near bankruptcy may use Chapter 11 to shed huge burdens like their obligation to pay pensions and other debt. They may also get juicy concessions from labor. That puts the dinosaurs that don't go bankrupt at a serious disadvantage. With their higher costs, those dinosaurs will be left with no choice but to be the ones with higher ticker prices or watch as margins get hit while they cut ticket costs to stay competitive. Either way, it wont be good for their stocks.
Some investors try to argue that a dinosaur like Northwest Airlines looks relatively safe from competition, with hubs in Minneapolis, Detroit and Memphis. But Northwest has some serious cost-cutting ahead of it, and needs to come up with about $4 billion to fund retirement plans, said Roger King, an airline sector analyst with CreditSights. One option, says King, might be to fund it with equity, diluting existing shares.
The bottom line is that it will be hard for the dinosaurs to restructure and maintain service levels, says Ray Neidl, an analyst with Calyon Securities in New York. Thats why he has a sell or neutral rating on all six dinosaur carriers.
| Regional airlines that run with the dinosaurs | | Company | EV/ASM* | Dinosaur Exposure** | | MAIR Holdings (MAIR, news, msgs) | 1.61 | Northwest Airlines (NWAC, news, msgs) | | ExpressJet Holdings (XJT, news, msgs) | 5.84 | Continental Airlines (CAL, news, msgs) | | Pinnacle Airlines (PNCL, news, msgs) | 8.28 | Northwest Airlines (NWAC, news, msgs) | | Mesa Air Group (MESA, news, msgs) | 8.32 | US Airways (UAIRQ, news, msgs), UAL Corp. (UALAQ, news, msgs), America West (AWA, news, msgs) | | SkyWest (SKYW, news, msgs) | 13.05 | UAL Corp. (UALAQ, news, msgs), Delta Air Lines (DAL, news, msgs), Continental Airlines (CAL, news, msgs) | | Republic Airways (RJET, news, msgs) | 17.05 | US Airways (UAIRQ, news, msgs), UAL Corp. (UALAQ, news, msgs), Delta Air Lines (DAL, news, msgs), AMR Corp. (AMR, news, msgs) |
|
*Enterprise value divided by available seat mile, a measure of capacity.
**Exposure to foundering legacy carriers; exposure to bankrupt or near-bankrupt US Airways, United and Delta is a bad sign.
Source: CreditSights
The dinosaur helpers
Alongside the six dinosaur airlines, youll find a whole ecosystem of regional airlines that feed off the legacy carriers. Thanks to their high costs and desire to focus on national and international routes, the major airlines have been pushing business down to the regional airlines for years. In one sense, its been an easy way for the legacy carriers to get around high, unionized labor costs. (Many of the regional airlines have unionized workforces, but their costs are still lower.)
Because of this dynamic, life has been great for most of the regional carriers, which include: Mesa Air Group (MESA, news, msgs), Skywest (SKYW, news, msgs), MAIR Holdings (MAIR, news, msgs) (which runs Mesaba Airlines and Big Sky Airlines), Pinnacle Airlines (PNCL, news, msgs), Republic Airways (RJET, news, msgs) and ExpressJet (XJT, news, msgs). In August, regional carriers saw traffic grow by 33%; the legacy carriers posted gains in the single digits, and low-cost carriers saw gains in the mid-teens.
These regional airlines enjoy another benefit. In exchange for services, the legacy carriers pay them a guaranteed return. In effect, they cover day-to-day costs for things like fuel and marketing, no matter how much those things cost. In exchange, the regional airlines only have to make sure their planes run on time and customers are happy. Thats been a sweet deal.
But with three of their partners in or near bankruptcy, regional carriers have a cloud over them. Pressure to cut costs or the need to trim service could mean the legacy carriers are about to change those sweet deals.
Whats worse, US Airways could be forced to liquidate under Chapter 7. That would be particularly bad for Mesa, which gets about 35% of its revenue from agreements with US Airways. That explains why Mesa trades at just 4.65 times next years projected earnings of $1.16 per share, even though it has a medium term growth rate of 22% per year, according to analysts reporting numbers to Thomson Financial.
Its tempting to think cheap valuations make the regional airlines a screaming buy right now. After all, respected sell-side analysts like James Parker at Raymond James think regional airlines will be able to handle the changes. The regionals can just strike up relationships with other legacy carriers if they lose business, or strike out on their own. Someone, after all, is going to have to provide service if, for example, Delta scales back or eliminates hubs in Dallas-Fort Worth and Salt Lake City, or if US Airways goes into liquidation.
Besides, some astute investors hold these stocks. One example: John Buckingham, who manages the Al Frank Fund (VALUX) and writes the top-ranked Prudent Speculator newsletter, has a position in Mesa. He thinks the stock is too cheap to ignore and calls it a buy up to $6.42. Here is a growth stock trading at a single digit multiple, says Buckingham.
Adam France, a money manager at Charlotte Capital, a small-cap value shop, holds Pinnacle for much the same reason. Pinnacle is a screaming deal here at $9.50, says France. It will earn $2 to $2.20 next year, so at these prices, a lot of the worst case is in this stock. France thinks Pinnacle is insulated since it partners with Northwest, which has hubs such as Minneapolis, Memphis and Detroit, where low-cost carriers arent trying to steal business as much.
A pairs-trade approach to the regionals
But not so fast, says King, at CreditSights. He thinks the low-cost carriers -- not necessarily the regionals -- will grab much of the business if a legacy carrier bails on a hub. And where legacy carriers do maintain their partnerships, theyll force the regionals to accept concessions. The sustainability of the growth at the regional airlines is now being questioned as the majors get roiled by financial crisis and face a high risk of increased restructuring, and the low-cost carriers start to grab share at some key airports, says King.
Instead of just snapping up the cheapest of the regional airlines, or avoiding them altogether, King takes a novel approach to this group -- an approach that makes a lot of sense. King values these stocks on the basis of what they actually sell -- capacity, regardless of whether it is used or not. Its called available seat miles (ASM) in the industry. Then he suggests setting up pairs trades, going long the ones that look cheap, and shorting the ones that look expensive by this measure.
For example, if you compare the enterprise value (EV), or market cap minus cash plus debt, to ASM for the regional airlines, youll notice that Republic Airways and Skywest look the most expensive. They have EV/ASM ratios of 17 and 13 (see chart). Yet these two have the biggest exposure to financially strapped legacy carriers US Air, United and Delta. SkyWest, for example, gets 95% of its business from arrangements with United and Delta.
At the other extreme, the cheaper regional airlines by Kings measure -- MAIR, ExpressJet and Pinnacle -- have the least exposure to the most troubled dinosaurs.
Conclusion: A good pairs trade might be to short Republic and SkyWest, and go long an equal amount of MAIR, ExpressJet and Pinnacle. There is huge range in valuation for doing the exact same thing, says King. MAIR also has an enormous amount of cash and long-term investments, or about $7.33 worth per share. Book value at $8.95 is above its recent share price of around $8.25.
The low-cost carriers
As the dinosaurs and the regionals retrench and adjust to changes in the airline sector, the low-cost carriers should continue to grab market share -- including some international routes close to the United States, says Caylons Neidl. Low-cost carriers maintain about 25% market share right now. We think this could grow to 35% over the years."
Two of the biggest winners in this group will likely be Southwest Airlines, because it has a proven track record, and JetBlue, which has shown it knows how to grow rapidly in this space.
Both look fully valued, so it may pay to be patient and buy when market turbulence brings their shares down.
|
