Description

Following the broad sell off of the markets in conjunction with United Airlines mischievous foray into capacity growth in the first couple weeks of February, airline stocks have broadly corrected 15-20% and we believe presents an attractive opportunity to engage in the sector. While the core thesis hasn’t changed (“it’s different this time”) from 3-4 years ago, we believe the relative delta in the sector’s valuation vs. the markets makes the opportunity more compelling particularly as market multiples continue to tread upwards. We believe Delta is best in class, but also believe United Airlines is interesting given the current leadership under Scott Kirby.

For those who are familiar with the change in airline industry, the synopsis of the opportunity can be summarized below:

·        Following a very strong conclusion to 2017 where Delta has seen strong demand globally (and where attention is now shifting away from domestic RASM growth to international growth), United Airlines announced capacity expansions of ~4-6% for 2018, which will persist over the next couple years

·        This led to an immediate compression of airline multiples as the fear of bad actors / return to price wars brought back fears of past market cycles

·        Since the whole profitability pie is unlikely to change significantly over the next 2-3 years (we believe imprudent to underwrite margin expansion for the sector), this undoubtedly means there will be some shift in profits among the top 4 players (~90% of the market)

Even though Delta/American/Southwest may have been overearning at the expense of United over the past few years, we believe the profitability pie of the industry has not been impaired as the sector valuation compression would suggest, but rather that the profit pool is shifting slightly back towards equilibrium. While this will hamper the growth of the other 3 main airlines, we believe the resurgence of GDP growth, international travel (first year all the airlines see international outpacing domestic), and potentially more business travel will reinforce low earnings growth (with United potentially seeing much higher growth than the others).

·        Conversations with American and Delta suggests that their perception of UAL’s capacity additions is a logical defensive maneuver (esp. since LCCs have more market share in a major UAL hub than UAL itself). Furthermore, domestic competitive capacity is only growing slightly over 2%

o   Delta and American have reduced capacity for Q2 marginally, which softens the likelihood of a mutually assured destructive response

o   Hub dominance strategy is already completed by Delta/American (who have over 50% share in nearly all their hubs, except 1), and so is a logical strategy for UAL to implement. DAL has 4 hubs where they have ~70% market share, American 3 (with >90% in Charlotte), while UAL only has one 60% share in Houston

·        Kirby came over from American Airlines so understands the status quo of the market and where UAL “ought” to earn back some of its profitability. When he was at American, Kirby had stated that American was overearning at O’Hare, that UAL was a mess there, and that one day someone smart would come in and fix UAL in O’Hare. Whether American now shares the same viewpoint or not (ceding some “excess earn”) is hard to tell, but it is not in Kirby’s interest to instigate a war in a hub like O’Hare after making public statements indicating the feasibility of a turnaround under someone astute

·        Similar to Southwest’s large capacity additions in Texas a few years past, if the capacity addition this year doesn’t yield margin improvements to UAL, we don’t think the capacity commitments for 2019/2020 will follow through

·        Overall health of the economy suggests demand growth (particularly international, but also domestic) will match capacity additions

·        In the meantime, the sector trades at 7-8x forward earnings and earnings could be more than cut in half to trade at current market multiples. The divergence in valuation makes the “bet” that things aren’t going to denigrate into a price war easier to make

The overall investment thesis around airlines continues to be anchored by:

·        Consolidation has put the market share of the top 4 players from 60% to ~90% currently, which legacy carriers increasingly focused on efficient management of their hub and spoke systems

o   Longest stretch of time since World War 1 without a new airline, as paucity and scarcity of gates to most important hubs continue to be a big barrier, as well as legacy carriers able to differentiate much more aggressively in basic economy to compete against the likes of Spirit/LCCs. Legacy carriers in the US are too healthy to allow LCCs to bully them around ala the likes of Ryanair, ezJet, and Wizzair

·        Balance sheets are harmonized – no longer do airlines fear bankruptcy in a recession and can hence compete more rationally in economic slowdowns (equity is no longer a “zero” in a downturn, creating incentive to protect the equity rather than go “all in” on price wars. Though we won’t truly see if this plays out until we hit the next recession). Companies are approaching investment grade

·        ROIC based incentive metrics for management compensation, rather than revenue and market share pre-2008 stifles empire building (also evidenced by huge buyback authorizations)

·        More and more profitability now derived from “aftermarket” ancillary revenue streams like baggage, seat upgrades, frequent flyer programs that creates some newfound profit permanence. Over the past 15 years:

o   Global load factors up from 69% to high 80%

o   Top 4 players from 63% of market to ~90%

o   5 large hubs removed

o   International capacity among top 4 from 25% to ~50%

o   OCF easily exceeds capex vs the other way around (and also with 36 billion of industry net debt among legacy carriers in 2008)

o   Return on capital (by IATA) exceeded cost of capital for the first time in 2015

o   Legacy fleet size has fallen 13% since 2007 but ASMS have stayed flat (up-guaging of seats, planes, and increased average stage-length)

§  Our estimate of a 10 person increase on a 737 from 150 to 160 seats/plane increases operating margin from 7.2% to 10.5% (63% incrementals)

§  Our estimate of going from an 737-700 to a 737-900 results in ~25% savings per seat (similar to A319 to A321)

·        ~20% price premium in airports where a legacy carrier dominates majority of traffic

·        Slots are a truly unique asset and also very scarce – there are 81 flights/hour capacity in JFK/Newark and demand is expected to hit 110-130 by 2030; LA/SFO all projected to hit capacity by 2022-2025

·        Labor costs recently negotiated and won’t be a real issue until 2022

Why Delta?

·        We believe Delta continues to be a best in class operator due to the low-cost and dominant nature of its main hubs, fleet expertise through its techOps program (which our conversations suggest would take 10+ years for a competing legacy airline to figure out)

o   Atlanta has airline landing fees of .82/1,000 lbs, on the lowest end with Charlotte (.87). Delta (and American) largest hubs have much lower “costs” to operate vs. more competitive hubs like O’Hare (7.87), SFO (4.87) or NY ($8-$10)

o   Atlanta and Salt Lake City have some of the lowest cost per passenger enplanements in the US. Charlotte is the lowest (American)

o   Not only that, delayed flights are very costly and sadly is dependent on the airport and airport capacity. Delta’s hubs have some of the best on-time performance (SLC, MSP, DTW, ATL) all above 80%. On the other end, EWR, SFO, ORD, LGA, JFK have on time performance in the low 70%. Each minute of delay can cost $80+ per plane

o   Atlanta quoted as the most profitable hub in the industry

·        TechOps

o   Aircraft expense as % of total is ~200bps lower than peer average (we estimate ~130 adjusted for lower rent). Their techOps allows Delta to operate planes that are significantly older than United and American

o   Delta is able to sell its excess MRO capacity to third party carriers. Our conversations suggest the only other player who can do this may be Lufthansa

·        Best on time arrival and LTM cancellations – whether structural or better operations; this reduces expenses significantly (in 2015, only 40bps of cancellation vs 1.4% for Southwest, 1.6% American, and 1.2% United). Furthermore, traffic related delays was only 1.8%, vs 2.3% at United, 1.8% at American, and 2.6% at Southwest (due to hubs)

·        Most of UAL’s growth overlapping Delta’s is already in contested routes where Delta only has 10-20% market share, which indicates a lower base of potential price impact than more important airports. However, there will be indirect effects if UAL/AAL competition carries over through hub competition

Valuation

We think a P/E multiple of 8x in today’s markets is pricing in significant deterioration (or at least uncertainty) in earnings resembling a belief that the bad actors mentality will return. While we won’t get a through the cycle multiple conviction until we hit a recession (and airlines will never trade at a market multiple), we don’t think its unfair to think that the best player in this industry warrants a ~10-12x P/E if/when the panic of price competition fades or turns out to be slightly better than expected.

We also think United can be interesting even though the Company’s desire to converge to Delta’s margin is wholly unlikely due to structural reasons (decades of building out hub strength in expensive, competitive hubs). However, we do think that Delta/American are more likely than not to “give back” some excess profitability to the least nimble legacy carrier as a sign of peace.

Catalyst

Stable yields through Q1'Q2; capacity reports