Description

Thesis:  The airline industry has experienced several structural changes that are likely to lead to higher and more sustainable ROICs moving forward than the industry has generated since deregulation in the late 70s.  The 3 changes include:  1) Significant consolidation, 2) Multi-decade tight supply/demand and 3) Convergence of the cost structures of low cost and legacy carriers.   Investors are currently over-looking the impact of these changes as we have just come out of the worst decade for airline profitability over the past 30yrs+.  Investors are hardwired to believe that this industry will always destroy massive value, cycles will be super short and profitability will be exposed to increases in the price of oil. 

UAL post merger has the largest airline network globally with the potential for significant cost/revenue synergies and currently trades at <60% of a conservative replacement value and a 40%+ FCF yield on our 2012E base case FCF which is ~50-100%+ ahead of street expectations (buy side #s even lower).  A reasonable upside scenario would result in EPS #s 2-3x street expectations.  UAL could easily be a multi-bagger over the next 2yrs. 

How This Plays Out:  The industry continues to push through price increases and UALs yields grow by ~12% this year and ~8% next year.  Improved pricing drives a 1-200bps+ expansion in EBITDAR margins over the next 2yrs even in the face of $100+ oil.  Pre-tax ROICs (EBITDAR-D&A/Invested Capital) expand from ~10% to 15-17%+ and UAL generates ~$10+/share in FCF in 2012 on a $23 stock price.

Quotes on Sentiment from Buy Side:

• "We know the fundamentals have improved but ultimately airlines are just going to trade with oil prices and there is a big risk of a spike in oil prices so we are underweight them"
• "We know we should look at them but there is just no interest here to look at airlines"
• "All of the reasons we havent owned them in the past have changed in favor of the legacy carriers but airlines are un-investable right now due to the risk of a further spike in oil prices"
• "We just cant look at them because it has been such a horrible industry historically and there are high risks of an oil spike and uncertainty around labor renegotiations"

What the Bears are Focused On:
1) Value Destructive Industry:  The airline industry has lost ~$15b in operating profits over the past decade and is a horrible industry that has never earned its cost of capital.  This quote from Buffett sums it up: "The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money.  Think airlines.  Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down."
2) Oil Prices are Likely to Spike: Carriers have thin margins and tons of leverage so small increases in oil prices can crush profitability.  Historically, airline stocks have traded inversely with the price of oil and that is likely to continue.  Airline stocks are un-investable today due to the risk of a further spike in oil prices. 
3) Macro-economy is Feeble:  An already weak household sector combined with increasing oil prices could push the macro-economy into another recession which would also hit airline demand.  Carriers wont be able to push through price increases in this environment and demand destruction would offset the benefits of higher ticket prices.

What the Bears Are Missing:
1) Structural Changes Should Drive ROIC Expansion:  There have been three structural changes that should lead to higher and more sustainable ROICs than the industry has experienced in the past. These changes include: 1) Significant consolidation, 2) Tight capacity utilization/better capacity discipline and 3) Flatter industry cost curve.  We are already seeing the positive effects of these changes in very strong pricing growth and there is a lot more to come.  Current prices remain 50% below inflation adjusted prices in the 1980s and are barely back to nominal prices from 2000.  Domestic airline spending as % of GDP is also depressed.
2) Significant Hardwiring:  There is investor hardwiring here as the industry is coming out of the worst decade for profitability since deregulation.  The industry suffered ~$15b+ in operating profit losses over the past decade due to over-capacity, aggressive low cost carrier pricing, 9/11, Hurricane Katrina, the credit crisis and a spike in oil prices from <$20 to $100+.  Investors are assuming that the next decade will only be slightly better than the previous one in terms of the level and sustainability of profitability.  We believe that margins/ROICs will be better than that experienced over the past 30yrs due to the structural changes described above but the stocks will do very well even if they just revert back to long term through cycle margins/ROICs.
3) Cheap Valuations:  Despite significantly better competitive/industry dynamics, investors are currently putting a discounted multiple on depressed fundamentals.  EBITDAR margin and ROIC expectations for 2011-2013 are currently below long term through cycle averages implying industry fundamentals have deteriorated when they have actually significantly improved. Current legacy carrier EBITDAR multiples are also ~15-20% below the past 5-10year average of ~6x.  UAL trades at ~4x  2012E EBITDAR and ~3x 2012E FCF based on mid teens EBITDAR margins (long term through cycle average) and mid teens pre-tax ROICs (through cycle average for legacy UAL throughout the 90s).  UAL trades at a discount to its legacy peers due to the underperformance of legacy United.  Post merger, there is a lot of room for CAL management to improve operations and generate cost/revenue synergies which we don't even factor into our #s.  Assuming a 6x EBITDAR multiple and 6x FCF multiple and UAL would double in the next 12 months.  Profitability and multiples could easily be much higher.

Key Points:

1) Structural Changes Should Drive ROIC Expansion:  Margins/ROICs should improve dramatically over the next few years and will outperform historical returns due to 3 important structural changes:
   1. Consolidation:  There has been significant consolidation over the past 3yrs+ with 3 of the most recent mergers consolidating ~25%+ of industry capacity (Northwest, Continental and Airtran).  The top 4 airlines now control ~80% of domestic capacity. These mergers have reduced the competitive landscape down to 3 major legacy players and 2 major low cost carriers.  This will result in more rational pricing/capacity dynamics and increased scale and network affects for the merged businesses which could increase the barriers to entry in the business.  Consolidation has also shifted bargaining power more in favor of management when negotiating with labor.  We believe UAL will be one of the biggest beneficiaries of increased scale and their merger benefits are just now starting to flow through. 
      i. As carriers are able to gain access to more hubs and greater share at any given hub, they are able to better utilize their network and offer more flight options/connections at each airport.   This should result in a network effect for the carrier as they increase the breadth and depth of their network and are able to keep passengers on their network longer and offer better services/bundles especially to their corporate customers. 
      ii. The fact that Southwest is purchasing Airtran may be a signpost that Southwest was having trouble growing organically into new markets due to these increasing network effects and was forced to acquire in order to grow outside their core markets.
   2. Tight Supply/Demand:  Industry capacity domestically has been reduced by ~15% since 2000 while demand has only declined by ~2%.  This has resulted in industry load factors of 83%+ which is the highest the industry has experienced since deregulation.  Most legacy carriers continue to cut domestic capacity as higher fuel prices have caused them to ground inefficient planes in the desert and even the low cost carriers have reduced their capacity plans for this year.  Even if carriers wanted to grow their fleets, they are constrained due to tight capacity at the OEMs.  High load factors with limited capacity additions should support continued strength in pricing.
   3. Convergence in Industry Cost Structure:  Over the past decade, low cost carriers have disrupted industry economics due to their reduced cost structure and they have increased their market share from ~10% of domestic capacity to ~30%.  That has now changed as low cost carrier market share gains are stabilizing and their cost structures have converged with that of the legacy carriers.
      i. Since the late 90s/early 00s, oil prices have increased from ~10% to ~25-30% of industry sales, low cost carriers have slowly evolved into more of a hub and spoke airline model and they have experienced rising labor costs as their employee base has aged.  At the same time, several of the legacy carriers have gone through bankruptcies and mergers which have allowed them to reduce their cost base.   As a result, low cost carriers used to operate at a CASM ~25% below legacy players and now that has compressed to ~10%.  
      ii. Low cost carriers are now focused on pushing through price increases to offset cost increases as opposed to leveraging their cost advantage and growing capacity to take market share.  Southwest, as an example, is now focused on pushing through price increases to meet its return hurdles as opposed to focusing on capacity growth.

2) Significant Hardwiring:  The industry has just emerged from its worst decade in terms of profitability and this has created investor hardwiring.  
   1. Investor sentiment is very poor and no one has any interest in owning or looking at airlines
   2. Investors are ignoring the industry changes and are overly focused on economics over the past decade and current macro risks, specifically the risk of a further spike in oil prices
   3. Investors are ignoring the fact that airlines are maintaining their margins even with $100+ oil as the industry continues to push through price increases 

3) Current Pricing/Demand is Depressed:  There is plenty of room for airline carriers to increase prices as current prices are still very depressed relative to history:   
   1. Current prices are still ~50% below inflation adjusted ticket prices from the 1980s and are barely back to nominal prices from 2000. 
   2. Another way to look at it is that total domestic airline spending is currently ~50bps of GDP and the multi-decade average spending is ~65bps of GDP with several years running at north of 70bps.  From 1980-2000, spending was consistently between 60-70bps and it wasn't until the 2000-2010 period where ticket prices got hit. 
   3. Given the improvements in industry/competitive dynamics, there should be plenty of room for carriers to increase prices another 25-30% from here over the next couple of years.
   4. Current demand is also depressed as the average domestic seat miles flown per person has declined by ~10% over the past decade.  We are not betting on it and don't include this in our #s but if the economy were to improve and demand were to increase, it would provide even further upside.

4) Cheap Valuation:  UAL currently trades at ~60% of a conservative assessment of replacement value and <3x 2012E FCF (based on through cycle margins/ROICs) and FCF could easily grow from there over the next few years.
   1. Through Cycle Profitability:  UAL generated a 15% EBITDAR margin and a ~10-11% pre-tax ROIC in 2010.  Assuming another 12% increase in prices this year and ~8% next year and their EBITDAR margins would expand ~1-200bps and pre-tax ROICs would expand to ~15-17% assuming oil prices stay around $110.  This is in line with industry and company historical average through cycle performance.  Assuming these margins/ROIC, UAL trades at ~4x EBITDAR, <4x EPS and <3x FCF based on 2012E #s and profitability could continue to grow for several years as industry economics continue to improve.  
      i. The industry has generated 15%+ EBITDAR margins on average since the 1970s through several cycles and that is including the past decade which was very depressed.  And legacy UAL generated a ~15% pre-tax ROIC (EBITDAR-D&A/Invested Capital) throughout the 1990s (legacy CAL was even higher).
      ii. The above #s also don't account for the $1b+ in cost/revenue synergies that UAL has announced and could reasonably generate given they will have the largest global network and the corporate customer base to leverage the network. 
   2. Up-cycle Economics:  If UAL is able to pass through the 25%+ price increases indicated above over the next few years, margins and ROICs would expand dramatically assuming oil prices remain around $110. Pre-tax ROICs would expand from ~10% in 2010 to ~20-25% by 2013.  Its not hard to see UAL generating these types of economics by 2013 (or earlier if oil prices decline some and pricing stays firm) which would imply UAL is trading at ~<2x EPS.  Assuming profitability could be maintained for several years as it was in the late 90s and investors could easily put a 6-8x multiple on earnings leading to 3-4x upside   
      i. If you look at what UAL earned from 1995-2000 during an upcycle, they generated a pre-tax ROIC of ~20-25% for ~5yrs.  The economic backdrop was much better during that time period but the industry/competitive dynamics are much better today.   
   3. Potential Re-Rating:  History has shown that carriers have tended to enjoy 5yrs+ of sustained profitability coming out of a downturn as they did in the mid/late 80s and 90s.  Investors have questioned the sustainability of current margins as the past decade was characterized by super short cycles.  As carriers continue to increase ticket prices and show the ability to generate strong earnings and better ROICs in the face of rising fuel prices and other weather related issues, the industry could easily get re-rated. In addition, several carriers today like UAL have a significant amount of cash on hand and reduced leverage profiles which reduces the probability of severity even if the economy rolls over.    

Recent Signposts:
1) Oil prices increased 20%+ YoY in the first quarter and airlines were able to largely offset the cost increase with price increases
2) Legacy domestic carriers all have plans for flat to negative capacity growth for this year
3) Southwest is earning less than their target 15% pre-tax ROIC and is vocal about increasing prices to get to their target
a. Southwest increased prices more in the first few months of 2011 than they did in all of 08 despite the larger increase in fuel prices then
4) Southwest purchase of Airtran is a sign that it is becoming increasingly hard for carriers to expand organically into major hubs
5) The cost structures of the low cost carriers is compressing with that of the legacy carriers
 
Risks:
1) Macro-economy rolls over and airline traffic gets hit
2) Oil prices spike and carriers are unable to pass through dramatic price increases b/c it causes demand destruction
3) The industry isn't consolidated enough yet and carriers don't act rational
  a. Traffic improves and carriers begin to act irrational and add back capacity as much as possible 
  b. Oil prices fall and carriers start cutting prices as a result
4) Labor renegotiations result in much more favorable terms for workers and CASM increases hurt profitability

Catalyst