Description

Purchase UAIR and short an equal dollar sized basket of the other four major US network carriers (AMR, CAL, DAL and NWAC). This is an impure arbitrage, but the valuation discrepancy is extraordinary. My thesis below is quite simple (maybe simplistic!), and I exclude issues that are not directly relevant to this thesis.

Note that for all the analysis below, when I refer to “airlines”, I am describing the major publicly traded legacy network carriers (AMR, CAL, DAL and NWAC, and not the LCC (low cost carriers) like Southwest, ValuJet and America West.

As Warren Buffett has famously pointed out, airlines are a terrible business. But by shorting a basket of the other (comparable) network carriers, you can hedge out some of the industry risk and the event risk (terrorism, etc).


BACKGROUND

UAIR emerged from bankruptcy a few months ago, trading in the pink sheets, and was listed on NASDAQ today. I was planning to suggest it after today’s UAIR earnings release, but before it was listed (I was under the impression that listing would not occur before October 31), enabling VIC buyers to take advantage of the pop that sometimes occurs when pink sheet stocks get listed, because of the new potential universe of buyers. But the company managed to get an accelerated listing. Ah well ….


VALUATION GAP

My logic for using EV/Revenue is discussed below.

Company EV/Revenue

AMR 80%
CAL 67%
DAL 82%
NWAC 71%
UAIR 23%

Note that cash from UAIR warrant exercise and the resulting new shares are included in the calculation above.

Equalizing UAIR to an EV/Revenue range of 67% to 82% yields a stock price for UAIR of $54 - $69, a significant rise from the current $9.

I also ran a similar analysis using EV plus Pension Liabilities; the resulting target price ranges for UAIR are $40 - $96.


RELEVANCE OF VALUATION TECHNIQUE

The airline business is a deeply cyclical business, which is showing incipient signs of a recovery. From cycle lows in early 2003, most of the network carriers (AMR, CAL, DAL and NWAC) have had significant share price recoveries, in the order of 3-10x. All except UAIR, which has been held back because it was listed in the pink sheets and not covered by analysts. As an aside, analysts from seven investment banks were on the UAIR earnings conference call today, and the company assures me that analyst coverage will begin shortly.

My focus is relative valuation. Given that the airlines are being priced on recovery earnings (2005), it is a fool’s game to hazard what current absolute earnings multiples are. However, if one is willing to assume that the economics of the network carriers are generally similar (more on that below), then Enterprise Value/Revenue can be used as a proxy for relative valuation.

So are the economics of UAIR and the other network carriers comparable?

Qualitatively, there are some important differences. UAIR is concentrated on the east coast of the US while the other airlines are global. Also, UAIR is the smallest (but not by much) airline and has probably suffered some image problems from having been in Chapter 11 (but has also benefited from Ch 11 related cost reductions, including significant debt reduction).

Quantitatively, however, it is interesting to note that in the second calendar quarter of 2003, profitability was similar – except for CAL - lending credence to the POV that their economics may be comparable.

I also assume that, except for CAL, the similar profitability indicates that the companies use similar ratios of operating/capital leases for their equipment, thus minimizing the need for related adjustments to EV and EBITDA.

Company EBITDA/Revenue EBITDAR/Revenue

AMR 3.4% 7.5%
CAL 8.4% 18.4%
DAL 2.9% 8.3%
NWAC 3.9% 9.1%
UAIR 3.2% 9.4%

Note that adjustments were made to EBITDA and EBITDAR for one-time events. Also I use 2Q03 numbers because not all 3Q03 numbers are out, and balance sheets are only available in the 10Qs.

In terms of balance sheet safety,

Company Net Debt/Revenue

AMR 63%
CAL 51%
DAL 69%
NWAC 56%
UAIR 14%

Net Debt is Gross Debt, Capital Leases, Minority Interest plus Preferred Stock less Cash (Restricted and Unrestricted, but excluding Equipment Deposits).

UAIR seems to have the greatest degree of balance sheet safety (not surprising, given its recent exit from Chapter 11).

Given these facts, the valuation gap is glaring.

As an additional data point, some major investors including Farrallon, Oaktree and Goldman Sachs purchased $35 million in shares from the company in August for $7.34 per share, the same price as the major investor in the Chapter 11 proceedings.

PLEASE NOTE THAT I AM NOT MAKING ANY JUDGMENT ON THE ATTRACTIVENESS OF THE AIRLINE INDUSTRY, OTHER THAN THE ASSUMPTION THAT UAIR AND THE OTHER NETWORK CARRIERS WILL SURVIVE IN THEIR CURRENT RELATIVE FORMS FOR THE DURATION OF THE ARBITRAGE (HOPEFULLY JUST THE NEXT FEW QUARTERS). SO, AS YOU COMMENT ON THIS IDEA, PLEASE REFRAIN FROM GENERAL QUESTIONS REGARDING THE AIRLINE INDUSTRY.


DISCLOSURE

I am currently long UAIR, but not correspondingly short another network carrier, because I am generally short-term positive (and have been for six months) on US network carrier stocks.


BACKUP CALCULATIONS:
(sorry about the formatting - the data is there and it would just take too long to reformat by hand).

AMR CAL DAL NWAC UAIR
Annualized 2Q03 Revenue $17,296 $8,864 $13,228 $9,188 $7,108

Balance Sheet
Current Assets
Cash & Cash Equivalents $ 157 $ 1,485 $ 2,815 $ 2,814 $ 1,225
Short-Term Investments 1,670 142 - - 200
Restricted Cash 550 - 208 125 173
Accounts Receivable 873 453 770 412 330
Inventories 557 230 190 202 162
Deferred Income Taxes 175 717 -
Other Current Assets 440 232 387 384 144
Total Current Assets 4,247 2,717 5,087 3,937 2,234

Total Flight Equipment at cost 15,571 6,691 20,570 6,108 2,537
Total Other Equipment at cost 2,421 1,301 4,328 1,018 373
Accumulated Depreciation (flight equipment) (1,754) (6,200) - (42)
Accumulated Depreciation (other equipment) (2,297)
Purchase Deposits 429 256 79 - 158
Total Flight & Other Equipment (after depreciation) 18,421 6,494 16,480 7,126 3,026

Total Equipment under Capital Leases 1,427 265 116 240
Route Acquisition Costs, net 1,270 995 98 634
Goodwill and Intangibles 144 2,092 818 3,210
Restricted Cash 375 405
Other Long-Term Assets 3,855 395 1,309 994 31
Total Assets 29,220 11,010 25,557 13,749 8,906

Current Liabilities
Current Porton of Long-Term Debt $ 564 $ 445 $ 845 $ 719 $ 71
Current Obligations under Capital Leases 158 - 26 -
Accounts Payable 1,100 853 1,725 2,445 433
Accrued Salaries & Wages 1,184 223
Air Traffic Liabilities 2,987 1,139 1,500 1,440 957
Other Current Liabilities 2,272 621 1,093 - 568
Total Current Liabilities 7,081 3,058 6,373 4,604 2,252

Long-Term Debt, Less Current Portion 11,241 5,392 11,343 6,220 2,999
Capital Lease Obligation, Less Current obligations 1,294 - 83 391
Minority Interest 278 - 537
Deferred Income Taxes 494 - 110
Post Retirement Benefits 2,729 837 2,277 3,529 1,634
Other Long-Term Liabilities 7,377 318 4,536 705 1,635
Total Liabilities 22,641 7,319 18,239 11,492 6,268

Preferred Equity 226

Common Equity (502) 633 945 (2,573) 386
Total Liabilities and Equity 29,220 11,010 25,557 13,749 8,906

Cash from Warrants Exercise - - - - 124
Unaccrued Value of Preferred Stock - - - - 27
Net Debt $ 10,880 $ 4,488 $ 8,899 $ 4,928 $ 970
Preferred Stock $ 266 $ 226

Stock Price $ 14.90 $ 19.58 $ 13.69 $ 14.65 $ 9.05
Market Cap $ 2,943 $ 1,459 $ 1,689 $ 1,362 $ 637
Shares Outstanding 197.5 74.5 123.4 93.0 70.4

Net Debt + Preferred / EV 63% 51% 69% 56% 14%

Enterprise Value $ 13,823 $ 5,947 $ 10,854 $ 6,516 $ 1,607
EV/Revenue 0.80x 0.67x 0.82x 0.71x 0.23x

Catalyst

NASDAQ listing, which occured today
Analyst coverage (currently none) which should begin shortly