Description

Airlines would normally not qualify as an idea under this forum. Though airlines can do incredibly well during years of good times, it comes with excruciating volatility and scant little downside protection. Yes there is no guarantee that this remains a great investment if you wake up from a coma 10 years from now, but that is a problem common to all cyclical industries. Nevertheless, I would still strongly argue that cyclically rising earnings in a leveraged business at 3.5x P/FCF would make a good investment over a 2-4 years horizon.

 

This writeup consists of 3 parts. The first part would address the industry backdrop. The second part would lay out the bull case for United Airline stock based on turnaround fundamentals and FCF yield. The third part would examine some of the common concerns about the airline space.

 

PART I – INDUSTRY BACKDROP

----------------------------------------------

Airline is a deeply cyclical industry that has a dismal track record of generating return for shareholders. Ever since the 1978 deregulation, the industry has suffered from overcompetition, overcapacity and market-share loss to the low-cost carriers. The last 5 years has been the darkest time in airline history. Not only did the industry come out from a period of aggressive capacity growth in the late 90s, 9/11 also caused air travel demand to collapse. Oil prices then went from $10 to $70. As if this is not bad enough for a beleaguered industry, bellwether low-cost carriers Southwest happened to have massive oil hedge at $26. With 15% of industry capacity pricing tickets with $26 oil, airlines are only left with a choice between losing $5B a year or $10B.

 

5 years after 2000 and $20B poorer, the industry was faced with another unprecedented crisis – Hurricane Katrina. Jet fuel shot up to $2.40/gallon ($100/barrel) and two major bankruptcies followed. That’s after two trips by US Airways and one long bankruptcy by United Airline itself. When Wall Street were speculating Continental would be the next bankruptcy, bankrupt Delta and Northwest both announced 15-20% domestic capacity cut that abruptly brought the industry demand/supply into balance. To be sure, robust economy has pushed up demand and load factors were already near 80%, level considered to be peak utilization. The demand/supply was going to find balance sooner or later, and Katrina brought this on sooner. Bankruptcies enabled Delta to restructure and move massive capacity to international routes. High fuel price forced Northwest to ground its huge fleet of 35-year-old DC9s. Suddenly there was a shortage of domestic capacity and the industry found itself with more pricing power than it knew what to do with. Carriers finally got a chance to pass on fuel costs since September 2005 and have been learning how to flex their pricing power since then. What was going to be a disaster turned out to be the tipping point of industry recovery.

 

Why hasn’t low-cost carriers moved in and capture the market share with lower prices? As Southwest CEO Gary Kelly had alluded to several times recently, they have more opportunities than they have aircraft. The aircraft shortage in US created as a result of surging global air travel demand was the key driver behind this. The Boeing and Airbus narrowbody order book was sold out to Asian, European and Latin American countries. Leasing companies have been moving useable aircrafts overseas to where the money is. What’s left sitting in the desert are nothing but old fuel-inefficient planes that are rendered useless by $75 oil prices. According to Airclaims, as of July 2005, almost no 737-NG were parked and only 15 A319/320/321 were parked, less than 0.62% of the aircraft type. And we continue to see carriers like Delta, American and Northwest grounding MD80s and DC9s. The unavailability of additional aircraft allowed domestic capacity to stay tight and was the key driver behind the pricing power.

 

With the history behind us, let us analyze what future holds. At the current level of fare level and fuel prices, airlines will become profitable in 2006 and very profitable in 2007 if they pick up a few more percent of unit revenue (RASM), producing substantial free cash flows. But what if RASM and fuel prices move significantly away from their current levels? When things are going really well for airlines, the question then becomes: what’s going to spoil the party? First, what if the economy reverses its course and walks into a recession? In that case, all bets are off. Demand for air travel would weaken. It’s impossible to quantify how much revenue loss would ensue, or whether that would be offset by fuel costs decrease. Nevertheless, UAL with its $4.5B cash on hand, does have the best balance sheet among legacy carriers to ride through an economic downturn. On the other hand, having achieved the RASM that the industry has achieved, I believe the industry only needs a 2% real GDP growth to continue the trajectory of profitability.

 

Much can still go wrong even if the economy holds. If fuel prices spike up again due to exogenous events, would airline be able to continue to pass on fuel price increase as they have done so far? It turns out that a $20 move in oil prices can be offset by about 6% increase in RASM. I would argue that people who have paid up so far to travel would not be held back by another 6% fare increase. Besides, $95 oil would probably further accelerate the retirement of old aircraft, further tightening demand/supply picture. Therefore, as long as capacity remains tight, airline profitability is not as sensitive to fuel prices as people make it out to be.

 

Tight capacity is not a given. This industry for decades has suffered from a structural tendency to grow into excess capacity. The unusual aircraft CONSTRAINT helped. Order book for narrowbodies is pretty much sold out until 2009. On the margin though, airlines can still squeeze out quite a bit of extra capacity by turning aircraft faster and optimizing schedules. One can take some comfort, from the call for capacity RESTRAINT by many major legacy carriers. United, US Airways and American management have all been pretty vocal about industry capacity discipline. Together they account for almost 50% of domestic capacity. Perhaps it’s a blessing that so many airlines are run by former CFOs (US Airways Doug Parker, American Gerard Arpey, Continental Larry Kellner, etc) – they tend to be more focused on financial return on capital than on strategic vision and market share growth. On top of that, you have another 30% of domestic capacity still operating by bankrupt carriers who are not exactly in growth mode. The point is, between the aircraft constraint and carriers’ restraint, the capacity should remain relatively tight for the next 3 years.

 

I would not have presented the complete picture if I didn’t point out the two distinct upside scenarios in which airline stocks will have incredible performance. One is the event that oil price falls back to $50. The second is the scenario that airline RASM increases surprise significantly on the upside, while oil stays relatively flat. The first scenario is self-explanatory. All airlines would more than double in this instance. The second scenario, which would also cause airlines to more than double, is rather probable. Consider what has already happened to the hotel rates. Yields (average air fares) today are still 17% below pre-9/11 level. Air passenger revenue as a % of GDP has dropped from 0.80%-0.85% pre-9/11 to 0.55%. As airlines have seen no resistance on fare increases so far, there’s a very good chance RASM can have another good 10% upside from here. After all, air travel plays a crucial role in our information-based economy and the companies that provide the service deserve to earn a return on capital. The prediction that telecommunications would reduce needs for air travel didn’t happen. Important business continues to be done the old-fashion way: face-to-face in person. I doubt if that will ever change. Therefore air travel demand should continue to reflect economic activity and pricing power would remain as long as capacity remains relatively tight.

 

PART II – UNITED AIRLINE VALUATION

-------------------------------------------------------

Financial Statistics

Shares outstanding: 115MM

                              EBITDAR     FCF         FCF / share       RASM yoy      jet fuel

                              -------------    ------------  -----------------         -----------------    -----------------

2006E EBITDAR:     $1,834M      $552M       $4.80                 9.1%            $2.15/gallon

2007E EBITDAR:     $2,475M       $931M       $8.09                3.5%            $2.25/gallon

NOL: ~$7.5B (therefore assuming no cash taxes in the foreseeable future)

 

Let’s benchmark these projections against the Plan of Reorganization Projections which assumes lower jet fuel at $1.52/gallon but a much weaker revenue environment (2.7% RASM yoy for 2006 and 2007). With rising fares, evidence in the industry are pointing to a more than complete offset for higher jet fuel prices. My projections assume that they would be $300M behind in 2006 EBITDAR because of fuel and non-cash stock comp expense. My 2007 EBITDAR number assumes that they would be $100M behind.

 

I think my assumptions are achievable because of the following reasons:

- Unit Revenue (RASM): 1Q06 RASM was up 10.9% yoy. from the statements among airline executives, it looks like second quarter should be better than the first quarter, partly because of continuous fare increases and the shift of Easter from first quarter into second quarter this year. We would see tougher comps in the second half but RASM improvement didn’t really start until 4Q05. Assuming 11.6%, 6.4% and 5.1% for 2Q06, 3Q06 and 4Q06 would get us to 8.5% for full year 2006.

- Fuel: jet fuel cost $1.95/gallon in the 1Q06, and assuming $2.15/gallon for 2Q06 and $2.25/gallon for the rest of the year would get us to $2.15/gallon for 2006.

- Salaries, maintenance, landing fees and other: these are fairly predictable line items and I expect them to track the POR Projections, adjusted for the non-cash stock comp.

- Regional Contribution: POR Projections assume a -$100M contribution from regional flying in 2006 and breakeven contribution in 2007. My assumption is in line with this.

 

Airline profitability (or lack thereof) is notoriously sensitive to fuel prices and to RASM. Since last September, we have seen RASM mostly offsetting fuel price increase. With planes filled, the economy has allowed airlines to get another $20 from travelers who are more than willing to pay up to get to destinations. I expect that to continue even in the event that oil goes to $95 / barrel (implying ~$2.62/gallon). As a point of reference, a $20 move in oil price would be offset by a 6.5% change in RASM. In a higher oil price, I expect that the industry will structurally adjust such that United will hit the $1.8B and $2.5B EBITDAR in 2006 and 2007.

 

I believe the tight capacity could persist at least till up to 2009 and therefore profits and FCF will go successively higher in 2008 and 2009. If you model in a few percent of RASM increase year after year and assume company make headway in cost-cutting so that total dollar amount of cash costs remain relatively flat, FCF would rapidly rise. I think with $8.32 of FCF in 2007, this stock should be worth $50 (at 6x cyclical multiple). And there is plenty of upside from there. A 3% outperformance in 2007 RASM would be $4 of FCF/share. Furthermore, bear in mind 12 months later people will be looking at 2008 and 2009 FCF, which will probably prove to be even better than 2007 due to the structural capacity constraint we have discussed above.

 

Comparables                          UAUA          AMR            CAL

                                             ---------          ---------          ---------

Share count                            117              260              102 

Share Price                            $28.34         $24.29         $30.04

Debt + 7x Rent                       $14,679       $17,860       $11,958

Underfunded Pension              $0               $1,400         $600

Cash                                      ($4,500)       ($5,180)       ($2,250)

Adj. TEV                                $13,495       $19,882       $13,372

Adj. TEV / 2006E EBITDAR     7.4x             7.2x             7.4x

Adj. TEV / 2007E EBITDAR     5.5x             6.3x             6.8x

P / 2006E FCF                       5.9x             10.4x           17.4x

P / 2007E FCF                       3.5x             5.9x             9.7x

 

Note: AMR has $2.8B underfunded pension liability and CAL has $1.2B. I take a hair-cut of 50% because they are zero-coupon accounting liability that doesn’t have to be funded immediately. Also don’t forget the in-the-money convertible notes of AMR and CAL when you calculate the share count. The FCF numbers of AMR and CAL assume pension reform, if funding requirements are relieved.

 

Is this the most attractive legacy airline stock? I believe so. But I will argue with nobody who thinks AMR or CAL are better or just as good. As you will see, the comparison with other legacy airlines are not one-sided at all. So I will layout the pros and cons of UAUA versus others and you can be the judge. What I strongly believe is, these three stocks will all do very well in the next 2-4 years.

 

Pros:

-    Free of pension liabilities: substantial cost advantage with or without pension relief. If pension relief for airlines don’t come, AMR would have to fund over $2B of liabilities over a very short period of time, further delaying any gratification for shareholders. United, on the other hand, don’t have that risk.

-    Lower labor costs: unionized labor cost is the toughest cost to tackle in the airline business. United is definitely ahead on this front. In addition, United’s labor contract is not up for renewal until first half of 2010, while AMR’s contracts are up in 1H08.

-    More low-hanging fruit in non-labor costs to cut: The superb management team at AMR and CAL has done the most impressive jobs in cutting non-labor costs. That also means less low-hanging fruit is left. In the next 4 years, United are likely to have more cost-cutting opportunities than AMR and CAL would have, inferior management notwithstanding.

-    Best route network: What’s undeniable is that United has as good a route network as American, if not better. United is the only US airline that has both fifth freedom rights at Tokyo’s Narita airport (along with Northwest) as well as extensive route authority at Heathrow (along with American). Since route network is an asset that takes decades to replicate (in the case for Narita and Heathrow rights, they are not replicable), I consider this a very important competitive advantage. Also see bruno677’s Northwest bank debt writeup for a good analysis on Routes Valuation.

-    A lot of dry powder on the balance sheet: The company has $4.5B cash on the balance sheet, $3.6B of which are unrestricted. Because the company has only drawn down $2.8B Term Loan on collaterals of $5.3B, you can argue that the company has another $1B-$2B of secured debt capacity. Note the CDS spread for the 1^st-lien debt is around 200bp. The collaterals consist of $1.3B of aircraft, $900M of spare parts, $2.4B for Narita and Heathrow Routes and $650M of other real estate assets. All of those have been recently appraised. The company has a MileagePlus loyalty program that generates over $300M of annual income, which can provide access to over $1B of capital should the company want to pursue what Air Canada has done with its loyalty program. (see Bear Stearn David Strine’s upgrade report on UAUA on 6/16/06) With over $6B of potential liquidity, the company should weather a downturn as well as any airline can. Even more interesting is the possibility of returning capital to shareholders with some of the $6B liquidity capacity.

-    Valuation: On FCF basis, this is the cheapest airline out there. This is not due to leverage because the company also is cheaper on a 2007E EBITDAR basis. 2007 is the first year when the cost-cutting efforts get fully reflected.

 

Cons:

-    Unproven and probably inferior management team: The street is rightly skeptical of this team and has low expectations, which can be beat if the team can do a few things right.

-    The underachieving culture of United is also not conducive to aggressive cost-cutting. AMR and CAL had both been in aggressive cost-cutting modes for the past 4 years, taking out billions dollars of costs when United is just getting started.

-    Revenue premium-driven strategy might underperforms should the economy falters: when everybody is going the low-cost carriers style by cramming in more seats and taking out the pillows, United’s strategy runs against conventional wisdom. But the strategy that everybody pursues is not necessarily the best strategy. I actually think the premium strategy, if executed properly, can come with great reward.

-    Older fleet than Continental but newer than American: After bankruptcy, United has a relatively simple fleet with average age of 11 years. Its domestic narrowbody fleet consist of A320s and 737 classics. The A320s are very fuel efficient but the 737 classics are quite old and very inefficient compared to the 737 NG. This is still much better than AMR’s 16-year-old MD80s. Overall I believe United’s fleet quality is still above industry’s average. Continental’s all-Boeing fleet is basically the best in the industry and that partly explains its premium multiple. You’d be surprised how much the fleet quality counts. AMR, on the other hand, badly needs replacement for its 327 MD80s and the replacement costs need to be factored in when you compare their valuation.

-    Lack of capacity growth: While United is growing capacity by 2.5% in 2006, this is nothing compared to the double-digit growth of low-cost carriers or Southwest and Continental’s 8% growth. Capacity growth is bad for the industry but it’s great if everyone else isn’t growing. If there were any good time for an airline to grow capacity, it would be now. For that United deserves a premium to shrinking AMR but a discount to steadily growing CAL.

 

PART III – CONCERNS

--------------------------------

<Airlines never earn attractive return on capital, if any at all.>

This is obviously not a true statement globally. There are some airlines overseas that have shown track record of return on capital no worse than a chemical company or a railway company. US airlines have been particularly difficult because the industry never fully consolidated since deregulation. Today we have 6 major domestic carriers when we should only have 3. Business is just tougher when you have too many players. Irrational behavior occurs more easily. Bankruptcies of Delta and Northwest provided a golden consolidation opportunity among 2 or 4 carriers. But even in the absence of that there is still a 3-5 year window for airline to deliver profits. If the industry find a way to consolidate, as most industries do, the sustainable return on capital like that delivered by global airlines might finally be reachable in US. You can wait for consolidation to happen before you invest in airlines. Unfortunately a lot of return would be forgone by the time the industry gets fully consolidated.

 

<Airlines are owned by unions. They have always been run for the benefit of the unions and shareholders are only left holding the bag when the music stops.>

Southwest has unions. European airlines have unions. Many Asian airlines have unions. Companies are generally better off without union. However the problems with unions are not insurmountable. The problems with airlines have much more to do with its lack of pricing power, which in turn is due to having too many players.

 

<Airline is a volatile industry and is highly sensitive to oil price fluctuations.>

It is one of the most deeply cyclical industries and its profitability does swing on small movement in fuel prices. Coming out from the Sept 2005 trough at this part of the cycle, though, I’m not sure if it’s a bad thing to be a deeply cyclical business. Oil prices is merely a raw material costs in this business. Like in many other business, raw material costs would be passed on when capacity is tight, and we’re in a tight capacity situation.

This concern might be particularly poignant in light of recent geopolitical unrest. Yes the recent spike in oil price will cost the airlines many bucks in EPS before future fare increases. But if one pay attention to the trading history of airlines in the last 9 months, there has been an observable pattern. When oil price moved up, concerns about widening loss or reduced earnings sink the stocks. Then when airlines absorb these with successive fare increases, manifesting themselves in strong RASM gains, the stocks rally back up and beyond previous highs. Therefore I would argue that times like this represent buying opportunity in airline stocks.

 

<Airlines have little pricing power and the product they sell is a commodity.>

I’m sure you know people who have loyalty to one of the mileage programs. And maybe leisure travel is near a commodity, but the leisure market is already dominated by low-cost carrier and it can’t get a lot worse. Besides, at $70 oil, I’m not sure if Jetblue or Southwest really have a cost advantage when legacy carriers can generate so much more revenue from the front cabin. There is also international travel which has a higher differentiation opportunity. If you consider the list of factors affecting people’s choice of whom to fly with, the claim that airline is a commodity business doesn’t stand scrutiny.

Catalyst

Although I don't have any inside scoop on how the second quarter earnings would compare to Wall Street expectations, I believe the second half 2006 earnings would change Wall Street's mind about this Company's free cash flow generation potential. So I believe the sentiment will gradually reverse as they report 3Q06 and 4Q06 earnings.