Keep these airline stocks on your radar screen

Their recent media-fuelled pullback has created an attractive entry point for investors.

Vikram Barhat 19 April, 2017 | 5:00PM
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As far as headlines go, this isn't turning out to be a great year for U.S.-based airlines. United Airlines' recent customer-service debacle hogged headlines and triggered a loud public outcry, barely weeks after it found itself dealing with an onslaught of bad press and social-media backlash for barring two teenage girls from boarding the flight for "inappropriate" leggings. Delta Air Lines, America's largest career, is still reeling from a whopping US$125 million loss in revenue due to flight cancellations. There have been lawsuits alleging racial discrimination, frequent flight cancellations and other instances of public relations failures.

However, what is lost in the media maelstrom and worldwide outrage is the quiet resurgence of the U.S. airline industry that has long been battling geopolitical headwinds, low fares forced by weaker oil prices, weather-related cancellations and general economic malaise. Further, the recent sell off in airlines stocks, due to deteriorating unit revenue guidance, tends to mask an otherwise positive and improving 2017 outlook for the airlines, according to a Morningstar report.

The pullback has created an attractive entry point for investors looking to buy airline stocks that appeared slightly overvalued in the past not so distant, says Morningstar equity analyst, Chris Higgins.

Year-to-date, the major U.S. network airlines are down between 5% and 12% versus a gain of nearly 5% for the S&P 500, as of April 13. The S&P 500 Airlines Industry index slipped almost 9% in the month of March as a result of recent volatility.

Nevertheless, there are a lot of numbers supporting a positive outlook for U.S. airlines, asserts Higgins. The following airline companies are adding new routes, buying new jets, successfully gaining passenger traffic and billions of dollars of Warren Buffett's money, and are worth a closer look, according to Morningstar equity research.

Delta Air Lines Inc.
Ticker DAL
Current yield 1.67%
Forward P/E 7.3
Price US$44.35
Fair value US$58
Data as of Apr. 17, 2017

One of the world's largest airlines,  Delta Air Lines (DAL) flies to more than 325 destinations in 60 countries, and operates a fleet of 832 aircraft. The company generated US$39.6 billion in revenue in 2016.

"Delta remains one of the best-managed airlines, with the highest operating margins among U.S. network carriers, a clean balance sheet and a commitment to returning 70% of its free cash flow to investors," says a Morningstar report.

Delta's strategy of operating older aircraft -- its fleet is the oldest among U.S. network carriers -- keeps capital costs low. And although older aircraft demand higher maintenance, Delta's maintenance operations are among the best in the industry, says the report.

"Delta's strategy also entails forming joint ventures with companies such as Virgin Atlantic and China Eastern to access international markets," says Higgins. The airline that lost US$125 million in revenue due to storm-related cancellations in early April reported better-than-expected quarterly profits and forecasted second-quarter passenger unit revenue to increase 1% to 3%, supported by improving demand and fares, according to Reuters.

Higgins recently raised the stock's fair value estimate from US$48 to US$58, prompted by "a revised forecast with higher operating margins, a lower pension liability and an assumption of lower effective tax rates thanks to corporate tax reform in the U.S."

Delta is well positioned to achieve return on invested capital exceeding its cost of capital from 2017 to 2021, projects Morningstar. Further, supported by persistently low fuel prices, annual average revenue is set to grow at 2.4% over the next several years, forecasts Higgins.

United Continental Holdings Inc.
Ticker UAL
Current yield -
Forward P/E 7.7
Price US$70.77
Fair value US$76
Data as of Apr. 17, 2017

 United Airlines (UAL) operates more than 4,500 flights a day to 339 airports on five continents. The airline is a member of the Star Alliance, which provides service to 192 countries via 28 member airlines. In 2016, the carrier had US$36.6 billion in revenue, of which US$31.5 billion was passenger revenue.

Among the U.S. airlines, United looks the most attractive from a valuation standpoint, says a Morningstar report of the stock that has fallen more than 5% year-to-date, as of April 14.

"United enjoys one of the most attractive route networks, with hubs in the five largest U.S. markets," says a Morningstar equity report. The carrier, which is introducing a new Polaris business and first class seat in a bid to raise the business travel stakes, recently raised its flight capacity growth to 2.6% for the first quarter of 2017 from a prior forecast of a 1%-2% increase, according to Reuters.

"We expect the company to achieve returns on invested capital, or ROICs, above its cost of capital from 2017 to 2021," says Higgins, who forecasts ROIC levels for 2020 and 2021 to be 10% and 11.8%, respectively.

The third biggest U.S. airline by passenger traffic is not without its share of near-term challenges -- higher labour and fuel costs, for instance -- that beset the entire industry and which will create profitability headwinds, warns Higgins. He asserts, though, that the turnaround plan outlined by management will improve performance over time.

"Over the medium to long term, there is a real possibility that United's new and very capable management team will permanently fix the problems that have historically plagued the carrier's operations," says Higgins, who pegs the stock's value at US$76 and projects 3.4% annual average revenue growth during 2017-21.

As for social controversies like passenger removal, they tend not to have a material impact on a company's financial condition, says a report citing a Citigroup analyst note to clients.

American Airlines Group Inc.
Ticker AAL
Current yield 0.9%
Forward P/E 7.2
Price US$44.23
Fair value US$45
Data as of Apr. 17, 2017

 American Airlines (AAL) operates nearly 6,700 flights per day to 339 destinations in 54 countries. The carrier generated more than US$40 billion in revenue during 2016.

"American Airlines' management is betting that a newer fleet and a more aggressive balance sheet coupled with cabin segmentation will position the company for competitive success against its network peers and enable it to compete more effectively with ultra-low-cost carriers," says a Morningstar equity report.

New cabin offerings such as basic economy -- no-frills, restricted tickets -- will enable American to drive more revenue and compete with rival airlines, the report adds. The move has started producing results as these bargain-basement seats, offered in limited numbers, get snapped up quickly, allowing the airline to then sharply increase the price of main cabin seats by as much as 117%, padding its profits, says a Los Angeles Times report.

Further, passenger revenue for each seat flown a mile, a key traffic metric, jumped as much as 4%, relative to a previous forecast of 1.5% to 3.5%.

The company is more than halfway through integrating the merger with US Airways. "American can squeeze more efficiency out of its operations as it continues to work through its merger," says Higgins. "This gives us confidence that management's expectation of driving further cost savings and efficiency through reduction of overlapping functions and head count throughout 2017 will bear some fruit."

Higgins, who puts the stock's fair value at US$45, projects 3% annual average revenue growth, including cargo, over the next several years.

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About Author

Vikram Barhat

Vikram Barhat  Vikram Barhat is a Toronto-based financial writer specializing in investing, stock markets, personal finance and other areas of the financial services industry. He also writes for CNBC, BBC, The Globe and Mail, and Toronto Star.

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