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We Believe Airline Stocks Are Undervalued



Many analysts and investors believe airline industry is in a secular bull market, driven by a change in fundamentals over the last five years that have allowed carriers to grow profits and improve free cash flow in varying oil-price environments.

A recent Deutsche Bank report now seems to side with this position, stating that “the industry over the past several years has demonstrated its ability to successfully offset most, if not all, of the rise in fuel expense via a combination of cost savings and various revenue initiatives.”

Looking ahead to the end of the year, Deutsche Bank sees airlines generating $24.7 billion in operating income, or the money that remains after certain operating expenses are paid such as research and development, wages, maintenance and the like.

Deutsche Bank’s 2015 estimate—a healthy 45-percent increase from 2014’s $17 billion, driven largely by savings in fuel costs—is in line with the one made by the International Air Transport Association (IATA) last year.

As we all know, oil fell from over $100 per barrel in July 2014 to a low of $44 in January 2015, and jet fuel prices followed closely at its heels, declining to multi-year lows. According to the IATA, airlines worldwide are expected to spend $71 billion on fuel in 2015, a savings of $84 billion compared to 2014.

Airlines Are Cheaper Than Other Transportation Stocks

Despite the record quarterly profits, airline stocks in general are relatively cheap compared to both the S&P 500 Index and the Dow Jones Transportation Index.

The price-to-earnings ratio, or P/E ratio, measures a company’s valuation by comparing its current share price to its earnings per share (EPS). A P/E ratio of between 10 and 17 is traditionally considered to be a fair trade; anything below 10 could mean that the stock is undervalued or that its earnings might be substantially above historic trends.

By 2016, the estimated P/E ratio for airlines is 8.07, compared to the Dow Jones Transportation Index’s 13.87 and the S&P 500’s 15.78.

And the positive data doesn’t end there. Philip van Doorn, financial analyst and columnist with TheStreet.com, found that among all of the companies in the Dow Jones Transportation Index as well as transportation companies in the S&P 1500 Composite Index, airline stocks were the cheapest.

Among our group of 35 transportation companies, all of the stocks trading below 13 times consensus 2016 earnings estimates are airlines, which as a group have shown remarkable performance over recent years.

Below you can see how cheaply valued some of the airline stocks are, based on forward P/E, which uses estimated net earnings over the next 12 months, and price/earnings to growth (PEG) ratio.

Airline Closing Price – May 19 Forward P/E (12/2016) PEG Ratio (5 Years)
Alaska Air Group Ltd. $67.38 10.7 0.68
United Continental Holdings Inc. $62.25 6.6 0.16
American Airlines Group Inc. $49.00 6.3 0.22
Delta Air Lines Inc. $47.37 8.2 0.53
Southweat Airlines Co. $42.14 11.1 0.42
Source: Yahoo! Finance, Thomson Reuters, U.S. Global Investors

The PEG ratio is a stock’s price-to-earnings ratio divided by the estimated earnings growth rate for a certain period of time. A ratio below one indicates that a company is undervalued; in other words, it’s trading below a level that reflects the expected growth rate of earnings.

Efficiency Leading the Way

An important metric Deutsche Bank uses to illustrate that the industry is in expansion mode is operating margin, which measures a company’s efficiency in generating revenue. This figure tells you how much of each dollar earned the company keeps as profit after taxes. Generally speaking, the higher the number, the more efficiently the company is being run and the more capital it can use to pay down debt and return to investors in the form of stock buybacks and dividends.

Because of fuel cost savings, all 11 of the companies featured below are expected to increase margins by the end of 2015.

The carrier expected to see the greatest increase is Las Vegas-based Allegiant Air, the ultra-low-cost regional carrier that focuses on underserved cities. The company provides a “complete travel experience” that allows customers to book hotel stays and car rentals on top of flights.

Claiming the highest margins last year was Spirit Airlines, the carrier known for its “Bare Fare” pricing structure. Even though it offers some of the lowest prices in the industry—they’re 40 percent lower than the competition on average—Spirit is able to maintain these margins because of its stripped-down, no- frills service and experience.

Spirit certainly has grounds to justify this highly-frugal business model. In a June 2014 survey, close to 1,500 air travelers were asked what they considered first when looking to purchase an airline ticket. Fifty percent of respondents cited price as the most decisive factor, whereas only 3 percent said it was legroom.

The Season of Record Earnings

For the first quarter, most airlines beat analysts’ expectations. Below is a quick roundup of some of the announcements.

American Airlines, which was recently added to the S&P 500, reported a record net profit of $1.2 billion, or $1.73 per share. This is a tripling of the carrier’s net profits in the first quarter of last year.

American CEO Doug Parker is so bullish on his company, in fact, that he has asked to be compensated solely in company stock going forward. It’s normally a good sign when executives choose to invest in their own companies, especially so heavily as Parker plans to.

Delta reported higher-than-expected earnings—$0.45 per share—with an average beat of 5.11 percent over the last four quarters. This marks the company’s eighth consecutive quarter of record profits, according to President and CEO Gary C. Kelly.

“We are managing our invested capital aggressively and continue to provide healthy returns to our shareholders,” Kelly stated in a press release. “During first quarter 2015, we returned $381 million through the payment of $81 million in dividends and the repurchase of $300 million in common stock. And we expect to complete the repurchase of the remaining $80 million under our existing $1 billion share repurchase authorization next month.”

Alaska Air’s earnings per share came in at $1.12, with earnings up 75 percent on a year-over-year basis. The company reported record first-quarter net income of $149 million, a 67-percent increase from last year. During the quarter, the company also bought back $102 million worth of common stock and paid a $0.20 per- share dividend.

Southwest reported record profits of $453 million—or $0.66 per share, beating consensus by one penny—up from $152 million in the first quarter last year.

United Continental reported record first-quarter profits of $582 million, earning $1.52 per share, beating estimates of $1.44. The company paid back $200 million to shareholders in its proposed $1 billion share buyback program.

Finally, Allegiant also posted a record quarterly EPS of $3.74, up from $1.86 last year. This marks the ultra-low-cost carrier’s 49th consecutive profitable quarter.

Past performance does not guarantee future results.

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The S&P 500 Stock Index is a widely recognized capitalization-weighted index of 500 common stock prices in U.S. companies. The S&P 1500 Composite Index is a broad-based capitalization-weighted index of 1500 U.S. companies and is comprised of the S&P 400, S&P 500, and the S&P 600. The index was developed with a base value of 100 as of December 30, 1994. The Dow Jones Transportation Index is A price-weighted average of 20 transportation stocks traded in the United States.

The price-to-earnings ratio is a valuation ratio of a company's current share price compared to its per-share earnings. The price/earnings to growth is a stock's price-to-earnings ratio divided by the growth rate of its earnings for a specified time period. The price/earnings to growth (PEG) ratio is used to determine a stock's value while taking the company's earnings growth into account, and is considered to provide a more complete picture than the P/E ratio. Forward price-to-earnings (P/E) is a measure of the P/E using forecasted earnings for the P/E calculation.

Free cash flow (FCF) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base.

Earnings per share (EPS) is the portion of a company's profit allocated to each outstanding share of common stock. Earnings per share serves as an indicator of a company's profitability.

It is not possible to invest directly in an index.