After what has felt like an endless string of new highs in the airline stocks for the last month the sector hit an air pocket today on the heels of just OK November traffic data and the stabilization of crude oil. The stocks of most large U.S. airlines were down about 5% on the day at their lows, and with stocks like Spirit Airlines (SAVE) down 17% at one point, now down 12%.
The price action in the sector has been extreme since September as most components had started to make new 52 week highs anticipating lower oil and then fears of an Ebola hitting airline bookings, causing most stocks to decline at least 20% in a matter of weeks. Well, we all know happened since not only have the Ebola fears abated but oil has collapsed from $90 to the low $60s since the start of October. And thus the seemingly never ending higher highs.
It is my sense that the benefits of lower oil for months if not quarters to come is reflected in the major U.S. airline stocks, at least from a sentiment point for the near term. But what is uncertain to me is what lower for longer oil prices are saying about demand. If weak global demand has been a larger than believed contribution to oil’s crash then I suspect that mildly negative data points regarding capacity may continue to have greater than expected downward volatility as we get into the New Year and past the seasonally strong holiday period.
As the stocks have made new highs, options prices have actually increased a bit off of recent 52 week lows as demand for calls have help keep options prices bid. Looking at United Airlines for instance, total options open interest is heavily weighted to calls, 375,000 to 208,000 puts, as 14 of the top 15 strikes of open interest are all calls. Even on a day like today with UAL down 3%, calls outnumber puts 2 to 2, with the largest block a buy of 2500 March 65 calls when the stock was $62.65.
Make no mistake about it, airlines stocks are cheap on earnings multiples as most of the majors have squeezed cost savings from recent consolidation, pricing power, surcharges and now lower oil costs. The real question for the long term bull case is can these carriers who tripped over themselves time and time again remain disciplined in an environment where sales growth will likely always remain in the low single digits.
Why am I foccusing on UAL? Well all three major U.S. carriers, the other two being American Airlines (AAL) and Delta Airlines (DAL) are all expected to have about $40 billion in 2014 sales (AAL ~$43 billion, DAL ~$40 billion and UAL ~$39 billion), yet UAL’s market cap at $23 billion severely lags AAL at ~$35 billion abd DAL at ~$39 billion. So why the lag? lower margins the result of poor execution and greater competetion from domestics and regionals in key hubs and a greater dependance on international routes (about 40% of passenger revenues to about 30% for AAL and DAL). the last reason is the big one…..Despite lower oil, maybe UAL is affected more in the new year from a weaker global economy.
Looking at the one year chart of UAL, its hard to suggest that the breakout above $50, on its way to $65 in a little more than a month was nothing short of a work of art. But I would add that is oil settles in here or higher, and the impending calendar change causes investors to reconsider the benefits of low oil vs the potential for decreasing demand early in 2015, airlines stocks could re-trace a bit of the recent move:
[caption id="attachment_48844" align="aligncenter" width="600"]
UAL 1yr chart from Bloomberg[/caption]
A re-tracement back to the breakout level, which corresponds with the stock’s rising 50 day moving average could be in the cards to about $52.50 in the coming weeks/months.
At the moment I am not looking to pick a top in one of the few supply/demand situations that appear to make sense to me, but if I were looking to do so, put butterflies look attractive targeting the low to mid $50s in the next couple months:
Hypothetical Trade: UAL ($62.30) buy the Jan 60/52.50/45 Put Butterfly for 1.40
-Buy 1 Jan 60 put for 2.50
-Sell 2 Jan 52.50 puts at .60 each or 1.20 total
-Buy 1 Jan 45 put for .20
Break-Even on Jan Expiration:
Profits: between 58.60 and 46.40 make up to 6.10, with max gain of 6.10 at 52.50
Losses: between 45 and 46.40 & between 58.60 and 60 lose up to 1.40, max loss of 1.40 above 60 and below 45
Rationale: I would not be too worried about the worst case downside scenario, and the trade structure offers a nice wide range of profitability to the downside. The biggest issue with the out of the money call fly, and likely the major reason why I am not doing this trade now is that if I get direction wrong in the near term then the probability of success decreases every day. This is the first real down day after a monster run, I want to see what sort of bounce the stock has, if it has one…..