MorningWord 01/07/15: Cruising Altitude

by Dan January 7, 2015 9:35 am • Commentary

To state the obvious, Airline stocks have been the clear winner in the game of stock market roulette during this decline in oil. Stocks like AAL, DAL & UAL have risen 50% since their October Ebola lows.  In hindsight, the trade set up in early to mid October was potentially explosive as sentiment could not have been worse with two Malaysia Airlines disasters earlier in the year and Ebola travel fears. And then this happened:

Crude Oil 1yr chart from Bloomberg
Crude Oil 1yr chart from Bloomberg

Crude oil started blasting through round numbers in $10 increments, as the commodity headed towards a 50% re-tracement from the 2014 highs.

With oil as the single largest input cost for the airlines there is no arguing the benefit of lower for longer oil for the airlines.  But these companies hedge and what the implications of unwinds and rolls of said hedges going forward is anyone’s guess.  Also, if oil is to stay low I suspect it will have more to do with demand as opposed to oversupply in what is likely to be an increasingly deflationary environment where the dollar continues to surge and those carriers that have more global exposure could see demand wane.  About a month ago, when most of the airline stocks were about in the same spot I took a quick look at the sector and decided to focus on UAL (read  here):

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 focusing 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 competition from domestics and regionals in key hubs and a greater dependence 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.

From where I sit (currently a middle seat row 37) I see little reason to buy airline stocks with further crude weakness.  I see cheap stocks for a reason.  The industry has benefited from consolidation, massive cost cuts, ridiculous fees and general pricing power that has not been witnessed in a very long time.  If oil were to stay low it would be for reasons that likely make committing new capital to equities sub-optimal.  If oil rises quickly wouldn’t some of the “low oil” premium have to come out of the stocks??  Sorry peeps, it appears you missed this one if you are just now running to the gate.