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Oil’s Slump Could Lift Airlines Higher

10 December 2014 in Trading Ideas

It’s been a yearlong rally for the shares of airline operators, but some analysts believe many of the names are still undervalued.

The Taking Flight motif has gained 46.2% so far in 2014. In that same time, the S&P 500 has advanced 13.6%.

In the past month, the motif has increased 6.4%, the S&P 500 is up 1.3%.

Part of the advance for airline stocks has come on the wings of lower jet fuel prices. As a recent Barron’s article pointed out, a gallon of jet fuel has dropped to $2.09 from $2.87 at the end of August.1

Barron’s noted that JPMorgan estimates that this slide will save the top six US carriers an estimated $10 billion a year.

But the combined stock market value of those six companies has increased by just $23 billion since August.

According to Barron’s, this means investors are putting a price-to-earnings ratio of just 2.3 on the fuel savings. That compares with a forward P/E of 6.4 for American Airlines, 8.6 for United Continental, and 10.9 for Delta.

For Barron’s, this suggests investors are betting that either oil prices will rebound or that airlines won’t put the savings to good use.

However, neither of those is a likely scenario, Barron’s declared.

Oil prices are falling because global economic growth is weak at a time when the US has unlocked a vast new supply through shale drilling, and neither trend looks likely to reverse soon, Barron’s said.

Saudi Arabia won’t cut production because it can weather much lower prices than its OPEC peers, and perhaps hopes to squeeze marginal US shale drillers.

Meanwhile, ExxonMobil and Chevron say they can withstand a drop to $40-a-barrel oil, vs. this week’s drop below $63. Lower oil prices would cut into their profits but also give them an opportunity to scoop up smaller rivals on the cheap, according to Barron’s.

As for responsibility to the bottom line, the magazine said the financial crisis brought about a reckoning that resulted in layoffs, route reductions, union concessions and more. Ticket prices have been rising, even as oil has been falling.

That’s partly because competition is down as a result of airline mergers and fewer routes.

In addition, Barron’s said oil’s drop is tied to overseas weakness while flight demand is tracking the stronger US economy.

That gives airlines the freedom to spend windfall profits on debt reduction, stock buybacks and dividends. Barron’s noted that Delta has spent $600 million on buybacks this year, and Credit Suisse expects it to ramp up spending in the fourth quarter, bringing the total for the year to $950 million.

United Continental, which is less far along in its turnaround, Barron’s said, is slashing debt and spending modestly on share repurchases. Analysts say a dividend could be next.

Any rally in the airlines industry should come with a note of caution and tolerance for volatility for investors, but one could also argue that the tailwinds recently helping the sector – namely, cheap oil — remain very much in place so far.

1Jack Hough, “Airline Stocks Could Fly a Good Deal Higher,” barrons.com, Dec. 4, 2014.