Airlines Might Finally Be Investments

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After decades of losing money and bankruptcies to all the major players, the industry may have finally consolidated enough to reach consistent profitability. The big signal might have been the AMR Corp (NYSE: AAMRQ) bankruptcy back in November. With the parent of American Airlines finally succumbing to reorganization and a merger with U.S. Airways (NYSE: LCC), the industry might have all the major players on board for a profitable future.

For a long time, the industry has been run to enrich labor unions and stroke the ego of corporate execs latching onto the ‘cool’ factor of running an airline. Even as new entrants quickly came and went and legacy providers struggled to survive, hardly a year passed without a new airline entering the fray. The industry might have been the most competitive around; even though, it was very unprofitable.

The mergers that created Delta Air Lines (NYSE: DAL), United Continental Holdings (NYSE: UAL), and now U.S. Airways/American Airlines helped reduce the constant price wars of the past allowing for six successful price increases in 2012. More of the same is expected in 2013 as reduced competition allows for a better operating environment. Note the Forbes contributor, Peter Cohan, is very negative on the merger for all the reasons that might finally make this sector an investment.

Revenue multiples

A key metric for the potential of the airline stocks is the commonly used price to revenue multiple. The airline stocks trade at some of the lowest levels of any industry. As an example, the leader in the car rental business trades at a substantial higher multiple. Hertz Global Holdings trades at nearly a 1x revenue multiple. The car rental business has under gone a similar consolidation recently as well and is highly dependent on the airline travel for business making it a great comparison. Could the airlines eventually reach that multiple?

The typical airline only trades at a fraction of those levels with revenue multiples in the 0.3x range. In fact, the recent merger of bankrupt AMR should yield a value of around 0.27x the expected revenue level of around $40 billion. If the stock reaches a level of only 0.8x revenue, the stock would double from current levels.

Quick view of the majors

With the completion of the U.S. Airways/American Airlines merger, the industry will be down to three majors with revenues around $40 billion as follows:

Delta Airlines – the stock has a market cap of $13.4 billion with analysts expecting revenue to reach $38 billion this year on 3.2% revenue growth. More importantly, analysts expect earnings to grow to $2.60 from $1.88 last year. Analysts even expect earnings to reach $3 next year.

United Continental – the stock has a market cap of $9.6 billion with analysts expecting revenue to reach $39 billion next year. Earnings are expected to more than double to $3.70 this year and reach a further $4.92 in 2014.

U.S. Airways/American Airlines – the combined company is expected to have a valuation around $11 billion on projected revenues of $40 billion. Individually U.S. Airways expects to report solid earnings the next two years. The company forecast the American Airlines deal to be very accretive in 2014.

Competition

Outside of the majors, the industry faces competition from Southwest Airlines that has considerable scale already. If not for the mergers, Southwest Airlines would be in the major range with a revenue base of $18 billion. The stock valued at nearly $9 billion is already comparable to Delta and United.

Alaska Air Group and JetBlue Airways provide considerable regional competition on opposite sides of the coasts. The key for the sector though would be avoiding future entrants into the sector. The history of the sector suggests that no logical investor would enter the industry until the sector has a decade of profits.

Conclusion

The industry that has historically been a horrible investment might finally provide solid returns. Even with sky-high jet fuel prices, the industry has been able to generate strong profits. If it can avoid competition from new entrants, it might finally be right sized for steady profits.

Investors can finally consider the sector for investing though don’t stay invested if signs of illogical competition pops up.


Mark Holder and Stone Fox Capital Advisors, LLC have no position sin any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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