Airline Stocks: Immense Value or Trap?

Jacob is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Airline stocks have long been shunned by value investors given the high degree of cyclicality involved. However, it appears to be changing if one takes a looks at the recent performance of air carriers such as SkyWest (NASDAQ: SKYW), Southwest Airlines (NYSE: LUV), and PHI (NASDAQ: PHII).

Airline companies are not only flying fuller planes, but they also seem to have understood the importance of managing debt levels – two of the biggest factors why the companies kept losing money through the previous decade or so.

According to the data released by the U.S. Bureau of Transportation Statistics, airlines improved occupancy levels of their planes to a record 83% in 2012, up from 72% in 2011. This discipline was well complemented by strength in domestic fares during the year.

While the stocks have seen a smart rally so far, it would be early to conclude that the gains from these initiatives have been completely factored in the prices. Here is why there may be more upside in these stocks:

Southwest Airlines is essentially a low-cost passenger airline player which offered services in 97 destinations in 41 states at the end of 2012. Being a low-cost player, the company focuses on point-to-point service instead of the "hub and spoke" model adopted by major airlines. One big advantage of this model is the high asset utilization, as these secondary or downtown airports are typically less congested than the hub airports used by the larger players.

This simple shift appears to have contributed to a 9% growth in revenue in 2012, while profit grew to $421 million from $178 million in 2011. This performance is likely to continue, as reflected by its forward price to earnings ratio of just 11. A low debt-equity ratio of nearly 0.45 is another factor expected to help in achieving higher profits on additional revenue. Even though it has advanced 24% during the past quarter, the stock continues to trade at a discount to its price targets, which are around $15.

Regional airlines are hit

Utah-based regional carrier SkyWest has seen its stock gain 29% over the previous quarter, but still trades at 11 times its forward earnings. On a trailing 12-month basis, its P/E multiple works out at 16.4 – not expensive by any standard.

What’s more, its market price is still 40% below the book value. The fact that the regional airline business is better suited to exercise the above mentioned financial discipline is highlighted in the recent quarters.

In the last quarter, the company posted a profit of $13.9 million, even though the top line did not grow. Regional airlines typically operate smaller aircrafts on lower-volume routes than major carriers. However, instead of competing with major airlines, regional players usually enter into revenue-sharing agreements with one or more major players, which result in the regional players' smaller, lower-cost aircrafts being used by a bigger player.

As of Dec. 31, 2012, 557 of the company’s 559 small regional aircraft operated under fixed-fee agreements with other players, including Delta and United. This way, regional airlines are better shielded from unpredictable fuel costs. As bigger players are witnessing a windfall of sorts, some of these benefits are trickling to regional players too.

Air services too not behind

The factors mentioned above are not only true for airline companies, but also for mission critical air service provider PHI, which operates a fleet of helicopters in the Gulf of Mexico. The company largely caters to the oil and gas industry, in addition to offering air medical transportation for hospitals and emergency service agencies.

Over the last 12 months, the company has witnessed significant traction in demand for its services. As a result, revenue grew 19.8% to $646.7 million. High operating costs mean margins are thin in this business, but the company still managed to grow its profit to $18 million during the year from $4.8 million in 2011.

After sustaining significant adverse impact of the Macondo oil spill in recent years, the company appears to be suitably placed to benefit from renewed activity in deep water drilling in the region. Although PHI is not tracked by analysts, it would not be surprising to see the growth continuing in 2013 as well.

However, despite the positive outlook for these companies, investors would do well to keep an eye on oil prices, which is the key input cost for all the three companies.

Jacob Wolinsky has a short position in LUV, no position in any other stocks mentioned. The Motley Fool recommends Southwest Airlines. 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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