Big Airlines Are Still Attractive

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

Airline operation is one of the toughest businesses out there. The margins are thin. The level of responsibility is enormous. Every incident gets huge media coverage and puts airlines and aircraft producers under the microscope. And yet, airline stocks have had a tremendous run this year. Delta Air Lines (NYSE: DAL) has gained a whopping 85%. United Continental (NYSE: UAL) is up 49%, while US Airways (NYSE: LCC) is up 42%. Is the momentum sufficient to push the stocks even higher?

Back on track

These airlines have recently reported their quarterly earnings, beating analysts’ estimates. The companies have shown solid performance. After the surge in oil prices and the credit crunch that followed, airlines were under tremendous pressure. The business suffered, and the stocks were punished. This year was marked by the rise in the stock prices, as well as by significant improvement in the business itself.

Delta Air Lines has reported that passenger revenues were up 1%. The company has seen an improvement in margins and has stated that it expects to see an operating margin between 11% and 13% at the end of the year. United Airlines also showed a 1% revenue growth. The company has reported an 8.2% operating margin for the second quarter of this year. US Airways’ pretax profit of $409 million was highest in company’s history. The revenue was up 2.9% year over year due to increase in capacity.

Dealing with debt

Big airlines are piled with debt, and this fact was pressing on the stocks for a long time. As the environment is favorable for the companies, it’s time to deal with that debt. Delta Airlines has stated that it ended the quarter with $10.4 billion of debt. The company targets to reach $10 billion by the end of the year. United Airlines has paid off $540 million of debt in the second quarter, including $144 million of prepayments. The company claims that the interest expense is down 9% from the previous year. The debt remains high at $10.2 billion. US Airways has paid down $98 million of debt in the quarter. However, there is $5.4 billion more to pay.

The debt levels remain high and present significant risks to airlines. The current environment of low fuel costs and increased passenger activity should not be taken for granted. It seems like management is comfortable with what it sees. For example, Delta has announced a $500 million stock repurchase program. While the desire to return cash to shareholders is understandable, in my opinion, this cash is better spent to reduce the debt level.

What are the prospects?

Ticket prices account for only 70% of airlines’ revenue nowadays. The rest comes from additional services. This is surely positive, and this trend is likely to continue. United Continental has stated that it plans to put more emphasis on  products such as global satellite-based Wi-Fi and annual subscriptions on existing products. Other airlines are moving in the same direction.

The key to the valuation of US Airways is the assessment of its future merger with American Airlines. During the earnings call, the company has expressed hope that it was the last call as an independent company. The market is not sure about the synergies that the merger would bring, and US Airways trades at a discount to two other airlines.

Another factor that increases risks for US Airways is that the company does not hedge its fuel costs. So far, the tactic has paid off handsomely. The company has one of the lowest fuel costs in the industry. However, a sudden rise in the oil price is always a possibility, and US Airways risks to get caught on this.

United Continental has reported that its capacity was down 2.1% year over year. The company intends to match capacity with demand and maintain capacity growth at a rate less than the rate of GDP growth. Such moves indicate that the growth would come from non-ticket revenue rather than from extensive expansion.

Bottom line

Despite the recent rise in price, airlines trade at cheap valuations. Delta trades at 6.89 forward P/E, while United Continental trades at 7.10 forward P/E, and US Airways trades at 6.31 forward P/E. Debt levels continue to present significant risks for these companies. The planned merger with American Airlines adds uncertainty for US Airways prospects.

All in all, the businesses look up and running and the valuations are cheap. Delta Air Lines and United Continental would be attractive buys after the inevitable pullback. At the same time, US Airways would most likely underperform its peers until the effect from the merger could be seen and properly assessed.

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Vladimir Zernov has no position in 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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