Summary
- Price target - $120.
- 2015 EPS forecast of $12 per share.
- Airfare prices should remain relatively stable thanks to favorable economic tailwinds.
Idea:
American Airlines (NASDAQ:AAL) - $49.81
Target Price:
$120 (140% upside)
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Investment Thesis:
American Airlines currently trades at 4.1x our current forecasted 2015 EPS. While other airline competitors hedged their fuel exposures, Doug Parker, AAL's CEO, removed all fuel hedges as of July of 2014. As oil has declined from 115 per barrel to 48, jet fuel prices have decreased from $2.86 per gallon to$1.42. This will increase 2015 net income by approximately $5.6 billion.
American Airlines will benefit significantly versus peers in a low oil environment, and with the recent consolidation in the airline industry, airfare pricing should remain constant. If American Airlines merely maintains its current market share and remain disciplined in airfare pricing, it will earn a record $12 EPS for fiscal 2015.
We think the investment thesis is currently not priced into American Airline's stock price because of investor's skepticism towards airline industry in general and we detail it further below.
Why does this opportunity exist?
Variant Perception:
We believe Wall Street sell side analysts have not modeled in the new jet fuel prices for their 2015 forecast. Out of the 19 analysts that follow American Airlines, only one analyst, Bob McAdoo who is highly ranked on tipranks.com, is forecasting approximately $13.00 EPS for fiscal 2015. The average estimate is $9.92, up from $6.95 60 days ago.
As demonstrated in the chart below, there's a direct correlation between jet fuel prices and crude prices.
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On November 6, 2014, Derek Kerr, AAL's Chief Financial Officer, forecasted fuel prices to be $2.56 - $2.65 per gallon for Q4. Since November, fuel prices have dropped to approximately $1.42.
Sell side analysts are still currently using outdated fuel price numbers in their forecasts and will soon reflect upon this error when American Airlines report Q4 earnings at the end of January. During that time, American Airlines will also give guidance for 2015. We believe there will be a material difference between what analysts are forecasting and what the company will project.
We build our level of confidence on this assertion by checking with historical crude/jet fuel prices. We used 2009 oil prices because crude oil hasn't hit levels seen since 2009. Our only reference point to insure our accuracy for jet fuel prices was to backtrack it to 2009.
As indicated in the chart below, take a look at 2009 April jet fuel prices versus crude prices.
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As shown in the charts above, crude prices are currently at April 2009 levels, and jet fuel prices during that time were around $1.369. There's a material difference between what analysts expect American Airlines to deliver versus our expectations.
Share Price Performance:
American Airline's stock price has more than doubled since its merger. Investors are hesitant to buy a cyclical company with unknown competitive dynamics. The rationality of an oligopoly like pricing structure has not been demonstrated over the long run in the airline industry, and investors are warranted for their skepticism.
However, we caution investors to not pay attention to past price performances, but instead pay attention on the current fundamental dynamics of American Airlines and what it's capable of earning in the future.
Airfare Pricing Uncertainty:
Historically, airfare prices have moved in tandem with jet fuel prices. This has caused a lot of uncertainty in the investment community. The question to ask is, will airfares drop with cheaper oil?
Almost identical to Micron's case, the Hynix fire sparked a major rally in DRAM prices. At the start of 2014, analysts were uncertain if the current prices were sustainable. This level of uncertainty is what gave us the opportunity to capitalize. We think the same level thinking is happening in the airline industry.
Industry Analysis:
We are by no means fans of the airline industry. Historically, it's been excruciatingly cutthroat and has lost legendary investors millions of dollars. It's so disliked; Warren Buffett has touted that he needs to call a 1-800 hotline to convince him from buying airline companies.
We don't disagree with their assessments, but the airline industry reminds us a bit of our 2014 best idea, Micron. We recommended Micron in February of 2014 because we truly believed that the merger between Micron and Elpida was going to rationalize the whole industry. At the same time, we forecasted Micron was going to earn between $3.50 - $4.00 per share and believed the shares to be substantially undervalued.
Since our writing, we have exited our position, and believe the story has largely played out. However, the Micron investment thesis is very similar to that of what's going on at American Airline.
After the merger between U.S. Airways and American Air, the industry has consolidated into 6 major players from a dozen in 2001. Four airlines (Delta, United, Southwest, and American) control approximately 85% of the market share.
Competitive Pricing Dynamics:
We don't believe the airline industry will cut fares in the near term as many of American's competitors have fuel hedges in place, which indirectly increases their fuel cost. American Airline is the only airline with ZERO fuel hedges in place and will reap all of the benefits.
Delta's (DAL) Hedge:
On its 2014 Q3 earnings call, Paul Jacobson, CFO of Delta, explained that Delta participated in 80% of the jet fuel decline, which implies it's hedged approximately 20% of the book. However, according to Delta's 10Q, it estimated that a 20% decrease in jet fuel prices will result in $800 million worth of losses. These projections were made on the assumption that jet fuel prices were 20% lower than $2.57. It's currently lower by almost 47%, which would mean Delta would need to post margins of almost $1.6 billion! This will invariably increase Delta's fuel cost by more than 30% for 2015!
In 2014, it will have roughly $10 billion in fuel cost related expenses. If we assume that Delta purchases all of its jet fuels at current prices, it will decrease the cost by half. But we have to add the $1.6 billion in hedging costs, which equates to a total cost of ~$6.6 billion.
Southwest's (LUV) Hedge:
On its 2014 Q3 earnings call, Tammy Romo, Southwest's CFO, explained that Southwest will participate in 80% of the jet fuel decline. There was no sensitivity analysis done, but the numbers shouldn't be too far off from Delta's.
United's (UAL) Hedge:
As of Q3 2014, United indicated in its 10Q that it has hedged approximately 24% of its fuel exposure. No sensitivity analysis was included.
Why do these hedges matter?
Three of American Airlines' competitors will broadly benefit from the overall jet fuel price decline, however, from a cash flow point of view, these three competitors will suffer significant market to market losses.
One risk this may impose is for these airlines to sell far out in the future plane tickets at discounted prices. If the competition does this, it will alleviate a significant amount of the current cash flow problems, but negatively impact its future profitability.
The second way to alleviate this cash flow problem is to keep airfare prices steady while fuel costs decrease. We think this is the most likely scenario, as it will help sustain the industry's future pricing power, while also reaping the benefits of lower fuel costs.
Valuation:
We have a 12-month probability weighted price target of $120 for AAL.
How did we arrive at this price target?
The only difference between the three scenarios below is the PRASM (passenger revenue per average seat mile) assumption. We kept all other assumptions constant.
Base Case
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Assumptions made:
- AAL uses current spot jet fuel prices of ~$1.42 per gallon.
- PRASM decreases modestly at 1% from the previous year.
- CASM ex-fuel rises by 2%.
- No taxes ($4 billion + NOL).
- Shares outstanding to decrease by 2%.
- 10x P/E multiple applied.
We applied a confidence weighting of 60%.
Bear Case
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Assumptions made:
- PRASM decreases by 10% due to competitive pricing by competitors.
- 9x P/E multiple applied.
We are highly confident that a price war will not breakout, and thus applied a 15% confidence weighting to this scenario.
Bull Case
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Assumptions made:
- PRASM increases by 3%. The U.S. economy continues to strengthen relative to other countries. The PRASM increase in domestic flights greatly offsets South America's weaknesses. The demand for air travel remains constant, and competitors stay disciplined in airfare pricing.
- 11x P/E multiple applied.
Risks:
Integration Risk:
In the world of theories, company A merges with company B and creates the world's largest airline measured in traffic should excite scholars and business professors. "Economies of scale lad, this is the key principle as to why companies merge!" Sorry Professor, it's not that easy.
There are many risks with regards to the integration between American Airlines and U.S. Airways.
- Cost integration
- Bad capital allocation - This is very common in the airline industry dating back to the early 1990s.
- Fleet integration
Airfare Decreases Alongside Fuel Prices:
Integration is a concern, but the thesis destroyer is if airfare drops in tandem with fuel prices almost at the same magnitude. In our analysis, we project PRASM to stay flat. Our analysis derives from the assumption that the airline consolidation has contributed to more rational pricing power.
Our sensitivity analysis concludes that a bear case scenario of a 10% fall off of PRASM will lead to a target price of $59.78, a 20+% return.
Fuel Prices Surge:
If fuel prices surge back up to pre-sell off levels, our EPS estimate will almost certainly not materialize. Pre oil sell off jet fuel per gallon was ~$2.88, and analysts were estimating ~$6 EPS.
Terrorism Attack:
Terrorist attacks using airplanes will not bode well for airline companies. This will materially decrease the number of passengers and decrease PRASM.
Broad Economic Slowdown:
Airlines are very susceptible to broad economic influences. A recession or a slowdown in the economy could hurt future load factors and materially influence our estimates. We did not project an economic expansion, but we did use historical assumptions.
Conclusion:
We believe the market is currently underappreciating the benefits of cheaper oil for the airline industry. American Airlines is the best-positioned company to take advantage of the cheaper oil. Competitors' current hedges will greatly impact their current cash flow, and we believe that will lead to more disciplined pricing in the near-to-medium term. We believe that American Airlines can earn ~$12 per share fiscal 2015 and is able to navigate through the merger challenges smoothly.
Our price target is $120.
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