U.S. Airlines Fly Back Onto Our Radar Screen
Undervalued Delta remains our top pick.
We’ve reviewed the systematic and unsystematic risk profiles of the U.S. airlines we cover. This combined with adjustments to our forecasts has resulted in fair value estimate increases for Southwest Airlines (LUV), Delta Air Lines (DAL), and United Continental (UAL) and a decrease for American Airlines (AAL).
Among the U.S. carriers, we prefer Delta, and our lower fair value uncertainty rating places the shares deeper into 4-star territory. Still, we don’t think Delta or any other U.S. carrier has an economic moat, as evidenced by the recent price wars plaguing the industry.
As a result of consolidation, we believe U.S. carriers’ operating margins will now fluctuate between a high-single-digit trough and a midteens peak versus a history of negative trough margins coupled with peaks of roughly 10%. These dynamics tighten our forecasts and led us to decrease our uncertainty ratings for Delta and Southwest to high from very high.
Despite their more predictable performance over a cycle, we’re maintaining very high uncertainty ratings on United and American because of an ongoing turnaround at the former and financial leverage at the latter. Uncertainty reflects forecasting accuracy, which is captured in the spread between our bull and bear cases. For investors, uncertainty equates to a margin of safety: A high-uncertainty stock trips 4 stars when it trades at roughly a 15% discount to our fair value estimate, whereas very high uncertainty requires a 20% discount to hit 4 stars.
Although we didn’t adjust United’s uncertainty rating, we did decrease its cost of capital by 50 basis points to 9.4% to reflect a lower credit risk rating. We’ve also decreased our cost of capital for Southwest to 8.6% from 10.4%. Our updated outlook for the systematic risk profile of the company drives down its cost of capital. On the other hand, we raised our cost of capital for American by 50 basis points to 9.6%; persistently high financial leverage pushes the cost of equity higher. Delta’s cost of capital is unchanged at 10.2%.
The lower uncertainty rating for Delta means that we think investors can narrow the margin of safety required to find value in the stock. Even though our fair value estimate increased a modest 3%, the shares dove deeper into 4-star territory thanks to the now-lower uncertainty rating. As a result, Delta’s shares look more attractive to us on a risk-adjusted basis. We continue to believe Delta is the best-positioned U.S. carrier thanks to its existing (if under pressure) premium on passenger revenue per available seat mile and its laserlike focus on operational efficiency. Additionally, we like its U.S. domestic exposure and structural advantages (for example, a less unionized workforce, lower airport costs, and first-mover advantage in basic economy) versus other network carriers. Our fair value estimate increase for Delta was driven primarily by our view that normalized operating margins will land at 16%, which compares with a previous midcycle assumption of roughly 15%. Despite an earnings miss last quarter, we remain impressed by management’s ability to drive operating margins higher in the face of revenue headwinds and cost pressures. We attribute our new lower uncertainty rating for Delta to a narrower range of outcomes in our valuation model’s bull and bear cases.
Although we like Delta, when it comes to high-quality names in the U.S. airline sector, nobody beats Southwest. After trading in slightly overvalued territory year to date, the shares now look slightly undervalued at a price/fair value of 0.91 based on our new $57 fair value estimate. As part of the broader review of our U.S. airline coverage, we’ve lowered our cost of capital for Southwest to 8.6% from 10.4%. This was driven by a reduction to our assumed cost of equity due to a lower systematic risk profile. This adjustment would have boosted our fair value estimate by $13 per share, but it was offset by a lower normalized operating margin of around 16.5%, down from a previous midcycle margin forecast of 19%. Our updated forecast reflects our belief that oil prices will normalize at $60 a barrel and Southwest will continue to post the highest margins among the major U.S. carriers. However, margins will be tempered by a business model that will more closely mirror that of the network carriers over time, which means higher costs and lower profits. Concomitantly, we narrowed our forecast for Southwest’s financial performance. We now model a slightly tighter range for our bull and bear forecasts, although Southwest already had the tightest bull- bear range of the U.S. airlines we cover. Our new bull- and bear-case valuation scenarios are $90 and $36, respectively, compared with $91 and $34 previously.
We increased our fair value estimate for United by $2, to $85 per share. With shares now trading in 4-star territory, we see attractive risk-adjusted return potential. An updated credit risk rating for the company (to above average from high) drove our valuation higher. This lower credit risk translated into a 50-basis-point decrease in our cost of capital to 9.4%. All else equal, this decrease would have boosted our fair value estimate roughly $6. However, we also trimmed our 2017-21 operating margin forecast to an average of just above 10% from 11%. This was driven by our belief that increasing pressure on international routes from low-cost carriers and sixth freedom traffic from Canadian airlines (principally Air Canada’s Rouge low-cost arm) will create fare pressures. United remains the most exposed to international routes across the major network carriers with a rough 60/40 domestic/international operating revenue split compared with something closer to 70/30 for Delta and American. Although the new management team seems to be making progress on its turnaround plan, we’re still waiting to see how basic economy and the new yield management system, Gemini, perform in the market. Therefore, we continue to model a broad range of margin and cash flow outcomes for the carrier, which leads to a wide spread between our bull- and bear-case valuation scenarios and a very high uncertainty rating. In our base case, we model normalized operating margins of 11.5%, below our normalized margins for Southwest and Delta because of what we believe are structurally higher costs at the Chicago-based carrier.
We decreased our fair value estimate for American by $1, to $46 per share. We adjusted our systematic risk profile for American’s equity to very high from above average while dropping the company’s credit risk rating to above average from high. The net impact of these changes is a 50-basis-point increase to weighted average cost of capital, which is now 9.6%. This change alone would result in a $4 decrease in our fair value estimate. However, we boosted our valuation $3 to reflect a slight increase in our five-year growth forecast driven by American’s moves to counter United’s expansion plans coupled with a higher return on new invested capital in our second stage of 13%. We retained our very high uncertainty rating for American, reflecting our view that its financial leverage, which is the highest among the U.S. airlines we cover, magnifies the company’s already significant operating leverage. As a result, we observe a wider spread between our American bull- and bear-case scenarios versus those of Southwest and Delta.
Chris Higgins does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.