UAL - United Airlines: Now Is The Time To Buy

2023-10-19 11:01:56 ET

Summary

• United Airlines' stock dropped almost 10% yesterday after its third-quarter earnings report disappointed investors.
• Geopolitical conflicts, such as the Israel-Palestine military conflict, and labor disputes pose challenges for United Airlines in addition to the threat of rising jet fuel prices.
• Even after digesting the potential impact of these threats, I believe Mr. Market is not being fair to United's long-term appeal.
• As a growth investor, I am impressed by United's new approach to margin expansion which is in complete contrast to the company's pre-pandemic strategy.

The airline industry is currently navigating a turbulent environment, encountering a dual challenge stemming from labor disputes and geopolitical conflicts. United Airlines Holdings ( UAL ), a prominent player in this sector, recently unveiled third-quarter financial results that, at first glance, appeared promising. The company reported improved profits, largely bolstered by the exceptional performance of its international flights in the Atlantic and Pacific regions. However, a closer look reveals a serious problem. United Airlines' stock tanked almost 10% yesterday after its third-quarter earnings report spooked investors.

The macroeconomic outlook hints at potential disruptions in the form of suspended flights to Tel Aviv, a consequence of the ongoing conflict in Israel. Furthermore, the company's forecast for earnings per share fell short of Wall Street's consensus estimates, casting a shadow over its near-term prospects. Tensions in the Middle East often lead to surging oil prices as well, which paints a bleak outlook for United's short-term margin profile.

The challenges faced by United Airlines are not limited to geopolitical tensions. Labor unrest among its pilots and flight attendants is another challenge the company has to deal with. Employee demands for higher wages and improved working conditions have reached a pivotal juncture. Notably, United Airlines' pilots have ratified a new four-year contract , touted to be the costliest in the U.S. aviation industry, with an estimated value exceeding $10 billion. The agreement, demanded by the Air Line Pilots Association, promises substantial pay hikes, potentially reaching up to 40% over four years.

Even after digesting these challenges, I believe United Airlines is grossly undervalued in the market today, which creates an opportunity for long-term-oriented investors.

Israel-Palestine Military Conflict Impacts International Travel

The travel sector has shown impressive signs of recovery following the pandemic-induced downturn. Notably, air travel experienced a robust summer season, with international revenue surpassing that of domestic ticket sales. United Airlines stood out in this resurgence, reporting record-high profits in both the Atlantic and Pacific regions. In the Atlantic region, revenue saw a remarkable 15% increase compared to the same quarter in 2022 and a substantial 70% growth when compared to the same quarter in 2019. The Pacific region also performed admirably, with revenue exceeding 2019 levels despite operating with 24% less capacity than the same period in 2019.

An interesting statistic further underscores the travel sector's resurgence. According to a survey by the New York Fed, approximately 32.8% of U.S. households embarked on vacations between May and August, a notable increase from 28.5% in August 2022 and a record high since 2015. This rise in travel was also confirmed by the Transportation Security Administration, which reported that 246 million people passed through TSA checkpoints between May 1 and October 16, marking an 11% increase from the same period in 2022.

Exhibit 1: Household spending by categories

The situation in the Middle East introduces a complex dynamic at a time when the leisure sector is continuing to benefit from the pent-up demand for travel. According to UNWTO, the region had reported impressive results in the first seven months of 2023, with arrivals surpassing pre-pandemic levels by 20%, the only region to do so. Nevertheless, the Israeli-Palestinian military conflict poses a significant challenge to travel in this region. If the conflict escalates, it is expected to increasingly impact tourism traffic to and from the Middle East.

Exhibit 2: Percentage change in international tourist arrivals compared to 2019

The U.S. State Department has advised against traveling to Lebanon, citing an unpredictable security situation due to kidnappings, unrest following the Israel-Hamas war, and ongoing hostilities between Israel and Hezbollah. United Airlines, with significant exposure to Israel, has suspended flights to Tel Aviv until conditions permit their resumption. Of the three major U.S. carriers, United Airlines has the most significant exposure to Israel. According to a Reuters analysis of Cirium data, for the fourth quarter, Israel constitutes 1.9% of United's planned global capacity. This suspension, along with others by U.S. and international carriers, is projected to contribute to United's non-fuel costs which are expected to rise by as much as 5% in the December quarter compared to the previous year.

Given these circumstances, United Airlines has projected a year-over-year increase of 9% in its fourth-quarter revenue if Israel flights remain suspended through the end of the year, and 10.5% if the suspension lasts only through October. On a positive note, the company has observed a 20% year-over-year increase in revenue from premium products, accounting for more than half of its passenger revenue. This suggests a resurgence in lucrative business travel, with bookings for trips closer to departure dates in August and September significantly outpacing last year's trends.

Fuel Price Surge And Geopolitical Factors Impacting Airlines

The resurgence of fuel prices since July has presented a formidable challenge to the profitability of U.S. carriers, and United Airlines is no exception. In a span of just a few months, the company has witnessed a staggering increase in fuel costs, surpassing the 20% mark since mid-July. This substantial surge in fuel expenses paints a complex picture for the airline, with projections indicating an anticipated 11% increase in the average fuel bill for the quarter through December when compared to the previous quarter. The ramifications of this spike are amplified by the fact that jet fuel prices at major U.S. airports have surged by nearly 25% since the beginning of the summer season.

A noteworthy aspect of the fuel price equation is the impact of geopolitical events, particularly the war in Israel. Although this conflict has not directly disrupted the physical supply of oil, it has added what could be termed a "war premium" to oil prices. This premium reflects the market's anticipation of potential risks to oil supply, should the conflict escalate into a regional confrontation. This element of uncertainty has contributed to the increased volatility in oil prices over the last week, further complicating the cost dynamics for airlines.

The situation becomes even more complex when considering data from the International Air Transport Association. While the week ending October 13 witnessed jet fuel prices averaging $121.20 per barrel, it's worth noting that this figure represents a decline of almost 10% from the levels observed for the week ending September 15. Airlines were gearing up to make the most of these declining fuel prices but geopolitical tensions in the Middle East, in my opinion, will likely exert pressure on oil prices, ruining the party for airlines.

Exhibit 3: Weekly average fuel prices

Navigating the current challenging geopolitical conditions will be tough, at least in the short term, for United Airlines. However, as a long-term-oriented investor, I believe there is an opportunity for investors to exploit here.

The Expected Hit To Margins Will Be Offset By Efficiency Gains; Shares Are Cheap

When the airline sector faced unprecedented challenges at the height of pandemic fears and mobility restrictions in 2020, I thought Southwest Airlines ( LUV ) was a good bet for contrarian investors given that the company had substantial exposure - it still does - to the domestic air travel market which I thought would recover faster than international travel. Today, the tables have turned. I am expecting a saturation of domestic air travel demand in the coming quarters while the international sector and business travel sector will remain strong in the foreseeable future. This is one reason for me to shift my focus from Southwest Airlines to the likes of United and Delta Air Lines ( DAL ). Although flight cancelations resulting from geopolitical tensions and elevated jet fuel prices will negatively impact United's margins in the foreseeable future, I believe there is room for long-term margin expansion.

Through 2032, United is expecting the delivery of 800 new aircraft, which includes both narrowbody and widebody aircraft. This represents a strategy shift from the company from before the pandemic when United focused on cost-cutting measures to expand margins. This is one of the main reasons why I avoided United as I am a growth investor looking for mispriced bets in the market. Today, United's strategy has shifted to a more growth-focused approach where the company is trying to improve operational efficiency by acquiring new aircraft that are more fuel-efficient. This strategy also allows the company to sell more premium and extra legroom seats, which is likely to positively impact margins. The company, with access to a higher number of total seats, will be well-positioned to compete with low-cost airlines in the future as well, potentially grabbing market share across several categories.

From a valuation perspective, the company immediately looks attractive at a forward P/E of around 4. The company is valued at a quarter of its TTM sales too. However, before jumping on board, investors have to evaluate the threat of a few risks that are looming on the horizon.

1. United is one of the most vulnerable U.S. airlines to a shock in the international air travel market. As I write this article, I have a feeling that we are moving into a phase that would be characterized by major air travel disruptions.
2. United will take a beating from the new labor agreements. The impact of the recent deal could turn out to be devastating in the short term if the company misses its revenue goals.
3. Jet fuel prices are likely to remain higher for longer.

That said, I believe United is already trading at a discount to many of its closest peers, which gives me the confidence to claim the company is fairly valued in the market today, even in the worst-case scenario where the company will take a massive revenue hit from a disruption of international air travel demand.

Exhibit 4: Valuation comparison

It is not a bad idea to invest in a fairly valued company when long-term growth prospects are intact. United, in my opinion, is a company with a meaningful runway for growth and is fairly valued.

Takeaway

The short-term outlook for United Airlines is not rosy. The company, however, is well-positioned to benefit from favorable travel industry trends and market dynamics in the long run, and as a growth investor, I believe the company's new approach to margin expansion is commendable. The recent selloff, therefore, makes UAL stock an attractive bet.

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