2023-09-18 22:15:42 ET
Summary
- Airlines have rebounded over the past year as air travel normalizes and growing costs are pushed into airfare prices.
- United Airlines costs will grow faster over the coming years following its pilot union deal and the recent rise in jet fuel prices.
- Slowing household disposable spending capacity could hamper United Airlines by lowering ticket sales volumes while costs rise.
- United Airlines is not discounted today because its enterprise value and "EV/EBITDA" are back within its pre-COVID range.
- UAL appears fairly valued assuming healthy operating conditions but overvalued assuming economic strains mount.
Airline stocks were one of the most popular "recovery trade" opportunities after their collapse in 2020. Across the industry, valuations fell extremely low as many airlines temporarily lost all revenue. Most airlines, particularly the largest, such as United Airlines ( UAL ), had to take on immense debt loads to maintain liquidity during that tumultuous period. As interest rates rise, United Airlines and its peers face increasing interest costs, mainly due to variable debt loads. Further, inflationary pressures, such as labor and fuel, have created headwinds for airlines, tempering economic demand and increasing costs. Many investors believe United Airlines to be a significant discount rebound opportunity today due to its low "P/E" valuation and "discount" to its pre-COVID value. However, I believe the combination of debt and economic headwinds makes it riskier than many may assume.
United is Valued and Operating Normally
Despite cost pressures, United Airlines has pushed increased expenses into ticket prices as its operating margins are now back at pre-COVID levels. TSA travel volumes show that today's US air traffic is as high and slightly above the levels seen before 2020. From an operational standpoint, United Airlines and its peers are no longer facing direct pressures related to the 2020-2022 issues. Of course, that leads many investors to believe UAL is undervalued because it is trading at around half of its pre-COVID value. However, it is trading at such a low price simply because its total debt has increased dramatically since then. The company's true value, measured by its market capitalization plus its net debt, is now back firmly within pre-COVID levels. See below:
From a share price standpoint, UAL remains far below its 2019 level. That said, its share price in 2019 was also abnormally high because the company benefited from lower interest rates during that period, allowing it to buy back shares inexpensively. The opposite is essentially true today because its leverage is much higher, as well as its borrowing costs, causing the company to sell new equity (dilution) over recent years. Considering these factors, we can see that United's Enterprise Value is nearly unchanged from its pre-COVID range.
Its EV is at the low end of that range but is well within it, suggesting that United Airlines is now fully valued according to its pre-pandemic valuation range. Its forward "P/E" of 4.2X may make it appear very undervalued. That said, its financial debt-to-EBITDA is around 6X, indicating high operating leverage. Further, its "EV-to-EBIT" is at 5X while it was 5-7X from 2015-2019, indicating its debt-adjusted valuation is also within normal levels. Thus, while the stock is cheap from a pure "P/E" standpoint, it is usually valued after accounting for its immense debt leverage. Of course, it is still exposed to significant volatility as economic shifts could dramatically alter its profitability over the coming year.
How Long Can United Push Costs Forward?
After accounting for changes in debt leverage and interest costs, we can clearly see that United Airlines is trading in the valuation range it held from ~2014 to early 2020. For UAL to be undervalued today, it must have also been undervalued during the 2014-2019 period because its enterprise value and operating margins are back at the same levels it was then. Operationally, considering TSA traffic is equal to or higher than in 2019, the only difference from pre-COVID to today is the broader changes in the macroeconomic climate.
Before 2020, there were far fewer inflationary pressures impacting airline stocks. Around 2019, some recessionary concerns were rising as many data pointed to a 2020 slowdown. Of course, there was a recession in 2020. Still, that situation was greatly obfuscated by lockdowns and the subsequent immense stimulus that quickly pulled the economy out of a downturn (while also exacerbating inflation). So, for United Airlines, there are two significant economic risks I see. One is difficulty pushing rising fuel and labor costs into ticket prices. Two, ticket demand declined due to an erosion in household discretionary spending capacity. In all likelihood, United Airlines will only face considerable EPS declines if its costs grow while airline traffic demand fades since that would make it impossible to push rising costs forward.
The airline industry has generally greater exposure to wage pressures today due to its immense labor needs than many other industries. There is currently a relatively large pilot shortage due to a substantial retirement wave and fewer new pilots emerging from the military; without a significant decline in demand, the shortage is expected to persist through at least 2027-2032 because it takes years, and immense costs, for new commercial pilots to go through school. Congress has looked into lowering training requirements for new pilots to ease the shortage, but that generally seems unlikely due to risk issues. Flight attendants have also been in shortage , leading to a sharp increase in pay. The same also appears true in support activities, such as air traffic control, which airlines indirectly pay for. Overall, air transportation weekly real earnings are still generally rising while they're trending lower for US jobs as a whole. See the five-year trend below:
These data are relevant to passenger and freight airlines such as FedEx ( FDX ); however, in most instances, the labor pools are the same or similar for both, so the data is relevant to both. A particularly sharp increase in weekly pay for air transportation over the past month indicates that the shortage is exacerbating wages during the summer travel season, likely related to the recent pilot pay union negotiations. United Airlines' recent union deal will increase pilot pay by a staggering 40% over the coming four years.
United Airlines' cost of goods sold strongly correlates to jet fuel prices. Over the past year, its COGS has continued to rise while jet fuel prices have fallen, indicating that higher wage pressures completely offset lower fuel costs. Those wage pressures persist today, but jet fuel prices are also rising. See below:
I expect fuel costs to continue to increase over the coming months as the energy market faces tailwinds from oil production cuts and a decline in SPR reserve supplies. Combined with wage pressures, I expect UAL may see its COGS rise faster over the coming year than in 2022, on par with the overall increase from 2020 to 2022. Thus far, airfares and all prices have been up around 25% since 2020. Air fares fell compared to inflation dramatically over the 2020-2021 period and are now rising much more quickly, indicating that airfares, compared to other prices, should soon become abnormally high.
Facin g falling median household inflation-adjusted incomes (a trend that persists despite the slight rebound in real hourly pay), many people have seen their savings levels decline dramatically below pre-COVID levels. Initially, low savings were offset by increased consumer debt growth. However, this, too, has reversed over recent months, indicating that many have used all the debt they can, meaning they must now reduce discretionary spending. See below:
The fact is that most US households are still seeing negative cost headwinds despite the disinflationary trend. Credit card debt increases have offset this trend, enabling spending to be abnormally high over recent years despite negative real income trends. However, this is rapidly reversing as credit card defaults rise . Consumer sentiment remains low, and I expect will soon translate into lower discretionary spending as consumer debt peaks. Airlines are also negatively exposed to the upcoming end to the pause on Federal payments because many travelers are in that key working 20-40-year-old demographic with higher student loan debt.
The Bottom Line
Overall, I am relatively bearish on UAL today, but I do not believe it is a short opportunity. United Airlines is fairly valued if, and only if, we assume that it will experience operational stability. This means United must not face a sufficiently significant decline in air travel demand nor a large increase in jet fuel or labor costs. A slight decrease in air travel demand would not harm United because that would lower wage pressures. Further, a small cost increase would not harm United because it can generally pass small cost growth onto customers. Under no change in these circumstances, I expect UAL to remain near its current price, the debt-adjusted range it held during the stable years of 2014-2019. In other words, it is fairly valued, assuming continued economic stability.
While operating in normal conditions today, most key trends are adverse for United Airlines. Wage pressures are accelerating, particularly for pilots, creating particular issues if jet fuel prices continue to rebound. Further, many US households are in a situation where they must reduce discretionary spending. Some portion of air travel will persist, but I expect many may take fewer vacations, travel shorter distances, and avoid air travel if possible. To me, it is most likely that people's ability to pay air fares declines while air fares rise due to growing costs, creating a significant issue for airlines as both supply and demand factors create pressure.
To make matters worse, United has immense debt leverage and negative working capital of $2.25B, meaning it does not have sufficient solvency or liquidity to handle negative cash flows associated with a recessionary dynamic. Again, I am only slightly bearish on United because its valuation appropriately accounts for its debt level. That said, personally, I believe United will face solvency issues in a sufficiently large recession because its balance sheet is so levered at a seemingly poor time. Thus, I expect that its upside is only around 10-20% (at best) if healthy conditions persist. In comparison, it could easily fall by over 50% in a recession as banks are unlikely to give it significant additional debt, so it would need to dilute equity.
For further details see:
United Airlines: No Recovery Upside, While New Headwinds Mount