United Airlines Shares: Lifted by Falling Oil (NASDAQ:UAL)

Summary

United Airlines (NASDAQ:UAL) is probably not the lowest-cost airline, but its share price is cheap. Very cheap, given that the airline industry is fundamentally sound and does not become obsolete.

Whereas our natural tendency is to look for business with strong competitive advantages, it is quite difficult to maintain an edge in this highly competitive and cyclical industry.

We focus our analysis on potential cyclical variations as well as general industry trends when assessing the attractiveness of companies, as we do not believe that a long-term buy-and-hold is a viable strategy for this industry.

Airlines have been one of the worst performing market sectors over the past 5 years as many stocks have yet to recover from the turbulent post-Covid period.

We think United Airlines finally has a chance to break out and get some back value, due to the currently favorable macro context.

The cost increases have rattled United and the larger industry

One of the main reasons for the airline’s slow recovery after COVID-19 has been escalating costs. The most significant costs for airlines are labor and fuel, both of which have appreciated considerably.

Jet fuel costs have risen as oil markets have recovered, resulting in a considerable increase in costs.

The average price per gallon rose from about $2 in 2019 to $3 at the end of 2023. Overall, United’s fuel bill rose from $9 billion in 2019 to $12.6 billion in 2023. This difference is greater than the total earnings of the business last year.

Fuel wasn’t the only cost item to increase from 2019. Wages and related costs also increased by $2.7 billion. Overall, the cost per available seat increased by 24% between 2019 and 2023.

Some of the cost increase was passed on to consumers in higher ticket prices, but not all. United was able to pass on most of these cost increases as revenue per available seat mile increased 21% over the same period.

More importantly, airfares have a negative price elasticity, meaning that as higher prices are passed on, fewer people fly. Some estimate that the elasticity of leisure travel is as low as -2, meaning that once ticket prices rise by 10%, the demand for those tickets falls by 20%.

As tariffs were raised to offset higher costs, overall industry demand must have fallen considerably.

Cost reductions, such as a drop in the price of jet fuel, not only provide airlines with additional revenue, but also create additional demand, which results in higher load factors. This partly explains the industry’s strong performance in 2019.

The tariff that allowed the reduction of capacity increases after COVID

Covid has led to unprecedented disruption to the airline industry as a large proportion of aircraft have been grounded for a long period of time and many employees have been let go. As travel demand picked up again, airlines initially struggled to meet the growing demand. Lack of capacity has led to stronger prices.

The latest data suggests that capacity has now been built back up to pre-Covid levels. Even though the total number of scheduled flights is still below, the capacity per flight has increased. It would seem that in the future, it will become more difficult for airlines to maintain their pricing power.

Load factors began to decline again from about July 2023 as more capacity was added. As more seats compete for the same passenger, it will be more difficult to pass on cost increases.

Falling load factors are now starting to impact prices. In the second quarter of 2024, United’s revenue per seat mile fell 2.4%. On a positive note, costs also stopped rising rapidly, as in the second quarter adjusted operating cost, excluding fuel, rose just 2% from last year.

Lower cost appreciation has helped United protect profit margins even in a more adverse pricing environment. However, if inflation picks up again, United will most likely struggle to pass on costs if the industry’s spare capacity is higher.

Consumer confidence has declined

For now, inflation does not appear to be a threat. On the contrary, the economy seems to be softening.

A significant share of the industry is discretionary leisure travel, which could be adversely affected if the economic situation deteriorates further. On the other hand, lower fuel prices will help the industry maintain some profitability and could boost demand.

From around March 2024, consumer sentiment started to decline, but seems to have rebounded most recently. Weaker sentiment would undoubtedly be negative for leisure travel.

In a recent consumer sentiment survey, McKinsey found that 33% of respondents plan to spend less on domestic flights in the next 3 months. Net intent for the category is little changed from last year.

Overall, consumer sentiment appears to be deteriorating, however definitive conclusions cannot yet be drawn as it is still early in the cycle and some data already point to recovery.

Increased capacity coupled with reduced demand would spell trouble for United.

Oil prices are starting to moderate

In a recent positive development for the aviation industry, oil prices have started to fall. As we write this article. The price of US crude oil fell below 70 dollars per barrel, the lowest level in the last 9 months. Price weakness is not driven by US consumption, but rather by the outlook for Chinese demand and OPEC+ production.

Saudi Arabia, as well as the wider cartel, are currently cutting output but plan to gradually increase output. OPEC+ plans to start raising oil production in October, but those plans are now being reconsidered due to a weak demand outlook, particularly in China.

China’s oil stocks rose despite lower import volumes due to lower refinery output. The volume of oil processed by Chinese refiners was 14.19 million bpd in June, down 3.7 percent from the same period last year.

There are a lot of moving parts in the oil industry, as always, and predicting oil prices is not easy. However, what we see today is a picture of weakness. Even as OPEC+ tapers and Middle East production and transportation risks rise, oil prices are still weak.

The main driver of the oil market today is the weak demand outlook, which does not appear to be recovering anytime soon. China, in particular, is experiencing weakness, and we see no signs of it coming back anytime soon.

We think it is very likely that for the remainder of the year, oil prices will remain weak. Such a development should help United meet its profit targets for the full year.

United Airlines is trading outside its valuation range

During its last earnings call, United provided earnings guidance of $9-$11 per share.

Most analysts polled by Seeking Alpha expect the company to hit a lower estimate of $9.50 per share and continue to grow earnings thereafter.

It’s not very often that we come across structurally sound companies with realistic growth prospects trading at 4.6 times forward earnings.

As we noted previously, labor and other operating costs have already stopped rising rapidly, and consumer spending has eased somewhat, but still appears robust. Additionally, oil prices are expected to remain weak for the rest of the year. Ticket prices should moderate only gradually, and costs may decrease or remain unchanged once lower oil prices are factored in.

This environment should provide an opportunity for United to hit its earnings guidance. The current earnings multiple seems to suggest that many market participants assume that United will not be able to sustain this higher level of profitability. Now it looks more and more likely that they will be able to achieve their goals.

As we write this, United’s share price is up 4% as US oil has fallen below $70 a barrel. Oil is the main factor that seems to tip the odds in United’s favour.

Airlines are a cyclical and capital-intensive industry and it would not be reasonable to expect the sector to achieve market average valuation multiples. On the other hand, 4.6X is quite low even for a challenging industry.

Before COVID-19, United traded in the range of 6x to 12x earnings. Current valuation multiples fall outside their historical valuation range.

Therefore, we conclude that given the current valuation as well as the macro context, United stock appears to have upside potential. There would be a 30% upside if the stock revalued at a 6X EPS multiple.

The main risks

Several factors could invalidate this optimistic thesis:

• Consumer confidence in the US could deteriorate further, forcing airlines to cut fares aggressively to keep load factors reasonable. The resulting margin contraction could reduce profit margins and make it difficult to meet earnings expectations.
• Oil prices are inherently volatile. Even if the sentiment appears to be bearish at the moment, unexpected events can lead to a quick rebound.

conclusion

United Airlines is one of the largest carriers in the country and currently sells at an especially attractive earnings multiple.

Covid wreaked havoc on the airline industry, leading to rising costs and capacity constraints later. The price was, however, firm and allowed airlines to pass on higher costs and protect their profit margins.

It would appear that load factors have now started to decline as capacity has returned to pre-Covid levels and consumer sentiment has deteriorated.

Markets appear to be concerned about United’s ability to hit its earnings guidance, and that’s why the stock is trading at a particularly low valuation multiple.

We believe the latest macro developments have been positive for United and the sector in general. Consumer sentiment moderated in August as oil prices continued to fall.

With the current macro environment, United is increasingly likely to meet its earnings guidance, and the stock should have at least a 30% upside as it returns to a longer-term valuation range.