Description

While virtually every cyclical and retail stock site near 52 week highs if not all time highs. The US legacy domestic carriers are on their lows in some cases approaching the lows hit in the heart of the financial crisis.  I am advocating going long a basket of airline stocks - specifically an equal weight basket of UAL, DAL, LCC and AMR.  I think they will outperform the general market, but that they will also outperform a basket of cyclical and momentum retail stocks (which the brave are free to short against this basket).  We have been involved in the space since late 2008 given our view that consolidation and capacity discipline would transform domestic airlines and provide a long and sustainable earnings runway in an industry that had suffered since the days before deregulation.  We have gotten the operating results dead right as the industry --through ancillary revenue, capacity cuts, and ticket price increases -- continues to make money in spite of $100 oil.  However, the market is viewing the sector as the perfect hedge for rising crude and the components of the basket have sold off from 23% in the case of UAL to 47%in the case of AMR over the year, most of it coming in the last few weeks despite inline earnings.  I believe the basket will at least double from here over the next six months.  It is interesting to note that we are also seeing insider buying in a sector that rarely, if ever, shows any insider buying.   Simply put, for all their well-known issues, these stocks are still way too cheap.

With the exception of AMR, they all make money and have all used the bankruptcy process to flush their legacy liabilities and renegotiate union contracts.  That said AMR has just cut a game changing aircraft purchase deal with Boeing and Airbus, which is bigger than the entire equity capitalization of the industry.   Amr  will also go from having one of the oldest, least fuel efficient fleets,  to having one of the youngest,  most fuel efficient -- which could make them a low cost producer should fuel stay high. Amr  estimates that the net present value of this purchase could be as much as 1.5billion. LCC, DAL, and UAL are all trading at single digit p/e' s.

The knocks on the industry are familiar and true up to a point: The industry has not collectively made money since Kittyhawk, high fixed costs, high and inflexible union costs, macro cyclicality.  However, you could have said many of the same things about the steel industry before it restructured and consolidated.  Over the past couple of years Continental, Airtran, US West and Northwest have all been purchased - reducing competition. Most of the industry has cut capacity and raised prices and there have been no significant new entrants or walking wounded companies in ch11 undercutting fares.  I believe that the industry will continue to make money and improve margins as they cut capacity even if  oil stays elevated  -- and  if the price of oil drops, hold on to your seats.

Catalyst

Investor appreciation of the sector's long term earning power.  A stabilization or lowering of crude prices.