Volatility in Airline Industry Stocks
Modern portfolio theory uses stock price volatility as a proxy for risk. As intrinsic value investors, we define risk as the permanent impairment of capital, while viewing stock price volatility as a source of opportunity to the degree it drives a company’s stock price away from intrinsic value. The airline industry has been a very volatile area of the market. Historically, this stock price volatility matched volatility in companies’ underlying fundamentals as high levels of financial leverage combined with operating leverage to destroy profitability in downturns, and destructive fare wars plagued the industry. While the domestic airline industry continues to be cyclical and capital-intensive, a more rational structure, much stronger balance sheets, and properly incentivized management teams are likely to lead to a more stable industry that can earn its cost of capital through a cycle. However, the industry’s long history of destroying capital continues to weigh on the minds of investors. This has resulted in persistent volatility in stock prices that no longer matches the changes in underlying intrinsic values, in our view. This volatility created an attractive opportunity to invest in United Continental Holdings, Inc., which is trading at a meaningful discount to our estimate of intrinsic value as investors have been slow to recognize a structurally changed industry and remain skeptical of United’s initiatives to improve margins.
Improvements in Industry Structure and Incentives
Consolidation has improved the industry structure and competitive dynamic. Due to consolidation, the vast majority of U.S. domestic market share is in the hands of four major airlines: United, Delta, American and Southwest. With the three large network carriers (United, Delta and American), most capacity growth is in their respective hubs where each has a competitive advantage, as opposed to competitive point-to-point service outside of their hubs. This limits “turf battles” and the incentive for destructive fare actions. While the new industry structure has not been tested in an economic downturn, management incentives should result in rational capacity actions in various demand and fuel environments. As outlined in proxy statements across the industry, management incentive compensation is heavily weighted towards pre-tax margins, returns on invested capital, absolute pre-tax profits, and total shareholder return. This incentivizes management to only add capacity when and where it makes economic sense and to reverse course if capacity additions do not meet margin and return-on-capital thresholds. Thus it places an additional hurdle to capital-intensive growth that is difficult to reverse and discourages large orders for new aircraft targeted for growth. As a result, management teams are more disciplined with capital deployment, generating meaningful free cash, and returning the majority of this free cash flow to shareholders through share repurchases and dividends.
Volatility Creates Opportunity
We made our initial investment in United during 2016 when airline stocks came under pressure due to concerns over a weakening revenue environment and fears that industry capacity discipline was eroding. We viewed the revenue weakness as transitory and thought the industry was acting rationally in a changing fuel environment. United’s stock price had declined more than 20% during the first four months of the year, and we felt it presented the most attractive opportunity among the airlines due to company-specific opportunities to improve margins to offset looming inflationary pressure in labor and fuel. United’s margins were lower than those of its peers, partially due to operational issues incurred in the years following the 2010 integration of United and Continental. Poor operational performance pressured costs, lost high-value corporate customers, and impacted employee morale. In our view, margins could be improved and assets better utilized by running a more reliable and efficient network, which was a top priority of the new management team. We gained incremental conviction in our thesis late in 2016 when the company added Scott Kirby to its management team. Kirby had a strong track record with revenue and network management, which gave us increased confidence that the company could improve its management of existing assets. And with a much-improved balance sheet, the company was in a position to allocate its free cash flow towards share repurchases.
Thus far, the company has dramatically improved on-time performance while reducing the number of cancelled flights. This is an important first step towards regaining share with corporate customers and improving asset utilization. As we anticipated, the company has used its free cash flow to repurchase shares. A sharp rise in the price of fuel and new labor agreements have prevented an absolute improvement in margins, but fundamentals generally remain consistent with the long-term expectations we’ve had in place since we initiated our investment. From the current earnings base, the company is in a good position to improve margins and grow operating earnings in the mid- to high-single digit range, barring another material increase in fuel costs.
Since the time of our initial investment, stock price volatility, which was tied more to the industry’s history than to current reality, allowed us to opportunistically add to our position.
Recently the stock price has declined following the company’s announcement in January that it plans to grow capacity by 4-6% in 2018 and at a similar rate for 2019 and 2020, which was more than the market was expecting. Similar to other periods of stock volatility over the last couple of years, the initial reaction from the market implied concern about a return to the destructive behavior of prior decades. We view this as a low probability because the nature of the capacity growth makes it difficult for competitors to respond. United’s goal is to improve scale in hubs and increase share in smaller, higher-yielding markets. Reducing capacity to small cities over the last decade placed United at a competitive disadvantage to Delta and American, as United did not offer as many city pairs through its hubs and did not offer as many frequencies to the domestic cities it did serve. This impacted convenience and resulted in lost traffic from passengers that would typically travel through those hubs due to their location. The risk in now adding capacity is that Delta and American may respond aggressively to defend the share they gained during the years that United retrenched. However, since United is adding capacity to dozens of different destinations through a connecting hub, it will be difficult for a competitor to respond to any given city addition.
While an increase in overall seats is certainly something to monitor, we take comfort in knowing management is incentivized to not engage in any destructive market share battles. Additionally, while early, we have not seen any indications of aggressive competitive responses since United’s announcement in January. We believe United’s revenue strategy makes logical sense and, if unsuccessful, is easily reversed thanks to significant fleet flexibility. Through expiring leases and the ability to not exercise options on new aircraft, the company can keep the fleet size flat, or reduce it, should the strategy not work according to plan and/or the economic or fuel price environment change.
In summary, we believe recent stock price volatility in United and other airlines is an overreaction due to the industry’s less-than-illustrious history, and the most recent selloff created another buying opportunity for us. As intrinsic value investors, we remain focused on long-term company fundamentals. While there have been puts and takes to fundamental performance over the last two years, our long-term profitability assumptions are roughly in line with our estimates from 2016 when we initiated the position in United. The company has generated over $5 billion of cumulative free cash flow over the last three years and used this cash flow to reduce its share count by 25%, increasing our ownership in the company as well as intrinsic value per share. As we look forward, our focus remains on our long-term fundamental assumptions and the risks to these assumptions. In our view, United is well-positioned to grow earnings per share in the double digit range through operating earnings growth and the ability to opportunistically repurchase shares at attractive prices. We cannot predict when the market will recognize a better industry structure with a higher multiple for United and the rest of the industry, but in the meantime, it creates opportunities for long-term investors.
As of February 28, 2018, Diamond Hill owned shares of United Continental Holdings, Inc.
Originally published on March 26, 2018.
The views expressed are those of the research analyst as of March 2018, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.