News Analysis date published New: 
Monday, July 16, 2012 - 13:00
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Monday, July 16, 2012 - 13:00
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Monday, July 16, 2012 - 13:00

This Group of Hated Stocks Could Jump 35-50%

Monday, July 16, 2012 - 1:00pm

Investors have had to rethink everything they know about airline stocks during the past few years. The considerable pain caused by the economic downturn of 2008 forced the airlines to make drastic moves. They aggressively cut labor costs, found new ways to charge for items that were previously free (such as checked baggage) and showed remarkable discipline when it came to paring any airline routes that were unprofitable.

Perhaps the poster child for this industry's renaissance can be seen in the operations of Delta Airlines (NYSE: DAL), which I projected would double in price when I profiled the stock nearly a year ago. (It's made a nice run, but is still well short of my predicted 100% gain.)

In recent weeks, I've been thinking about airline stocks a lot. Not only are these companies run so much more efficiently, but they've recently been the beneficiary of a solid multimonth drop in fuel prices -- which is their largest single expense. Even though oil prices have recently rebounded somewhat, due to tensions with Iran, I still see oil prices falling to fresh multiyear lows in coming months as I noted here.

Yet with every investment thesis, you always need to hear opposing viewpoints. Goldman Sachs just released a report that expresses ample concerns about these airline stocks. I disagree with some of their basic tenets, but they are worth noting anyway.

Goldman's biggest concern involves the state of the global economy. The firm is anticipating a drop-off in global air travel in coming quarters, which will affect profits of the major carriers. That could prove especially tough for Delta Airlines and United Continental (NYSE: UAL), each of which are now rated a "sell" by Goldman. JetBlue (Nasdaq: JBLU) and Southwest (NYSE: LUV) are rated "neutral" simply because they don't have as much foreign exposure.

Here's how Goldman's earnings view contrasts with the consensus forecasts.

You'll notice an especially big gap between Goldman's 2014 profit outlook and the rest of the pack. While most analysts expect industry profits to keep rising into 2014, Goldman thinks profits will shrink for most of the airlines (except Southwest).

Why the pullback? Because the Goldman analysts say airline carriers will revert to their old bad habits of adding a lot of new capacity in 2013, which will create price wars by 2014. Yet such a view flies in the face of what has actually been happening the past few years. In fact, once AMR, the parent company of American Airlines, emerges from bankruptcy -- likely though a sale to U.S. Airways (NYSE: LCC) -- analysts expect American Airlines' global roster of flights to be notably reduced, aiding the supply/demand balance of available seats for all industry players.

Yet it is fuel price assumptions where Goldman simply seems off the mark. Goldman sees jet fuel prices rising 12% sequentially in the third quarter to about $3.12 a gallon. The firm says oil prices will continue rising as they have in recent weeks. Yet it's worth noting that the current spot market for jet fuel is $2.78 a gallon, even with Iranian tensions already in place.

In subsequent periods, Goldman's energy analysts anticipate Brent Crude oil prices (the benchmark for Europe) to rise to $118 a barrel from a current $100. Yet these analysts can't have it both ways. If the global economy is not robust in coming quarters, then there is a very good chance that oil prices weaken from here -- not strengthen.

That's the view held by Deutsche Bank, which just boosted expected industry profits in the June quarter by $400 million to $2 billion, thanks to lower oil price assumptions. In tandem, Deutsche Bank just raised earnings forecasts for all of the airlines it covers for both 2012 and 2013.

And it's not just oil prices that may represent savings, according to Deutsche Bank. Airline carriers have refinanced debt at lower interest rates, which is lowering quarterly interest expense. Moreover their total debt loads continue to shrink, which will lower interest expense even further in coming quarters.

Deutsche Bank's favorite airline stocks: Delta (with a $16 price target), United Continental ($31) and U.S. Airways ($20). That's roughly 35-50% upside for each name. In contrast, Goldman's target prices on Delta and United are roughly 10% below the current prices.

Risks to Consider: The U.S. economy is indeed slowing, and even though that hasn't affected demand for air travel yet, it's too soon to conclude that demand won't weaken. The question is by how much. My view: the industry already operates as if we are in a recession and are built to be profitable at a range of revenue levels.

Action to Take --> The analysts at Goldman are likely correct in anticipating a slowdown in air travel. But their expense assumptions appear all wrong. These airline carriers will likely see the lower revenue and falling oil prices offset each other. These stocks, which took solid hits in Thursday trading, thanks to Goldman's call, will likely start rallying again the minute oil prices start to move back to their recent lows.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.