3 Stocks in this Sector Could Easily Double

Between 1970 and 1975, a quarter of companies in the U.S. railroad industry were forced to file for bankruptcy protection. There were simply too many competitors and they could not handle the high levels of government regulation, volatile fuel costs and the billions of dollars it took to maintain thousands of miles of track, locomotives and freight cars.

Since that time, the remaining competitors have steadily merged and there are only seven leading players today. The leading players now have the size and scale to justify high capital expenditure costs and can effectively compete with the trucking industry. A government report stated that railroads have seen productivity gains that have far exceeded the gains seen in other industries and the economy as a whole.

In perhaps the biggest vote of confidence the industry could ever receive, Warren Buffett announced he would spend $26 billion to acquire Burlington Northern Santa Fe, one of the largest companies in the space, in late 2009. Railroads have become great investments.

But I’m not interested in railroads as an investment. I’m more interested in the next sector to follow in their footsteps: the leading U.S. airlines.

This may seem strange, given the history of bankruptcy in the airline industry. Buffett himself once famously called airlines “lousy investments.” But the same could be said about the railroad companies at one time. I think some of the major airlines have turned over a new leaf, so contrarian investors who get in early before the crowd realizes it stand to make a lot of money. 

For starters, the airline industry has many similarities to the railroad industry: heavy regulation, volatile fuel costs and very high fixed costs to buy and maintain airplanes, support airports and maintain safety for flight crews and passengers. Many airlines, including Braniff and Eastern Airlines, ceased to exist (both liquidated in 1989), while big players were forced to declare bankruptcy. United Airlines went bankrupt in 2002 and it was U.S. Airways’ turn in 2004, only to be followed by Delta Airlines in 2005.

A trip through the bankruptcy courts allowed these leading players to clear away debt and push through other needed reforms. And more recently, the largest airlines undertook a series of mergers that have made them more competitive. Last year, United merged with Continental to form United Continental Holdings (NYSE: UAL), while Northwest Airlines merged with Delta to form Delta Airlines (NYSE: DAL) in 2008. There is speculation that there could be further activity, with U.S. Airways a possible party to a big deal.

Like railroads, airlines have consolidated sufficiently to make them sustainably competitive. The proof is in the cash flow, as detailed in the table below…  

Last year, United, Delta and US Air posted very strong free cash flow. Projections for 2011 call for solid earnings per share (EPS) and continued positive cash flow. It is no coincidence that the players restructured through bankruptcy have become the most financially sound, both in terms of cash flow generation and reasonable debt levels, as evidenced by the debt-to-equity ratios above. AMR (NYSE: AMR), parent of American Airlines, staved off a bankruptcy filing, but is paying the price, as it is not profitable and has negative equity after years of losses. A debt-to-equity ratio below 70% signifies pretty low indebtedness overall.

Another positive for the industry is the move to extra fees. Except for Southwest Airlines (NYSE: LUV), the largest players in the table above now charge to check bags, for food service while in the air, and some charge for seating or boarding priority. These fees added nearly $4 billion in extra revenue during the first half of 2009, when the fees first started being charged. The fees are beneficial in that they are very high margin, as the airlines were already spending to provide them in the first place. They have also kept airline ticket prices somewhat stable, adding extra fees for only those that need the services.

One wild card is fuel prices, which as you can see from the chart below, have started to increase again and now exceed $100 per barrel. The extra fee revenue will help the airlines this time around, as most hedge their fuel costs anyway. United is hedged for 40% of its fuel costs in 2011, while Southwest has proved particularly savvy in hedging its fuel costs to lower overall volatility.  


Action to Take –> I think the largest airlines will make it through the latest fuel cost increases with flying colors. Most survived the 2007-2008 period when oil hit $140 per barrel and are in much better position to fend off either high fuel costs, a down economy or other temporary drops in travel.

The investment appeal in United Continental, Delta and US Air stem from their rock-bottom valuations. Referring to the table above again, all three stocks trade at single digit multiples of forward earnings and trailing free cash flow. US Air, with a forward P/E of less than 5 and trailing P/FCF of less than 3 is astoundingly cheap and could see further gains if it merges with a smaller player.

The issue right now is that investors do not have faith that these airlines have entered a sustainable age of steady profit generation. Admittedly, 2010 is only one year, but the profit levels achieved are extremely impressive, and the low debt levels mean the leading airlines have plenty of downside protection. I find it very easy to see their share prices more than doubling from current levels as P/E ratios reach the 9 to 10-range. This can happen as the airlines start building track records and convincing investors the past is behind them and that they are very much like the large, stable railroad firms. Maybe even Warren Buffett will eventually take notice.