Value Investing

United Continental Still Undervalued – 10% Cashflow Yield + 11% Shareholder Yield

One of the cheapest stocks in our Large Cap 1000Stock Screener is United Continental Holdings Inc (NYSE:UAL).

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United Continental Holdings, Inc., (United) together with its subsidiaries, provides air transportation services in North America, the Asia-Pacific, Europe, the Middle East, Africa, and Latin America. The company transports people and cargo through its mainline and regional operations. As of December 31, 2015, United operated 1,236 aircraft. The company also sells fuel; and offers catering, ground handling, and maintenance services for third parties.

Airline stocks, including United, got a boost in late 2016 after it was revealed Berkshire Hathaway had added three of the biggest U.S. airlines to its third quarter portfolio. Stocks included — American Airlines Group Inc (NASDAQ:AAL), Delta Air Lines, Inc. (NYSE:DAL), and United Continental Holdings Inc (NYSE:UAL). According to the September filing, Berkshire owned 21.8 million American Airlines shares worth $797 million, 6.3 million Delta shares worth $249.3 million, and 4.5 million United shares worth $237.8 million. While there are a number of airline stocks in our Large Cap 1000 - Stock Screener, today I want to focus on United.

A quick look at the company's share price history over the past twelve months (below) shows that the stock has risen over 50% to $72.06, just 5% off its 52 week high of $76.80.

(Source, Google Finance)

United recently announced its Q4 2016 and full year 2016 results. A quick look at the company's quarterly income statements (below) shows that Q4 2016 revenue increased 0.2% to $9.052 Billion from $9.036 Billion for the previous corresponding period. Full year 2016 revenue was down 3.5% to $36.6 Billion from $37.9 Billion for the full year 2015.

Quarterly Income Statements
($ amounts in millions)
Quarter Dec15 Mar16 Jun16 Sep16 Dec16
Preliminary
Revenue 9,036 8,195 9,396 9,913 9,052
Gross Profit 6,478 5,350 6,244 6,573 5,785
Operating Income 1,081 649 1,060 1,624 1,005
Pre-Tax Income 905 494 931 1,510 884
Tax Provision -82 -181 -343 -545 -487
Tax Rate % 9.06 36.64 36.84 36.09 55.09
Net Income 823 313 588 965 397

(Source, Company reports)

The company also reported that Q4 2016 consolidated passenger revenue per available seat mile (PRASM) decreased 1.6% and consolidated yield decreased 1.2% compared to the pcp. This out-performance versus the company's initial guidance was due to stronger close-in bookings and yields in November and December. For the full-year 2016, consolidated PRASM declined 5.4% compared to the prior year driven by factors including a strong U.S. dollar, lower surcharges, reductions from energy-related corporate travel, and declining yields.

What's most notable in the quarterly income statements above is that the company's net income dropped by 52% in Q4 2016 compared to the pcp, which on the face of it seems quite alarming. The reason for the significant drop can be found in a line item above called Tax Provision.

As you can see, the Tax Provision in Q4 2016 was $487 million compared to just $82 million for the pcp, a difference of $405 million. While the company's effective tax rate for Q4 2016 was 55% the tax provision was also impacted by a special tax expense of $180 million. The company recorded approximately $180 million of deferred income tax expense adjustments in AOCI, which related to losses on fuel hedges designated for hedge accounting. Accounting rules require the adjustments to remain in AOCI as long as the company had fuel derivatives designated for cash flow hedge accounting. In 2016, United settled all of its fuel hedges and has not entered into any new fuel derivative contracts for hedge accounting.

Also impacting full year profit were a number of special items that are non-recurring and that management believes are not indicative of United's ongoing performance. These included:

Labor agreement costs and related items: The fleet service, passenger service, storekeeper and other employees represented by the International Association of Machinists and Aerospace Workers (IAM) ratified seven new contracts with the company which extended the contracts through 2021. The technicians and related employees represented by the International Brotherhood of Teamsters (IBT) ratified a six-year joint collective bargaining agreement which extended the contract through 2022. During 2016, United recorded $171 million ($110 million net of taxes) of special charges primarily for payments in conjunction with the IAM and IBT agreements described above.

Severance and benefit costs: During the three months and year ended December 31, 2016, United also recorded $10 million ($6 million net of taxes) and $37 million ($24 million net of taxes), respectively, of severance and benefit costs related to a voluntary early-out program for the company's flight attendants and other severance agreements.

Impairment of assets: In April 2016, the Federal Aviation Administration (FAA) announced that it will designate Newark Liberty International Airport (Newark) as a Level 2 schedule-facilitated airport under the International Air Transport Association Worldwide Slot Guidelines effective October 30, 2016. The designation was associated with an updated demand and capacity analysis of Newark by the FAA. In 2016, the company determined that the FAA's action impaired the entire value of its Newark slots because the slots are no longer the mechanism that governs take-off and landing rights. Accordingly, United recorded a $412 million special charge ($264 million net of taxes) to write off the intangible asset.

Cleveland airport lease restructuring: Lastly, during 2016 the City of Cleveland agreed to amend their lease with United, which runs through 2029, associated with certain excess airport terminal space (principally Terminal D) and related facilities at Hopkins International Airport. United recorded an accrual for remaining payments under the lease for facilities that it no longer uses and will continue to incur costs under the lease without economic benefit to the company. This liability was measured and recorded at its fair value when the company ceased its right to use such facilities leased to it pursuant to the lease. United recorded a net charge of $74 million ($47 million net of taxes) related to the amended lease.

As a result of all of the above, the company reported full-year net income of $2.3 billion, diluted earnings per share of $6.85, pre-tax earnings of $3.8 billion and a pre-tax margin of 10.4%. When we exclude special items, United's reported full-year net income was $2.9 billion, diluted earnings per share of $8.65, pre-tax earnings of $4.5 billion and a pre-tax margin of 12.2%.

With regards Q4 2016, United reported fourth-quarter net income of $397 million, diluted earnings per share of $1.26, pre-tax earnings of $884 million and a pre-tax margin of 9.8%. When we exclude special items, United's reported fourth-quarter net income was $562 million, diluted earnings per share of $1.78, pre-tax earnings of $857 million and a pre-tax margin of 9.5%.

Strategic Initiatives

United recently recorded its best full-year on-time performance while reporting its lowest number of cancellations, delay minutes and mishandled bags in company history. The company appears to be on track with the new initiatives announced back in November 2016 in which the company stated it expects to unlock $4.8 Billion in value by 2020. These initiatives included:

Introduction of Basic Economy Airfares

This new offering provides customers with the option to pay the lowest fares to their destinations, while still receiving the same standard economy experience, including food, beverage, Wi-Fi and personal device entertainment, with a few key differences. Customers who choose Basic Economy will be assigned seats on the day of departure, be assigned to boarding group five and be permitted only one personal carry-on item that must fit under the seat.

Optimizing Its Network

The company also announced plans to fully optimize its network potential by continuing to leverage its leading international position while strengthening its domestic network, including improving the bank structures at key hubs in Chicago, Houston, and Newark/New York, and further improving both schedules and product in top business markets. United has opened several new international routes to key growing markets. In Q4 2016 the company launched its service to Havana, Cuba from its Newark and Houston hubs. During 2016, the company also introduced new routes between San Francisco and five international destinations including Tel AvivXi'an, China; Singapore; Auckland, New Zealand; and Hangzhou, China. This was in addition to the December launch of its United Polaris service, and the opened of its first premier United Polaris lounge in Chicago.

Adjusting Its Aircraft Order Book

The company announced a modification to its narrow-body order book. United is converting its original order for 65 737-700 aircraft into 4 737-800 aircraft to be delivered in 2017 while the remaining 61 will be converted into orders for 737 MAX aircraft, with delivery dates to be determined. These changes will allow the company to take advantage of the superior fuel efficiency of the MAX aircraft while also reducing capital expenditures by approximately $1.6 billion through 2018. In addition, the company has agreed to purchase 24 Embraer 175 aircraft from Embraer, instead of leasing these aircraft through a capacity purchase agreement as was originally planned. These aircraft will be leased to third-party carriers operating as United Express. During the 2016 year, United took delivery of 22 new Boeing aircraft, including 737NGs, 787s and 777s, as well as six used Airbus A319 aircraft.

Mobile Strategy

The company is accelerating its mobile technology strategy, using its award-winning mobile app. The app has more than 14 million downloads and expands the types of transactions customers can make throughout their journey, including managing documentation for international travel and expanded re-booking options. In addition, the company provided its employees with 50,000 mobile devices which will enable them to provide a better experience to customers by equipping them with the technology and information they need.

Ratified Agreements

In what is a significant step forward in the company's future, United has now ratified new labor agreements for all United employee groups in an effort to build a partnership between management and labor while driving higher employee engagement. This commitment to employee engagement was further highlighted with the $628 million pay-out as part of its employee profit-sharing program and full year cash-incentive payments of approximately $120 million for employees that achieved operational performance goals.

United is continuing its rigorous cost management program and expects 2017 unit costs to grow 3.5% to 4.5% excluding fuel. The company also expects 2018-2020 unit costs excluding fuel to grow less than 1% per year due in part to its planned removal of $700 million of costs by 2020, as compared to 2015 levels.

United has made significant progress in operational reliability, with an improvement of nearly 10 percentage points year-to-date in on-time departures. The company plans to further improve performance with a specific focus on decreasing the time it takes to turn narrow-body aircraft, continuing to reduce long delays and cancellations, and executing on previously announced fleet reliability measures. United is also in the process of improving its revenue management system to more accurately forecast demand to better maximize profitability on each flight. The company expects these system improvements to drive $900 million of incremental revenue by 2019.

United has proven that it's also prepared to shake things up in terms of its top management. The company continues to build a world class leadership team, a critical step forward in the company's future. Back in August 2016 the company appointed Scott Kirby as president of United in a newly created role. Kirby came from American Airlines, where he held the title of president since the merger of American and US Airways in 2013.

At the time the appointment was made United's CEO Oscar Munoz said, "Scott is a proven leader, whose deep airline experience and expertise will further accelerate our efforts to build the best airline in the industry. Scott's appointment, along with other recent leadership announcements, is the culmination of the formation of my senior leadership team. This is just the latest step in our mission to be an agile and innovative industry leader."

The other recent leadership appointments that Munoz was referring to were the addition of two key members to its executive leadership team including the appointment of Andrew Levy as executive vice president and chief financial officer, and Julia Haywood as executive vice president and chief commercial officer.

Levy came to United following more than thirteen years of leadership at Allegiant Travel Company, a highly successful ultra-low cost carrier, and Haywood joined United from The Boston Consulting Group (BCG), where she served as partner and managing director. Haywood had been a partner on BCG's revenue and network transformation team at United.

Also in 2016 were the December announcements of Julie Yates Stewart as Managing Director, Investor Relations; Jonathan Ireland as Vice President and Chief Financial Officer - Commercial, and Tom Doxey as Vice President and Chief Financial Officer - Operations.

Let's Run The Numbers

While we still don't have the 10-K for the full year 2016, United has stated in its Q4 2016 & Full Year 2016 Earnings Call that the company generated $5.5 Billion in operating cash flow and had $3.3 Billion in adjusted capex.

(Source, Company reports)

The same report also states that the company generated $2.2 Billion in free cash flow. With this being the case, if we consider the company's current market cap is $23.2 Billion that equates to a FCF/Price yield of 10% (ttm).

For full-year 2016 United also purchased $2.6 billion of its common shares, representing approximately 14 percent of shares outstanding, at an average price of $51.80 per share. As of Dec. 31, 2016, the company had $1.8 billion remaining to purchase shares under its existing share repurchase authority. Based on its current market cap, the $2.6 Billion share re-purchase equates to a buy-back yield of 11% (ttm).

Valuation

In terms of United's current valuation, we still don't have the company's FY2016 10-K, so we'll use the company's latest available 10-Q, dated September 30, 2016. This shows that the company had cash and cash equivalents of $4.9 Billion and Debt and Lease Obligations of $11.5 Billion, or net debt, if we subtract cash and cash equivalents, totaling $6.6 Billion. If we add the net debt to the current market cap that equates to an Enterprise Value (EV) of $29.8 Billion.

We favor EV over market capitalization as it includes additional liabilities–like debt, preferred equity and non-controlling interests–if you were to purchase the entire company. EV is calculated as:

Market Cap + Preferred Equity + Non-Controlling Interests + Total Debt – Cash and Equivalents.

If we consider that the company had operating earnings* of $4.98 Billion (ttm), that means United is currently trading on an Acquirer’s Multiple of 5.99 or, 5.99 times operating earnings*.

The Acquirer’s Multiple is defined as:

Enterprise Value/Operating Earnings*

*We make adjustments to operating earnings by constructing an operating earnings figure from the top of the income statement down, where EBIT and EBITDA are constructed from the bottom up. Calculating operating earnings from the top down standardizes the metric, making a comparison across companies, industries and sectors possible, and, by excluding special items–income that a company does not expect to recur in future years–ensures that these earnings are related only to operations.

With a FCF/Price Yield of 10% and an Acquirer's Multiple of 5.99, or 5.99 times operating earnings*, that places United squarely in undervalued territory.

Summary

While the company's recently announced full year 2016 revenues were down slightly compared to 2015, United is a company on a clear growth trajectory based on the strategic initiatives it announced back in November. These initiatives include the introduction of basic economy fares, optimizing its network, adjusting its aircraft order book, and ratifying new labor agreements. United is embarking on a rigorous cost and revenue management program and has embraced the use of mobile technology, with its award-winning mobile app, to better serve its customers as well as improving operational efficiencies for its employees. CEO Oscar Munoz has demonstrated his willingness to shake-up his senior leadership team in order to achieve his goal of making United an agile and innovative industry leader.

In terms of its valuation, United generated $2.2 Billion in free cash flow for the full year 2016 and remains squarely in undervalued territory with a FCF/Price Yield of 10% (ttm), a P/E of 10.5, and an Acquirer's Multiple of 5.99, or 5.99 times operating earnings. The company also provides a nice shareholder yield of 11% thanks to its aggressive and ongoing share re-purchase strategy.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.