Highland Capital Management On American Airlines – Can The Bull Market Continue?

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Below is a presentation by Highland Capital Management ($23 billion hedge fund) on U.S. Airlines such as American Airlines Group Inc (NASDAQ:AAL), Delta Air Lines, Inc. (NYSE:DAL), JetBlue Airways Corporation (NASDAQ:JBLU) and Southwest Airlines Co (NYSE:LUV) and the industry trends led by the ongoing bull market. Found via Harvest

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Highland Capital Management on AAL

Industry Trends

We believe that positive tailwinds will persist and that current valuation levels could provide an attractive return. Industry consolidation combined with higher fuel prices and financially-focused management teams have all been contributing factors to the ongoing environment of domestic capacity constraint. Gone are the days when Delta would attempt to steal market share on the Dallas to Chicago route, and American Airlines Group Inc (NASDAQ:AAL) would retaliate by adding a bunch of capacity between Atlanta and New York. There is finally an appreciation of the greater good that can be achieved by rational decision-making, and the benefit of this capacity constraint is becoming evident.

As shown in figure 1, domestic capacity growth has remained below that of GDP for the past three years. This combined with the three major carriers now controlling about 75% of the market has helped them to produce substantial profitability growth. The recent lackluster performance at United actually masks the improvement at American Airlines Group Inc (NASDAQ:AAL) and Delta Air Lines, Inc. (NYSE:DAL), whose LTM margins are at or over 16% as of the second quarter, and obfuscates the progress and momentum within the industry.

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American Airlines Group Inc (NASDAQ:AAL) is still in the midst of a merger and an internal restructuring under new management that, once completed, will position it alongside industry-leading Delta as the two premier domestic network carriers. Against the favorable industry backdrop, we also find JetBlue Airways Corporation (NASDAQ:JBLU) interesting given a number of revenue enhancement opportunities that management has thus far eschewed but that investors are more vociferously demanding.

What Else Has Happened

Another positive factor has been the reduction of labor constituencies (via consolidation) and the relative harmonization of labor costs (via court restructurings). In regard to cost structures, network carriers are on a more even playing field than ever before. One of the more forgotten facets of the pre-crisis industry was the role that Southwest Airlines Co (NYSE:LUV) (the other major, or “ankle-biter” according to some airline executives at the time) played in price setting, which was largely attributable to its substantial fuel hedge portfolio as prices began to escalate.

For example, more than 90% of its consumption was hedged at a crude oil equivalent price of $50 per barrel in 2007, a year in which WTI averaged $96. Southwest set the price on competitive routes, and the legacies would typically follow suit. However, that fuel price advantage has essentially disappeared, and the company is now battling non-fuel cost creep due to its labor contracts and expansion into more primary airports. One is now hard-pressed to find those really low priced fares that were once ubiquitous at Southwest.

Furthermore, all carriers have made significant strides in fare unbundling and ascribing value according to customer needs. These ancillary revenues typically have little costs associated with them and, thus, provide a direct benefit to the companies’ bottom lines. All of these factors have contributed to creating an industry that is more disciplined, cost competitive, and profitable than at any time in its history, and there is no reason to believe that it cannot persist and be improved upon during the near-term.

Fuel Pricing

Besides the structural changes that the industry has experienced, we believe that crude prices could serve as a catalyst for improved profitability due to the current airline supply/demand environment and the period of fare price rigidity that is likely to follow if fuel prices decline. Domestic crude production growth remains substantial, and there is now even talk of what has been considered verboten – allowing limited amounts of crude exports. This “Energy Renaissance” coupled with lower emerging market demand growth and increasing energy liberalization in places like Mexico could lead to lower, or at least stable, global oil prices going forward. The old adage in investing is that airline equities go down when oil goes up and vice versa. This is not difficult to comprehend given that 30-40% of airlines’ operating costs is traditionally related to fuel. One can see this historical relationship during the 2004 to 2009 period in figure 2.

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See full American Airlines: Can The Bull Market Continue? in PDF format here or scribd below.

U.S. Airlines Can the Bull Market Continue

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