Times of robust economic growth have ended, and the economy is cooling down rapidly. Inflation and slowing economic growth are leading to consumers pulling back on spending while corporations look for ways to cut costs. However, the travel industry, especially airlines, is different. I know far, there are no signs of the industry slowing. In fact, airlines are struggling to meet demand. Thus, with continuous signs of a robust demand environment and no signs of slowing down as of today, I believe the airline sector is a buy, and of the sector, Delta (FROM THE) and Southwest Airlines (LUV) are the most attractive as they are most resilient and undervalued in comparison to its peers United (UAL) and American Airlines (AAL). Therefore, investors should sell United and American for Delta and Southwest Airlines.
Strong Demand Environment
Since the easing of Covid restrictions in early 2022, the airline industry has been enjoying strong pent-up demand and corporate travel recovery. Even today, more than halfway through 2022, the industry is seeing strong demand and recovery with an expectation for the demand to stay elevated throughout 2022. Domestic leisure travel has already surpassed 2019 levels leaving minimal room for further growth; however, corporate and international travel has more room for recovery. Full-time remote work is being replaced with either traditional office or hybrid working environment prompting more business travels while the international travel restrictions easing is unleashing international pent-up travel demand. As such, the elevated demand environment is expected to continue to benefit airlines, which is in-line with Delta, Southwest, United, and American Airlines’ guidance.
Further, I think the pandemic has fundamentally changed our lives. People started putting more value into experiences in comparison to goods. For example, more and more money is flowing into the entire travel industry while the retail industry is slowing with the economy. Lodging companies like Airbnb (ABNB) and all airlines continue to estimate elevated demand while retail companies like Lululemon (LULU) and Best Buy (BBY) are seeing a slowdown in sales. Therefore, with the consumers’ value proposition permanently changed, the travel industry may be more resilient than previously forecasted despite risks of economic downturns in the near future.
While the demand for travel is strong, airlines are struggling to meet the demand. The sudden pop in traveler numbers was too much for airlines and airports to handle after more than a year of demand depression. Airlines have responded to the problem with both higher ticket prices and capacity limitations to contain cancellations and delays. Because the fundamental reason causing these problems, staffing shortages including pilots, rest within the entire system, the current environment of airlines’ pricing advantage is likely to continue.
Overall, a strong demand environment combined with staffing shortages is expected to be ongoing continuing to benefit airlines throughout 2022.
Delta & Southwest Over United & American
Among the airline industry, I believe investors should only consider Delta and Southwest Airlines as these two companies have the most resilient balance sheet and attractive valuations in comparison to United and American Airlines.
Starting with the balance sheet, Delta and Southwest Airlines both had positive stockholder equity of $ 3.8 billion and $ 11 billion, respectively, while United and American Airlines had $ 3.9 billion in stockholder equity and $ 8.4 billion in stockholder deficit, respectively.
(Despite market capitalization differences, United and Delta Airlines had nearly identical total liability to asset ratios at 94% and 95%, respectively.)
Without considering the valuation and operating margins, it may seem as if United Airlines is on-par with Delta; however, this is not true.
Delta and Southwest Airlines reported an operating margin of 11.7% and 17.2%, respectively, in the previous quarter while United and American Airlines reported 7.2% and 7.6%, respectively. Given the same strong demand environment allowing airlines to charge a significant premium, both United and American Airlines showed far inferior operational efficiency.
On top of the operating margin discrepancy, however, United and American Airlines also had either similar or higher valuation multiples. United and American Airlines 2023 forward price-to-earnings multiple stood at 6.17 and 8.43, respectively, while Delta and Southwest Airlines’ 2023 forward price-to-earnings multiple stood at 6.25 and 11, respectively. Southwest Airlines has the highest valuation multiples, but considering the company’s highest operating margins and strongest balance sheet health, I believe this level of valuation multiple is justified.
Investors should sell American Airlines as the company had the weakest balance sheet, relatively low operating margins, and relatively high valuation multiples. In my opinion, investors should also sell United Airlines for either Delta or Southwest Airlines. Although United Airlines had a similar balance sheet strength as Delta Airlines, the company’s operational efficiency was significantly lower while maintaining a similar valuation multiple.
Overall, the nature of the airline industry puts all four companies’ stock price movements in a similar pattern. Strong demand and a positive travel environment will benefit all four companies while periods of weak demand will be negative. They will rise and fall at similar times. However, the magnitude of the rise and fall may vary significantly. Stronger companies will most likely be able to delay the impending storm and maximize their profits during times of strong demand. Further, if the magnitude of the negative sentiment in the market is not severe, Delta and Southwest might not even be affected while United and Americans see some levels of pain. As such, I believe investors owning United and American Airlines should sell their shares for stronger airlines, Delta and Southwest Airlines.
Since the beginning of 2022, investors have been seeing steady recovery in travel demand, but to most people’s surprise, the demand continues to be strong today with an expectation of it ongoing through 2023. As such, without economic woes, some fears linger in the airline stocks. However, in times of consumers’ pursuit of experiences over goods and recovering corporate and international travel, I continue to be bullish on the airline industry, Delta and Southwest Airlines in particular. These companies have superior operational efficiency, valuation, and balance sheet compared to United and American Airlines. Therefore, I believe investors should sell United and American Airlines for Delta and Southwest Airlines.