Should You Buy United Continental Holdings Inc (UAL) Stock? 3 Pros, 3 Cons

For long-time investors in United Continental Holdings Inc (NYSE:UAL), it has been a rags to riches story. UAL stock traded for under $4 several times during the financial crisis. Buyers at that price have made more than 15x their investment.

Should You Buy United Continental Holdings Inc (UAL) Stock? 3 Pros, 3 Cons
Source: Shutterstock

Reduced competition has set the stage for the great American airline revival. The sudden plunge in jet fuel prices from 2014 added the exclamation point to the turnaround, leaving airlines with a gusher of profits.

The bull case looks powerful. And the world’s most famous investor has gotten on board. But don’t take all the positives to mean that this will be a smooth flight. There is still a lot that could go wrong for UAL and the rest of the industry.

UAL Stock Cons

International Discount Carriers on the Rise: Much of airline economics is predicated around making international travel happen. International routes have generally been airlines’ crown jewel assets. The domestic hub-and-spoke feeder system serves as a tool to broaden an airline’s reach and pull in a higher percentage of that all-important higher-margin international traffic.

However, this profit stream is under increasing threat. Numerous discount airlines have launched in countries near the United States, driving down fares on formerly high-profit margin routes.

The Mexican market is one example. A decade ago, Mexico didn’t host any significant discount carriers. Today, Controladora Vuela Co Avcn SA CV (ADR) (NYSE:VLRS) “Volaris” has the lowest cost structure in all North America, and it is aggressively adding capacity to the U.S.

Its chief Mexican rival Interjet isn’t far behind. And the Ryanair Holdings plc (ADR) (NASDAQ:RYAAY) backed Viva family is causing multiple threats. VivaAerobus is also aiming at the U.S.-Mexican market, while VivaColombia has launched U.S.-Colombia service. Low cost carriers are taking off in Costa Rica this year as well. Discounters aren’t just a U.S. phenomenon, and UAL’s margins will drop as international service becomes yet more competitive.

Oil Price Tailwind Gone: For the last couple of years, airlines have benefited from sharply lower oil prices. Fuel typically makes up close to a quarter of an airline’s overall expense profile; it’s no surprise that taking the price of oil down from $90 per barrel to $50 or less would help the bottom line.

However, oil has now traded cheaply for more than two years. Airlines are now facing jet fuel prices higher than last year’s on a year-over-year basis. Additionally, some airlines have started boosting capacity to benefit from the cheaper expense profile in this low fuel price environment. As a result, airlines aren’t getting favorable earnings comps due to jet fuel anymore, and competition is starting to erode the benefit from lower prices. But with oil’s latest down leg under $50 per barrel over the past month, things could improve quickly for United stock on this front.

Too Much Capacity Expansion: Last week, Morgan Stanley analyst Rajeev Lalwani cut his view on the American airline sector. He did on the basis of “pricing cracks” forming in the industry. United projects a doubling of its supply growth rate. Lalwani anticipates that Delta Air Lines, Inc. (NYSE:DAL), Southwest Airlines Co (NYSE:LUV) and American Airlines Group Inc (NYSE:AAL) may well follow suit.

This sort of overexpansion always happens to the airline industry. It is far too easy to lease planes when conditions look good, and then get stuck with huge bills once the market turns down. Airlines have repeated this cycle without fail since the federal government deregulated the industry in 1978. While airline stocks are often good for a trade, there is not much evidence to suggest they will work out better as investments this time around. The temptation to grow haphazardly remains much too enticing.

UAL Stock Pros

Buffett Buying Airlines: In the past, Berkshire Hathaway Inc. (NYSE:BRK.A, NYSE:BRK.B) avoided airlines. Warren Buffett bought into stock of what was then U.S. Airways stock, and has apologized about it frequently. He has criticized the industry for “kamikaze pricing” and used plenty of other harsh language about the industry.

And yet, his Berkshire Hathaway investment firm piled into airlines heavily late last year. Berkshire showed little discrimination, piling into all three big carriers, including United, along with Southwest. What caused Buffett to change his mind? Read on.

Cheap Stock/Buyback: UAL stock is currently trading at 10x earnings. In this stock market, that’s an extremely cheap figure; U.S. stocks as a group are selling at about 25x earnings. Admittedly, however, price-to-earnings isn’t the best ratio for judging airlines, since they have many costs that fall outside of the traditional P/E calculation. However, on a more appropriate EBITDAR basis, UAL stock also looks attractive.

And regardless of how you judge earnings power, United stock is delivering shareholder value in a big way. Ignore the lack of a dividend. UAL is buying back its own stock hand over fist. At the end of the 2014 fiscal year, the company had 374 million shares outstanding. Today, we’re down to 315 million shares of United stock outstanding. In two years, UAL has retired 16% of the company’s outstanding stock. Good things happen when you combine a cheap stock with an aggressive share buyback.

Maybe Things Are Different This Time: While many skeptics expect UAL stock to decline when this airline cycle ends, it is possible we have entered a new economic environment for the industry.

At the turn of the century, the United States counted seven major carriers. Since then, the airlines have consolidated relentlessly, leaving far fewer major players. The combination of lower jet fuel prices and significantly more fuel-efficient jets has improved economics in that area. Airlines have done reasonably well at controlling labor costs. The airline industry may revert back to its old-school “kamikaze pricing”. But it may have turned the corner.

Bottom Line on United Stock

The bull case for UAL stock sounds tempting. Warren Buffett buying into airlines after years of scorning them certainly turned some heads. And they do look cheap now.

But we’ve heard this story before. Many times. There is still no reason — at all — to suspect that airlines have learned their lesson about oversupply. Even now, the airlines are starting to expand too quickly and setting the stage for another big price war. That’s while oil prices have stabilized. And international discounters are showing increasing ambition to take share. The odds favor the airlines’ current good fortune not lasting.

At the time of this writing, Ian Bezek owned BRK.B and VLRS stock. He had no position in UAL stock. You can reach him on Twitter at @irbezek.

Article printed from InvestorPlace Media,

©2021 InvestorPlace Media, LLC