American Airlines Poised to Reap Benefits of Long-Term Decline in Oil Prices

12/02/2014 8:50 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Turns out this airline company made a good call on the direction of oil prices when it sold its last hedges in July, so MoneyShow's Jim Jubak is taking advantage of yesterday's bounce by adding shares as of today, December 2.

I'm going to take advantage of yesterday's drop in the transportation sector on profit taking and the bounce in oil prices to add shares, today, of American Airlines Group (AAL) to my Jubak's Picks portfolio. Airlines are one of the major beneficiaries of falling oil prices. And with the drop in oil prices looking more and more like it will be with us into 2016, I think it's smart to add plays on falling oil prices like this (and my November 18 pick of Indian bank HDFC (HDB)).

Yesterday, December 1, shares of American Airlines fell 1.34% to close at $47.88. Today, they edged just 0.04% lower to $47.86. I'd set a target price of $57.50 a share by November 2015. The shares trade at 8.53 times estimated full year 2014 earnings per share (and at 20.31 times trailing twelve month earnings). The shares pay a very modest 0.84% dividend yield.

Airlines are extremely cyclical stocks. When they make money, they make very good money. That good money is a result of sector discipline (or distress) that has reduced seating capacity and pushed ticket prices higher. But airlines, almost inevitably it seems, look at the good times and decide to buy more planes, adding new capacity and leading to the kind of price wars that make profits disappear.

The swings are huge, especially in recent years when the industry has been consolidating rapidly in the face of losses that have generated big quarter-to-quarter charges. Delta Airline (DAL), for example, lost $19.08 a share in 2008 but will swing to a projected $3.28 a share profit in 2014. American Airlines lost $13.36 in 2009 and is projected to show a profit of $5.62 a share in 2014.

Fueling this swing to black ink has been a reduction in capacity through mergers and the reduction in routes and route frequencies. At the moment, we're at the point in the cycle where capacity discipline is holding and ticket prices are high. American Airlines, for example, projects it will add just 2.2% to capacity in 2014. Add in the industry's discovery of added fees for everything from checked bags to extra leg room and these were going to be the good ol' days for the industry.

And then the price of oil plunged. Which has meant that the price of jet fuel plunged.

The leverage from that plunge can be tremendous. American Airlines, for example, sees a 30 cents a share addition to earnings with each 5-cent drop in the annual average price of fuel, according to Credit Suisse.

Not all airlines get the same earnings bang for each drop in fuel costs. The degree of leverage depends on how much of its fuel costs an airline has hedged. Buy enough contracts on future jet fuel delivery and an airline can save big if fuel costs rise. (The airline also gets the added advantage of predictable costs for fuel.) However, if the price of fuel drops, the hedged airline doesn't get nearly all the advantage from that drop. When fuel prices are falling, it pays to be the unhedged airline.

American Airlines sold its last hedges on higher fuel costs back in July. Partly, that was what turned out to be a good call on the direction of oil prices. Partly, it was the result of the merger of American and US Airways. Over the last decade, US Airways has used far fewer hedges than competitors.

And, right now, that lack of hedges at American Airlines Group means that the company is in a position to reap all the benefits of a long-term decline in oil prices. With Wall Street increasingly pumping out reports calling for "A test of $60 a barrel" and even "Can oil go to $40?" I think shares of American Airlines Group will be a major beneficiary of the current game of "How low can oil go?" Forecasts show American Airlines producing margins in the fourth quarter that equal those of Delta, the sector leader in this category.

From a wider perspective, at the moment, the airline industry looks like it will hold its discipline on capacity. American Airlines, for example, is forecasting an increase in capacity of just 2% to 3% in 2015.

I wouldn't be willing to make a long-term bet on that discipline holding into 2016 or 2017. But for 2015? The odds are pretty good.

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