With all due respect to the brilliant research minds employed at Goldman Sachs, they may be on the wrong side of an important research call. Roughly a month ago, I noted that their bearish comments about airline stocks looked quite myopic.
Well, the folks who will be making decisions about capacity, financing, and other steps that affect cash flow have recently made clear that Goldman's view is flat wrong. In the past few weeks, Delta's Chief Financial Officer Paul Jacobson bought almost $500,000 in stock, while six different insiders at United (including the CEO, chief operating officer and CFO) acquired more than $2 million in company stock.
These executives have already begun to prove their mettle: despite a still-weak global economy, pricing strategies and cost controls have led to the strongest free cash flow in history.
These moves have come after each stock has swooned more than 20% since mid-July -- which happens to be around the time Goldman Sachs picked up coverage of the view with a dim outlook.
Of course, buying airlines has often been a fool's game, in large part because these firms often carried too much debt and left themselves vulnerable to economic weakness. Yet in recent quarters, these carriers have been applying their prodigious cash flow to steady pay-downs of their long-term debt. Delta, for example, is on track to pay off more than $4 billion in debt from the end of 2010 through the end of 2013.
Falling long-term debt ($billions)
(Note that year-end debt levels for 2012 and 2013 are extrapolated form debt reduction in the first six months of 2012).
Make no mistake, one of the reasons airline stocks sport very low price-to-earnings (P/E) multiples is that they have historically carried a high degree of debt-related risk. Yet as debt loads fall, investors are likely to award modestly higher P/E multiples to these stocks.
As an example, Delta and United Continental trade for less than four times projected 2013 profits. But what if investors come to conclude that a track record of consistent solid cash flow (which is now the case) and falling debt levels mean that a higher multiple is warranted? Well, a move up to a forward P/E of 6 implies 50% upside. A P/E of 8 means 100% upside.
That's not as crazy as it sounds.
Airline stocks have often traded up to that level when investors spot a profit growth spurt coming. As it stands now, Delta and United Continental are expected to boost profits by at least 25% in 2013, according to consensus estimates. Of course, as long as some have concerns profits won't grow in 2013 (which is the view espoused by Goldman Sachs), then these stocks will remain under pressure. The fact that airlines just pushed through a series of rate hikes may help bolster the case that profit targets can indeed be met in 2013.
Risks to Consider: Delta and United Continental have the greatest degree of foreign exposure in this group, and may be hard-pressed to post major gains until investors see that cash flow levels remain robust in coming quarters -- despite the global pressures.
Action to Take --> Forget about the near-term profit view. This industry is in a far healthier position than at any time in recent memory. As memories of the bad years finally fade, these stocks can begin a long-awaited rally that takes their shares well above current levels.
David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.
This article orginally appeared at StreetAuthority.com