Airline stocks continued to climb on Tuesday, tacking on 4% in morning trading. The stocks have now surged more than 16%, on average, in the last few sessions on signs that domestic travel is picking up and that a vaccine for the coronavirus may be arriving by year-end.
Citigroup’s Stephen Trent sees more gains ahead, particularly for Spirit Airlines (ticker: SAVE) and Delta Air Lines (DAL).
“An ongoing, choppy traffic recovery, combined with what looks to be continued weak pricing, looks like a good setup for Buy-rated Spirit,” Trent wrote in a note published Tuesday.
Among the major carriers, Citi likes Delta, “owing to its balance sheet strength, attractive loyalty/credit card program...and its consistent messaging on middle seats.” (Delta has been one of the few carriers to continue blocking middle seats as a health-safety measure.)
Trent has a $21 price target on Spirit’s shares, based on a multiple of 8.5 times forward earnings in late 2021 and early 2022. His target on Delta is $38, based on a multiple of eight times forward earnings.
“As the industry’s best operator, we think investors will seek refuge in Delta shares once the coronavirus fears abate and sector valuations normalize to long-term trend levels well above current multiples,” Trent wrote.
Spirit stock has been one of the strongest performers since March, more than doubling off its lows around $7. The ultralow-cost carrier focuses almost exclusively on the “visiting friends and relatives” market, and it is planning flight capacity in the third quarter to be down 32% from last year, which would be a big improvement over the spring and early summer.
The recovery isn’t expected to be linear. Travel demand and flight capacity trends are tough to predict since they have become tethered to coronavirus infection rates and state quarantine rules. Demand seems to have rebounded recently as infection rates receded, but airlines have been cutting their schedules for August and September, anticipating lower leisure travel during the back-to-school season, without business travel picking up the slack.
Nonetheless, at least one investor could theoretically make a profit on Spirit stock now: the U.S. government. Shares of Spirit are trading above the strike price of warrants issued to the U.S. Treasury in exchange for federal aid under the Cares Act. (In theory, the government could redeem the warrants for stock and sell at higher market prices.)
Indeed, shares of almost every carrier that issued warrants are now trading now above their strike prices, according to Trent, including American Airlines Group (AAL), United Airlines Holdings (UAL), and Delta. One exception is Southwest Airlines (LUV), whose stock remains slightly below the strike price.
Why does this matter? One reason is that airlines are trying to line up more aid from the government, hoping for a second round of payroll support beyond the $25 billion allocated under the Cares Act. That aid expires on Sept. 30. Airlines have announced plans to cut more than 75,000 jobs, when funding runs out in October, assuming demand trends don’t improve sharply.
The warrants issued under the Cares Act could now come into play as a bargaining chip. Congress could set more aggressive strike prices for additional warrants, giving lawmakers political cover as they head into the November elections, Trent notes. Bailing out airlines again could be a tough sell politically, especially if lawmakers can’t agree on unemployment benefits and aid to other industries.
“Deeper in-the-money warrants on a potential second round of aid might be one way to show taxpayers that their efforts are not in vain,” Trent wrote.
If the stocks continue to rally from here, the Treasury could see a nice return on its warrant investment.
Whether airlines would take more government money under tougher conditions remains unknown. And with negotiations on a stimulus package apparently stalled, it is unclear when more financing could start flowing. For now, the reason to own the stocks would be hopes that the virus infection rates continue to decline and that the economy springs back to life.