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Stocks  | April 7, 2020

If you’re looking for gains in airline stocks, stick with high-quality companies, such as Delta and United, and avoid those with vulnerable balance sheets and operations—namely American and Spirit.

Those views come from J.P. Morgan analyst Jamie Baker, who issued a number of ratings changes and price-target cuts in a note published Monday. Baker downgraded American Airlines (ticker: AAL) and Spirit Airlines (SAVE) from Overweight to Underweight. He also downgraded JetBlue Airways (JBLU) and Southwest Airlines (LUV) to Neutral, upgraded Alaska Air (ALK) to Overweight, and left Overweight ratings on Delta Air Lines (DAL) and United Airlines (UA).

Airline stocks were posting gains near midday Monday amid a broad market rally. The NYSE Arca Airline Index was up 6.5% while the S&P 500 was ahead 5.7%. The airline index is still down 64% for the year.

Why so many ratings changes? Because the outlook for the industry is changing so rapidly. A few weeks ago, analysts were forecasting a steep decline in travel lasting through the summer, followed by a recovery in the fall. But that is looking less likely. The new framework is a gradual recovery stretching into 2021 with a smaller, leaner industry.

Baker, for one, said he initially expected industry revenue in 2021 to hover around 2019 levels. He is now forecasting 2021 revenue to be 25% below 2019 levels. “Managements here and abroad appear to be targeting much smaller footprints than we first factored into our modeling,” he writes.

American appears to be the most vulnerable of the major airlines. It was the most heavily leveraged of the legacy carriers going into the crisis; it had amassed $34 billion of gross debt, $46 billion of annual revenue and $6 billion of earnings before interest, taxes, depreciation, amortization, and rent/restructuring cost, or Ebitdar, a measure of operating cash flow for airlines.

None of that looks sustainable. American is now expected to add $6 billion in debt, taking it $40 billion, while revenue and Ebitdar fall to $35 billion and $5 billion, according to Baker. That would take American’s leverage from 5.3 to eight times Ebitdar—and it would imply negative equity value for the stock.

Stocks can’t go below zero, of course, and Baker doesn’t expect American to file for bankruptcy protection. The company is likely to shed at least 20% of its fleet to reduce costs and conserve cash. Interest rates on most of American’s debt is relatively low, and lenders are likely to restructure its debt to help avoid a bankruptcy scenario. American is also in talks with the federal government about an aid package that would include loans and payroll grants.

But Baker isn’t convinced American will emerge with much equity value. “It’s the sheer amount of debt that we are worried about, and the cost of carrying this debt against a top line that could potentially emerge 20-30% smaller,” he writes. “The margin for error for American management to navigate this crisis outside of the courts is growing uncomfortably thin.”

As a measure of the uncertainty surrounding the stock, he withdrew his price target.

Baker sees more value in Delta and United. The big legacy carriers should benefit from corporate travel coming back quicker than leisure travel. Delta had the highest margins of the legacy carriers heading into the crisis and one of the strongest balance sheets. Delta could pick up market share from weaker carriers that have to cut back schedules and flight capacity. United wasn’t as profitable, but it was making progress on turnaround efforts and should weather the crisis with sufficient liquidity, Baker writes.

The ultra-low-cost carriers may be in a bind, though. Their big competitive advantage is pricing, but that may prove less advantageous in a climate where everyone’s labor and fuel costs fall. The legacy carriers engage in more aggressive discounting to bring back travelers, and leisure travel may be slower to recover because of widespread unemployment and financial stress on households.

Spirit was one of the most profitable carriers with Ebitdar margins above 24% in 2019, beating United and Delta. But it is highly dependent on price-sensitive leisure travelers who may be suffering some of the hardest financial strains. “We believe Covid-19 will materially impact the company’s profitability,” Baker writes.

He lowered his price target on the stock to $11 from $41, slightly above where shares traded Monday, around $10.73.

Granted, investors shouldn’t take any of these estimates as gospel. No one can accurately predict the trajectory of the virus, how quickly travel will rebound, or what a recovery in air travel will look. A big unknown now is the federal government’s role. Will airlines become wards of the state, as auto makers and banks were during the global financial crisis? How much equity value will be left if the government takes a stake in certain carriers? And how long will the government impose restrictions on dividends, buybacks and labor practices?

Analysts themselves acknowledge that forecasting has become even more of a guessing game. “If you’d prefer, come up with your own forecasts and leave us out of it,” Baker writes.

One investor who appears fed up is Warren Buffett. As Barron’s reported Friday, Buffett has been selling stock in Southwest and Delta, according to regulatory filings for his holding company Berkshire Hathaway (BRK.B), and now owns less than 10% of the shares outstanding in each company.

A revolutionary initiative is helping average Americans find quick and lasting stock market success.

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