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US airline undervaluation creates an opportunity for buybacks to boost shareholder returns

As investors in US airlines struggle to understand the dynamics of profits driven by lower fuel costs versus net income fuelled by unit revenue growth, some of the large airlines are taking the opportunity to increase shareholder returns by repurchasing shares they conclude are underpriced.

The four largest US airlines have expanded their share repurchase programmes in 2015 and some of those companies have also opted to increase their dividends. Shareholder returns by US airlines are no doubt reaching historical levels, which is creating questions about how far the rewards can go.

Stock prices of the four largest US airlines continue to trade below their yearly high points. The perceived undervaluation by management teams could create further opportunities for buybacks in order for airlines to deliver on their promises of sustained shareholder returns.

Delta Air Lines returns USD3 billion to its shareholders over a two year period

In Jun-2015 Delta Air Lines estimated that US airlines had delivered USD4.3 billion in shareholder returns during the last year. Delta embarked on its ambitious shareholder return programme in 2013, and the airline in Jul-2015 estimated that its shareholder returns during the last two years totalled USD3 billion. It completed a reauthorisation of USD2 billion from 2014, and has announced a new USD5 billion repurchase scheme scheduled for completion in 2017. Delta aims to return nearly USD2.5 billion to its shareholders in 2015.

Delta’s stated goal is to return 50% of its free cash flow to shareholders, and the airline has previously offered free cash flow estimates of USD4 billion to USD5 billion for 2015 to 2017. During 2Q2015 it issued USD72 million in dividends.

The airline in 2Q2015 “opportunistically repurchased an additional USD200 million under our new USD5 billion authorisation as we took advantage of share price weakness in the quarter,” Delta CFO Paul Jacobson recently explained. The airline also repurchased another USD50 million of its shares in the first two weeks of Jul-2015.

Unit revenue jitters are pushing airline shares lower, creating buyback opportunities

Shares of Delta, American, United and Southwest are trading below their 52 week highs, driven in part by investor trepidation over unit revenue weakness triggered by domestic competitive pricing actions, lower international fuel surcharges and headwinds from the appreciation of the USD against most global currencies. Those four airlines recorded passenger unit revenue declines in 2Q2015 of more than 4%, with American posting the largest decline of 6.9%

Passenger unit revenue (PRASM) decline of the four largest US airlines 2Q2015

American 6.9%
Delta 4.6%
United 5.6%
Southwest 4.6%

Current share price and 52 week high prices for the four largest airlines

Airline Closing price USD
19-Aug-2015
52 week high
USD
American 43.54 56.20
Delta 47.08 51.06
United 58.23 74.52
Southwest 40.45 47.17

See related report: American Airlines’ financial performance is clouded by concerns over unit revenue degradation

The fall-off in prices has increased the appetite for share buybacks even as airline management teams have attempted to stress that investors should focus on top line profitability and margin growth rather than unit revenue performance. “We would have not purchased USD753 million of our stock in the quarter [2Q2015] at an average price of USD43.53 if we thought the stock wasn’t worth more than USD43.53,” American CEO Doug Parker recently declared.

Mr Parker noted that the intense focus on unit revenues is important, “but I would encourage everybody to look at valuation”. He stated that the “market will do what the market will do. If it continues to have this view it will just allow us the opportunity to purchase more stock”.

United holds off on dividends, opting to expand its share buyback programme

American recently revealed a USD2 billion buyback programme in addition to a separate USD2 billion repurchase scheme unveiled in Jan-2015.

During 2Q2015 American returned a total of USD823 million to shareholders through the payment of USD70 million in dividends and the aforementioned share repurchase. The company estimates it returned USD1.1 billion to shareholders in 1H2015 and returned a total of USD3 billion since the close of the US Airways-American merger in late 2013.

United Airlines joined its large US global network rivals by initiating a USD1 billion buyback programme in 2014, and in Jul-2015 announced a new USD3 billion share repurchase scheme scheduled for completion at YE2017. The company anticipates completing the initial USD1 billion buyback in 3Q2015, which is about two years ahead of schedule.

United has not opted to include dividends in its shareholder reward programme. The airline at the end of 2Q2015 had a gross debt balance including capitalised leases of roughly USD17 billion, and its target is USD15 billion.

The company also “needs to continue to invest in our business,” said United CFO John Rainey in Jul-2015 (Mr Rainey is leaving United in Aug-2015). He explained those investments include improving operations and providing a better level of customer service.

“There may be a time and place for a dividend in our future, but at this point we still believe that returning cash to shareholders...the best way to do that is buying back our own stock,” Mr Rainey stated. United back in 2014 concluded that its stock was trading at a discount to its intrinsic value. “If you believe that the preferred method of deploying capital to shareholders is through a share repurchase programme, you want to do that at a point where you’re trading at a discount to that future earnings potential,” Mr Rainey stated at that time.

See related report: US airlines create a framework for consistent shareholder returns as investors grow more vocal

United’s market capitalisation is the lowest among the four large US airlines, which obviously increases the appetite for share buybacks.

Market capitalisation (USD) of the four largest US airlines as of 19-Aug-2015

American 29.28B
Delta 37.38B
United 22.06B
Southwest 26.60B

Southwest Airlines, one of two investment grade airlines in the US (the other is Alaska Air Group), recently issued its 156th quarterly dividend, of USD.075 per share, an increase from USD.06 per share.

During 1H2015 it returned USD811 million to shareholders through dividends and share repurchases. Southwest recently launched a new USD1.5 billion share repurchase programme.

An opportunity exists for airlines to increase buybacks as stocks trade lower

In late 2013 and into 2014 the three large US global network airlines – American, Delta and United – found themselves in positions to think strategically about shareholder returns. Southwest’s more favourable financial position allowed it to deliver shareholder returns long before its three major rivals.

But the solidification of shareholder returns also stemmed from investors demanding payback after years of watching the major us airlines underperform before Chapter 11 and consolidation set those companies on a path to sustained profits, strong cash flow generation and margin expansion. Now those airlines discuss shareholder returns regularly, and some have outlined clear cut guidelines for how they intend to deliver those returns in the short to medium term.

It is not clear if market jitters about the industry’s weak unit revenue performance have subsided. With airline shares generally trading below their highs and the value disconnect highlighted by some airline management teams with respect to share prices, an opportunity exists for airlines to undertake additional buybacks as they continue to tout consistent delivery of shareholder rewards.

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