Finding Value in 2014: Airlines

Last year was a big year for airlines as shares of the major carriers solidly beat out the returns of the S&P 500. While there's less value available in the industry than last year, some airlines still have upside potential as the industry continues to strengthen.

The merging airline
The biggest airline industry event of 2013 was the merger between US Airways and American Airlines parent company AMR. The new American Airlines Group is now the world's largest airline and will be working on integrating operations over the next few years.

The positives for this merger were laid out before the papers were signed. The new carrier targets $1 billion in synergies, along with being able to attract customers with a stronger network and the increased pricing power resulting from fewer competitors. Even with the required divestments from the Department of Justice settlement, American Airlines Group now has a network ready to fully compete with rival carriers.

Shares of American Airlines Group currently trade at only around seven times forward earnings. Prior to the merger, shares of US Airways traded near the same forward P/E ratio despite the weaker network of US Airways as a stand-alone airline. One potential reason for the low valuation of American Airlines Group shares is selling by former AMR creditors. These creditors are receiving much of their claims in American Airlines Group common stock now and over the next few months. However, these investors are primarily bond investors and not interested in owning common stock of an airline causing selling pressure as these investors sell their shares.

Once former AMR creditors finish selling their shares of American Airlines Group, probably around mid-2014, we should get a better picture as to how the market really values the airline without constant selling pressure. There are integration risks at the airline, but the preparation time for this merger mitigates some of these risks. If you are willing to accept these risks, I see American Airlines Group as one of the best values in the industry.

The unconventional airline
Since completing its 2008 merger with Northwest Airlines, Delta Air Lines has been changing what it means to be an airline. While other airlines have committed massive amounts of capital to new aircraft for several years, Delta is working to balance aircraft costs and fuel consumption by purchasing fewer new aircraft and acquiring used aircraft at bargain basement prices.

The savings at Delta are showing themselves in the form of shareholder returns. Delta has slashed net debt from $17 billion in 2009 to $10 billion today, and is on track to lower that to $7 billion by the end of 2015. Alongside that, Delta announced a share buyback plan and reinstated a small dividend. All this has made Delta the only legacy airline to join the S&P 500, and caused its share price to more than double in 2013, beating returns at US Airways, United Continental Holdings , and Southwest Airlines .

US Airways and United Continental do not pay a dividend, committing those funds to large acquisitions of new aircraft instead. Southwest has been a longtime dividend payer, and increased its dividend from $0.01 per quarter to $0.04 per quarter in 2013, better matching Delta's dividend.

As the economy recovers further in 2014, confidence in the airline industry should grow even more. With all the initiatives implemented at Delta, the airline's comparatively safer position should allow it to trade at a premium to the industry average. This would imply further upside for Delta despite its large gains in 2013.

Airline value

Despite big gains in 2013, I still see value in American Airlines Group and Delta Air Lines as the economy recovers and more investors see the airline industry stabilizing. American Airlines Group provides a unique opportunity to capitalize on creditor selling, and Delta lets investors collect a little income while owning a financially responsible airline.

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Alexander MacLennan owns shares of AMERICAN AIRLINES GROUP INC and Delta Air Lines. Alexander MacLennan has the following options: long January 2015 $22 calls on Delta Air Lines, long January 2015 $25 calls on Delta Air Lines, long January 2015 $30 calls on Delta Air Lines, and long January 2015 $17 calls on AMERICAN AIRLINES GROUP INC. This article is not an endorsement to buy or sell any security and does not constitute professional investment advice. Always do your own due diligence before buying or selling any security. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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