Learning to Fly with Airline Stocks

Each business sector operates under its own unique model. The structure of the airline industry is much different from that of the technology or healthcare industries. Screening an entire sector will allow us to see the commonalities and differences that can portend to valuation conclusions on select entities within the group.

The airline industry's growth outlook is very much dependent on the overall economic environment. Consumers' desire to vacation and the level of business travel are the main revenue drivers here. The largest cost for these companies is fuel and that can fluctuate greatly. Using the instruments available to us here at Zacks, let's prepare our evaluation.

Screening for Airline Stocks

In order to determine which stocks are ready for takeoff, I will begin with the Zacks Custom Screener, (our new Beta version) and prepare a checklist.

• First I located the specific industry: Transportation - Airlines. This is found under the Category of "Company Descriptors" and then just scrolling through the "Industry" item.

• Second, I will filter for companies with a Market Cap (in millions) of greater than $200 million. Market Cap is found under "Popular Items" and will now bring up the largest and most established companies.

• Finally, I want to see both the Zacks Rank and the Price to Sales ratio in my report. The Zacks Rank will tell me how the companies' recent earnings revisions are trending and where it falls in the context of the market as a whole.

The Price to Sales ratio is simply Price (Market Cap) divided by Sales (TTM). This is used to determine value by looking at how much it "costs" to buy $1 of the company's sales for comparison purposes. By selecting "Edit View" rather than "Edit Criteria" and then checking these two data points, I will be able to view them in my display panel rather than screening for some particular number.

You can add the Zacks Rank to your report display as well by selecting the Category "Zacks Rank and Recommendation" and then checking item "Current Zacks Rank". Price/Sales can be found under Category "Valuations" and then item "Price/Sales".

Now that my screen is set, I click on "Run Screen" and the Industry is highlighted. (See the screenshot below.)

Reviewing the data that has been screened shows 17 matches and extremely low Price to Sales ratios. It could be deduced that some of these stocks will need to go up 6 to 10 fold before they trade at a Price to Sales ratio of 1.0, a reasonable valuation in most industries. However, the airline industry's structure incorporates a large amount of debt that will have to be factored in.

For those using the Research Wizard stock screening and backtesting software, you can expand the list of criteria to include Enterprise Value. Enterprise Value is the sum of the company's market cap (equity) and any preferred equity with its long term debt (leases, mortgages, etc.) and then subtracts any cash or cash equivalents. Essentially, the enterprise value is what it would cost to buy the company today and pay off its obligations while pocketing the cash on hand.

Continuing with our search, let's add in some additional criteria to our report to dig deeper into this industry and to focus only on domestic carries.

• To locate Enterprise Value, go to the Category "Size and Share Volume" and there you'll find the item "Enterprise Value" to add to your report.

• Next, I created a calculation in my screen of "Enterprise Value divided by Sales(TTM)". This provides easier comparisons and valuations of this sector. Enterprise Value to Sales can be a more effective valuation metric for the airline industry than the Price to Sales ratio because P/S does not take into account debt that needs to be repaid.

An EV/S of 1.0 would reflect a value of the company that is equal to it's annual sales. An EV/S of .50 means you are paying 50 cents for every dollar in sales and would suggest deep value.

The Enterprise Value to Sales ratio is extremely useful when studying industries with high debt loads like the airlines.

For those using the Research Wizard, this calculation is: ( i661 / i155 ) and label it as "Enterprise Value / Sales".

Below is a screenshot of those results by order of market capitalization. This is a great snapshot of the largest airlines in the U.S.

You'll also notice I added in some additional criteria to view in my report so that we can see the companies' total long term debt, cash holdings, and average broker ratings.

The three companies highlighted look set to rise in the long term and the additional value metrics allow us to be more confident on our path to profits.

Conclusion

Airline stocks present a challenge in determining value. However, as I have shown, there are a number of ways to discover each company's worth. Understand that the price of oil holds as much weight as the state of the general economy in the future prospects for airlines. Any significant drop or rise in the price of oil will affect each company's operational cash flow. This, in turn, makes servicing their debt a quicker or slower realization and will be reflected in their market, and enterprise values.

Resources

Industry analysis is a great way to compare companies in a similar environment. By utilizing all of the tools available to us, we can make better informed decisions about stocks and all of our investments. Zacks Investment Research has just the tools to help you with this task.

Zacks Custom Screener

Zacks Research Wizard

David Bright is a member of the Zacks Research Wizard Group and contributes Investment Ideas utilizing tools available at Zacks.