Airlines have long been considered higher risk investments. With a history of bankruptcies resulting from economic downturns and the volatile cost of fuel being a core component of their business, airline investors have been burned many times before. However, the industry is cutting capacity and reducing competition, thereby allowing airlines to raise fares and other fees. Because of this, analysts are expecting strong earnings increases over the next few years, setting up a series of option plays for investors willing to take on more risk than owning the shares themselves would entail.
Since the earnings increase is expected to occur over the next few years, the options we will take a look at here are the LEAPS (Long-term Equity AnticiPation Securities) that expire on Jan. 17, 2015.
Three big airlines, two option plays
The U.S. airline industry has been undergoing a round of consolidation that is expected to result in three main carriers, Delta Air Lines, Inc. (NYSE:DAL), United Continental Holdings Inc (NYSE:UAL), and US Airways Group Inc (NYSE:LCC) which will take the name American Airlines assuming the merger with American is approved. Delta Air Lines, Inc. (NYSE:DAL) is in the last stages of integration and United Continental Holdings Inc (NYSE:UAL) is still working through the late to middle stages. With integration costs winding down for both these carriers, earnings estimates for the future can be trusted to a greater degree. But, US Airways Group Inc (NYSE:LCC) will inevitably incur merger related expenses, many of which will throw analyst estimates off one way or another due to the unpredictability of these costs. Since these option plays call for more predictable earnings in choosing the appropriate LEAPS, we will focus on Delta Air Lines, Inc. (NYSE:DAL) and United Continental Holdings Inc (NYSE:UAL) options rather than on the less certain US Airways Group Inc (NYSE:LCC) ones.
Analyst estimates
The following data was obtained from Yahoo! Finance and represents the average of 14 to 16 analyst estimates for 2013 and 2014 earnings. Investors who do not believe these earnings are achievable would need to adjust their views on the option plays accordingly.
| Airline | EPS 2012 | est. EPS 2013 | est. EPS 2014 |
| Delta Air Lines | $1.19 | $2.64 | $3.01 |
| United Continental | ($2.18)* | $3.68 | $4.89 |
*United Continental Holdings Inc (NYSE:UAL) incurred numerous one-time merger expenses for 2012.
2014 price targets
Using the above earnings, we can form a general price target based on a P/E ratio. For this analysis, we will use a P/E ratio of 10 as it represents a modest discount to the P/E ratios of Southwest Airlines and WestJet, two airlines typically seen as safer investments than their legacy counterparts.
Using this P/E ratio, we get a $30.10 per share target for Delta Air Lines, Inc. (NYSE:DAL) and a $48.90 per share target for United Continental Holdings Inc (NYSE:UAL). Any person with basic knowledge of statistics will note that these price targets have way too many significant figures attached and when the variability in airline earnings is factored in, investors should certainly not take these figures for granted.
However, we can use these price targets as a general estimate. Keeping this in mind, investors looking for a little less speculation could go with in the money calls at $17 for Delta Air Lines, Inc. (NYSE:DAL) and $30 for United Continental Holdings Inc (NYSE:UAL). These calls tend to trade in the $4 to $5 range and $7 to $8 range, respectively. Of course, investors that are more risk tolerant and more bullish may choose out of the money calls to try to gain more leverage over the stock. Again, this would carry additional risk but increases potential returns in the process.
Risk vs. reward
When choosing how to invest, investors need to examine what their risk tolerance is and what return they expect to receive. Obviously, airline options are not for everybody, airline stock itself is not even suitable for conservative investment portfolios. But for risk tolerant investors confident in a resurgent airline industry, LEAPS may be a good way to increase exposure and get higher returns over the next few years. As a result, I currently hold Delta Air Lines, Inc. (NYSE:DAL) shares and am considering adding Delta $17 LEAPS to the more speculative side of my portfolio in the coming weeks.
Alexander MacLennan owns shares of Delta Air Lines. The Motley Fool has no position in any of the stocks mentioned. Alexander is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
The article Time to Gain Leverage on Airline Shares? originally appeared on Fool.com is written by Alexander MacLennan.
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