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What's 'Next' For United Airlines Stock Heading Into 2022

Date: December 26, 2021

By The Stock Dudar, Seeking Alpha

Enterprise Value 2019 Vs 2021

It's tempting to look at United Airlines' (NASDAQ:UAL) share price over $90 towards the end of 2019, compare it with today's price in the low $40's, and conclude that UAL is over 50% cheaper than it was in 2019. Given the increase in outstanding shares, debt issuance, and larger cash balance, it's worth a balance sheet comparison to determine UAL's enterprise value today compared to the end of 2019.

Dec 23,2021Dec 31, 2019
Shares Outstanding323,806,610251,216,381
Stock Price$45/share$88/share
Market Cap$14.6 Billion$22.1 Billion

Accounting for assets can be nuanced. Fortunately, assets that I wouldn't want to include in an enterprise value calculation like operating property and equipment only differ by about 6%. For that reason, the table below will only reflect cash and cash-like assets

3Q20214Q2019
Cash and cash equivalents$19.4B$2.8B
Short-term investments$0.2B$2.2B
Total Liquid Assets$19.6B$5.0B
3Q20214Q2019
Current maturities of long-term debt$2.3B$1.4B
Long-term debt$31.5B$13.1B
Total Debt$33.8B$14.5B

Putting it all together, we can conclude that investors are only valuing UAL at ~$3 billion less today than they did at the end of 2019. That translates into a 9% lower valuation, which is counterintuitive given the stock is about 50% lower.

Dec 23,2021 (with 3Q21 assets and debt)Dec 31, 2019
Market Cap$14.6B$22.B
Total Liquid Assets-$19.6B-$5.0B
Total Debt$33.8B$14.5B
Enterprise Value$28.8B$31.6B

While enterprise value alone doesn't make UAL a bargain compared to 2019, the balance sheet make up takes a significant amount of risk off the table for investors. Airlines are risky, cyclical businesses where a downturn can result in bankruptcy if the company doesn't have enough liquidity. It's the situation many airlines found themselves in 2020, because balance sheets boasting $5 billion in cash, as UALs did in 2019 might not have been enough to survive the Covid downturn without government assistance. With almost $20 billion in liquid assets to end 3Q21, UAL should easily survive shorter lived downturns, even if it comes at the cost of debt. On the 3Q21 conference call, UAL's CFO commented that:

Longer term, we are laser-focused on reducing net debt balance and deleveraging. We could've done some more if we had more pre-payable debt, we simply don't.

UAL did make a voluntary $375 million pension contribution which they view as their most expensive pre-payable debt. Not all of UAL's debt is high interest; for example, $2 billion due in 2029 pays 4.6%, which seems like a fair rate in exchange for additional liquidity. It's worth mentioning that even if UAL's debt was pre-payable, they would likely have to make tender offers above par value to repurchase debt as we saw with companies like Ford recently. In a flat interest rate environment, the premium over par will naturally decrease over time, while rising interest rates could reduce that premium even faster. If inflation continues on a course anywhere near its current trajectory, the Fed may have to raise interest rates, which would help anyone looking to purchase debt, including UAL.

United isn't trading at the 2019 discount that the share price suggests, but other than serving as an interesting comparison point, a 2019 market valuation doesn't have a lot to do with UAL's fair value. To determine that, we need to look at the company's future earning potential which will be greatly influenced by UAL's "United Next" initiative.

What Is "United Next"?

United Next is UAL's operational restructuring that will take place from now through at least 2026. My interpretation is that United Next is primarily a cost reduction and efficiency plan achieved by:

  1. Retirement and replacement of 200+ 50-seat regional plans with nicer, higher seat capacity aircraft like the 737 MAX 10 and A321neo.
  2. Focus on premium seats, First-class and Economy Plus, over non-premium.
  3. $2 billion in non-aircraft related annual cost reductions

Aircraft Replacement Plan

When it comes to per plane seat capacity, UAL's presentation made two things clear:

  1. Smaller, regional jets are generally less economical
  2. United has a lot of small planes

Source: UAL Investor Presentation, Slide 12

The good news is that there's plenty of room for improvement; the bad news is the CapEx required. Perhaps the worst news is that by the time UAL completes these CapEx intensive aircraft purchases in 2026, the percentage of large narrowbody planes in their fleet will only be a few points ahead of where their peers were in 2019:

Source: UAL Investor Presentation, Slide 14

On slide 35 of the presentation, UAL said they could retire up to 275 aircraft from 2023-2026, but they have orders for 492 planes, some of them significantly larger, over the same timeframe. UAL guided to 4-6% Capacity CAGR through 2026 over 2019 which at the midpoint of 5% translates to >40% more capacity than the company had in 2019. Although, 2% of that growth comes from new routes and more active aircraft, so only ~3% comes of a larger fleet, which means UAL will have ~23% more seats compared to 2019.

I think the impetus behind the strategy was that UAL realized the company was outperforming peers internationally and lagging domestically. Because United is adding so many planes so rapidly, there's a good chance that UAL will have a considerably nicer domestic fleet in 2026 than their peers, which should aid the company in another leg of the strategy, a focus on premium seats.

Premium Seat Emphasis

This is one portion of United's strategy that aligns with the broader industry. While customers are ultra price conscious when it comes to base fares, they are willing to pay for more comfortable seats and additional leg room, in other words, an upsell. For that reason, UAL's new narrowbody aircraft which will replace many regional jets, will all make room for premium seat growth. The company already benefits from this advantage in international markets, contributing to historically higher margins than competitors, and they hope to replicate that success domestically.

Source: UAL Investor Presentation, Slide 18

The CRJ-550 is a strategic choice for a 50-seat aircraft that specifically adds capacity for premium seats without necessarily increasing overall fleet capacity. UAL's large fleet upgrade through 2026 should provide the airline more incremental improvement and flexibility to focus on premium seating compared to peers.

Structural Cost Reductions

UAL has a financial goal of implementing $2+ billion of annual cost savings unrelated to aircraft upgrades with:

  • $1.3 billion in workplace efficiencies
  • $0.7 billion in non-labor improvements

The workplace efficiency improvements are promising because they don't focus on pilots or flight crew. Instead, as we're seeing across many industries, traditional management structures are being replaced by machines and automation. On the 3Q21 conference call, management stated:

We estimate that we can fly at schedule 10% larger than 2019 with the same number of employees we needed in 2019. This includes a significant and permanent reduction in management employees.

Some of this will be offset by higher wages needed to retain or hire pilots, flight attendants, and other crew who are crucial for safety, with minimum staff laid out in FAA regulations based on number of passengers.

Finally there are non-labor, non-aircraft upgrade related cost savings that come from higher equipment utilization and lower fixed real estate costs. While $2+ billion of structural cost reductions sounds great, UAL states on slide 33 that the cost savings are only enough to offset inflation through 2023. The company expects the larger, more efficient aircraft discussed earlier to more than offset inflation after 2023 resulting in ~8% lower CASM-ex in 2026 vs. 2019.

Risks To United Next

After reading through the United Next plan, the risks that stand out to me are:

  • Weaker balance sheet as a result of aircraft purchases than peers
  • Potentially optimistic fuel price estimates
  • Implementation mistakes while adjusting fleet size

UAL Balance Sheet

With net debt exceeding the stock's market cap and many unknowns coming out of the pandemic, it is a bold move to spend so aggressively on new aircraft. I don't disagree with management's decision because UAL's inaction would likely lead to lost market share domestically. The current fleet also hinders the company's ability to capitalize on high margin premium seating. The balance sheet showed almost $20 billion in cash-like assets at the end of 3Q21, and with few options to pay down debt early, the cash isn't earning much for the company. That said, airlines are notoriously cyclical, and with net debt set to grow to $25 billion by the end of 2023 before hopefully coming down, risk-averse investors may want to opt for another airline (or no airline at all) with more conservative cash management plans.

Fuel Price Estimates

It's important to remember that CASM-ex, excludes a handful of expenses listed on slide 44 of the United Next presentation, fuel being the largest, roughly 30% of total CASM-ex. UAL includes a $2.20/gallon fuel price estimate for 2026, compared with $2.09/gallon in 2019. Low fuel prices that stemmed from oversupply in 2014 drove hundreds of exploration and drilling companies into bankruptcy and the oil majors are keeping tight purse strings on their CapEx budgets. Given generally high inflation, it's possible that UAL's $2.20 estimate won't even be close.

Implementation Risks

Transitioning to a larger fleet can be much more efficient, but only if the airline can fill those additional seats. Filling those seats may require new/altered/canceled routes, timing shifts, new pilot training, and a host of other business operation adjustments. UAL has the benefit of lessons learned from watching competitors make similar transitions, which should mitigate this risk.

UAL Valuation Estimate

One of the simplest methods to value UAL is to use management's 2026 EPS guidance then make adjustments and factor in a margin of safety to determine a fair value for the stock. From the 3Q21 conference call, the company provided an estimate: "adjusted EPS of around 20 at our current share count." If I believe management's estimate and am comfortable with a 12 EV-to-Earnings multiple:

Adjusted EPS$20/share
Share Count323,806,610 share
Annual Adjusted Earnings$6,476 million
EV-to-Earnings Ratio12
Estimated 2026 EV$77,712 million

If, and it's a big if, we think UAL is capable of hitting the adjusted EPS target, a current EV around $28.8 billion implies quite a bit of upside to 2026. 2019 EPS was ~$12, but adjusted for the most recent share count is more like $9.31, implying that UAL expects to double EPS over 2019 by 2026. Fortunately for investors, even if we assume $10/share and a EV-to-Earnings Ratio of 10, there's still some upside in the stock, and there are some tailwinds that could push UAL's EPS higher beyond the United Next plan components discussed earlier.

International Travel

Management gave bullish signals during the 3Q21 earnings call by saying:

Our bookings across the Atlantic are now approaching past 2019 levels. We expect a very strong bounce back next year in particular, starting this spring and summer.

I've written about the reasons United generally lags peers domestically, but their fleet is at the head of the pack internationally. That meant Covid hit the company hard on the way down, but should provide a tailwind on the way up in the wake of heightened demand and new routes.

UAL announced what it called its "Largest Transatlantic Expansion in its History" for summer 2022. The expansion adds new routes, more flights along existing routes, and a return of routes previously interrupted by Covid. Obviously, there's a risk of new Covid variants, but that's mitigated by two factors:

  1. The speed that pharma companies are turning around variant specific vaccines.
  2. Society's broader acceptance of life co-existing with Covid uncertainty.

UAL is still factoring in a slow return in trans-Pacific travel and business travel, and the company is incorporating that uncertainty into their guidance. International travel has better margins, partially driven by significantly lower fuel cost per ASM, and I think UAL's aggressive plans will set the company apart.

General Inflation

Inflation is high, and while that's obviously not good for UAL's expenses, uniform inflation would bring offsetting benefits on the revenue side. All things being equal, EPS should increase at the same rate of inflation. That's neither good nor bad for investors, but it does make EPS targets easier to hit.

One place inflation helps is net debt, so as long as inflation is uniform and doesn't wreak havoc on the global economy, it's a positive for indebted companies like UAL.

Potential SAF Credits

Credits for sustainable aviation fuels would offset some of United's fueling expenses, especially if oil prices rise. The proposed Build Back Better Act would have created a significant new SAF tax credit. The bill seems dead for now, but the fact that SAFs were mentioned suggests that various lobbies are pushing for a tax credit. Earlier this month UAL, became the first airline to fly a full passenger aircraft on 100% SAF, rather than a more typical blend.

UAL then took an equity stake in ZeroAvia which could give United the ability to fly 100% hydrogen engines on select aircraft by 2028. Although this decision conjures images of the Hindenburg in every aerospace engineer like myself, it could be an important inflection point for the aircraft industry.

Final Thoughts

Conservative valuation ratios and EPS relative to UAL management targets still suggest there is upside. On top of that, if UAL can achieve $20/share EPS in 2026, there should be significant upside in the stock.

United's business operations would benefit from a continued Covid recovery, but there are risks discussed above, and UAL is not the only way to invest in a global economic recovery. A travel ETF like JETS can spread out the risk, and even broader diversification is worth considering because UAL's operational plan is ambitious and not guaranteed to pay off. When considering enterprise value, UAL isn't as far below 2019 market value as the stock price suggests. However, for a risk tolerant investor that believes the company can at least get close to management's targets, there could still be 100% upside over the next five years.

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