American Air Gets a Downgrade but Wall Street Still Likes Airlines

Note: Third from the last paragraph has been updated to clarify a quote.

NEW YORK (TheStreet) -- Wall Street analysts are generally high on the airline industry -- some believe that investors fail to perceive the massive structural change that has occurred. Nevertheless, Goldman Sachs on Wednesday downgraded shares in American (AAL) , saying it sees more value elsewhere.

The downgrade to neutral from buy came even though Goldman has a six-month target price of $44, reduced from $48. In mid-morning trading Wednesday, American shares were down 74 cents to $38.44, apparently reflecting the impact of the downgrade, as shares in most every other airline were up.

Delta (DAL) was up 49 cents to $44.53. Southwest  (LUV) was up 31 cents to $37.99. United  (UAL) was up 69 cents to $53.15. Goldman rates all three a buy.

"American stock is trading at undemanding valuations of just six times 2016 P/E," wrote Goldman analyst Tim Kim in a report. "We think the stock will gradually rerate and trade higher over the long term."

However, Kim said, "We are mindful of three key risks" -- relatively high exposure to Latin American, where key economies are ailing; competitive capacity pressure, particularly in Dallas; and "major integration initiatives, including its reservations system" following the 2013 merger with US Airways.

American CEO Doug Parker canceled a scheduled appearance at the Airlines for America airline summit on Monday in order to preside over a weekly staff meeting where reservations integration was discussed.

Kim thinks merger integration is an important consideration for investors. "Among the legacies, Delta is furthest along in its post-merger integration and we think that this reflects well in its operational and financial performances," he wrote.

Additionally, "we think management deserves credit for setting ambitious financial and operational targets and holding itself accountable to them," he wrote.  Goldman has a price target of $60 on Delta. 

Southwest, meanwhile, "is trading at compelling valuations at just 9.9X our 2016 P/E, despite its potential to generate 11% EPS growth in 2016," Kim wrote. Some investors worry about Southwest's capacity growth, but Love Field growth represents a one-time event, he said. The price target is $53.

United, meanwhile, has room to catch up. "On our 2015 estimates, UAL is set to produce an operating margin of 13.3%, as compared to DAL and AAL of 16.8% on average," Kim said. However, "UAL has shown tremendous progress operationally, and we think that the market has yet to fully recognize it," he said. Shares trade at 6.6 times Goldman's estimated 2016 P/E ratio. Kim has an $83 price target.

Market experts who spoke at the A4A summit were also enthusiastic about industry prospects.

T. Rowe Price analyst Andrew Davis said current airline valuations are so low it is "laughable." He said that over the next three to five years, some airlines will generate free cash flow that is equivalent to half of their current market capitalization. He applauded the current proliferation of share buybacks, saying "you could double earnings per share if earnings are flat."

Wolfe Research analyst Hunter Keay said that over the next three to five years "there are a lot of nice things to come," but that investors are cautious because "they view it as unsustainable.

 "Airlines have to show that what they do is sustainable," Keay said.

 

 

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.

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