Delta Insider Bostock Is Buying

 | Aug 26, 2013 | 6:30 PM EDT
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Major airlines have been strong performers over the last year or so, as bulls have been reviewing not only fairly good results but also the potential advantages of industry consolidation as US Airways (LCC) merges with American Airlines. Between early August 2012 and the end of July 2013, Delta (DAL) was up more than 120%, US Airways rose 69%, and United Continental (UAL) increased a little more than 80%. However -- perhaps perked up by the public suggestion that this consolidation would result in higher prices -- federal regulators sued in an attempt to prevent the merger earlier this month, sending airline stocks down on the day.

Delta is still down since the beginning of the month, but we recently recorded a member of the company's board of directors, Roy Bostock, directly purchasing 10,000 shares of the stock at prices just below $20 per share. Studies generally show a small outperformance effect for stocks bought by insiders, which increases somewhat when multiple insiders have been buying; in fact, another Delta insider had bought shares in late July.

While the news of a lawsuit to block the American-US Airways merger was something of a surprise, there are a few reasons why it may prove little more than a speed bump to the deal. First of all, adjusted for inflation average airfares are down considerably over the last few decades -- and consider what's happened to fuel prices, a major cost for airlines, over the same period. In addition, the federal complaint attempts to exclude Southwest (LUV) and JetBlue (JBLU) as competitors as part of its argument that the deal will leave the U.S. with only three major domestic airlines. Lawyers for US Airways have attacked the government on this point and we're skeptical ourselves. In addition, airline investors have an unusual ally in this fight: big labor, which believes that a merger is the best course of action for the unionized workforce of the troubled American. This is not necessarily a big factor, but any political influence on the court battle should be positive rather than negative as is sometimes the case in mergers.

Markets are generally pricing legacy carriers fairly cheaply in terms of forward earnings estimates; Delta, our example here, trades at 7 times consensus earnings for 2014 -- and, in fact, at only 9 times its trailing earnings. Operating revenue has shown little change so far this year compared to the same period in 2012, but lower fuel costs have led a rise in operating income, helping make Delta profitable in the first half of 2013. We can't be sure that this trend in fuel costs will continue, but as things stand the market appears to be pricing in flat to negative profits growth over the next several years rather than any improvements in industry conditions from a completed merger. The stock is also fairly low priced in cash flow terms, with a trailing EV/EBITDA multiple of 5.5 times.

We've noticed that US Airways has regularly been one of the most popular small cap stocks among hedge funds (on average, this tends to be a bullish sign for a stock.) That company has more upside potential than its peers as a result of the deal, as it will increase market share on some critical routes, but also has to deal with integration risks. As a result, we'd take this interest as at least somewhat bullish on legacy carriers in general.

For purposes of comparison, both US Airways and United Continental are valued similarly to Delta in forward earnings terms, with price-to-earnings in the 5 to 6 range on that basis. The discount airlines, Southwest and JetBlue, are seen as more stable by investors and as a result they trade at a premium to the legacy carriers at 10 times to 11 times forward earnings estimates. This is still fairly cheap in absolute terms, though analyst forecasts there depend on significant increases in earnings per share (as they are likely seen to benefit from the US Airways-American merger as well.)

There are risks in investing in the legacy airlines, but we think the industry is worth consideration from value investors. Current prices seem to include little benefit from the merger, regulators' case against it has some big holes, and companies such as Delta could certainly stand to benefit from any sort of increase in pricing power and operating efficiency.



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