Plane Change: Imperial Turns Bullish On American Airlines, Neutral On Southwest

Imperial Capital changed course on airline stocks Friday by turning bullish on American Airlines Group Inc AAL and downgrading Southwest Airlines Co LUV.

The Analyst

Imperial Capital's Michael Derchin upgraded American Airlines Group from In-Line to Outperform with a price target lifted from $49 to $56. Derchin downgraded Southwest Airlines from Outperform to In-Line with a price target lowered from $68 to $54.

Bullish On American Airlines

The bullish case for American Airlines' stock is based on expectations for the airliner to reduce capacity after the Labor Day period — a decision that should be "well received" by investors, Derchin said in the upgrade note.

The rationale behind such a move is threefold, the analyst said:

• Higher fuel prices are pressuring margins, as the company is 100-percent unhedged against oil prices.
• Weaker demand during the off-peak period could improve its pricing power.
• Management bonuses are directly tied to the company achieving at least $3 billion in pre-tax income.

While it is difficult to value airline stocks given the inherent volatility in earnings and cash flows, non-traditional metrics like TEV/EBITDAR are more meaningful, the analyst said. Network airlines are typically valued at 4x to 7x during peak earnings periods, and American Airlines is likely in the "seventh inning" of the current cycle, he said. This implies room for further upside, Derchin said, as the $56 price target implies an 8.25x 2019E TEV/EBITDAR multiple.

No Longer Bullish On Southwest

Southwest is likely to face unit revenue pressures through fiscal 2019 and is poised to end flat in fiscal 2018, Derchin said in the downgrade note. The rationale behind this assumption is based on the following, the analyst said:

• Expectations for mid-single digit capacity growth after Labor Day with the arrival of the 737-MAX, which will result in pricing pressure due to an "imbalance" in supply and demand.
• Heightened competition in California.
• Potential weakness in Denver.
• The expansion to Hawaii in fiscal 2019 will likely prove to be dilutive to unit revenues for a few years.
• A lack of global distribution system presence, which implies minimal exposure to the higher-yielding corporate market.

Southwest's stock still deserves to trade a premium to the group despite a "narrowed" cost advantage and fewer revenue opportunities due to not being a part of a GDS, the analyst said.

A TEV/EBITDA multiple of 7x is realistic and implies a price target of $54, according to Imperial. 

Price Action

Shares of American Airlines were up 1.1 percent premarket Friday, while Southwest Airlines shares were up 0.2 percent. 

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