Scenario Analysis: How Will United’s Price Move Under Different Scenarios

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United Airlines Holdings

The US airline industry has been one of the top gainers from the downward rally of crude oil prices that started in the latter half of 2014. Since jet fuel costs constitute nearly a third of an airline’s total operating expense, the 50% drop in oil prices over the last six months has accelerated the bottom line of all major US airlines. Among the top three US airlines, United (NYSE: UAL) was the only airline to record an increase of over 2% in its EBITDA margin in 2014 due to the oil price collapse. As a result, the stock price of the Chicago-based airline soared by over 44% in the last ten months. Our current price estimate for United stands at $69 per share, assuming a gradual recovery of oil prices over the next two to three years. However, in this article, we will discuss three scenarios that could have a significant impact on United’s current valuation.

See our complete analysis for United here

Gradual Oil Price Recovery

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Since July of last year, crude oil prices have plunged from over $110 per barrel to an all-time low of $45 per barrel in January this year, on the back of weak global demand for oil, led by the slow growth in the Chinese economy, and surplus oil production due to the rising tight oil production in the US. In addition, the Organization of Petroleum Exporting Countries’ (OPEC’s) decision to maintain its current production rates further aggravated the demand-supply mismatch. While the decline has weighed heavily on the oil producing companies in the US, it has been profitable for most of the US airlines, particularly United. In 2014, United’s net profit almost doubled to $1.1 billion due to a decline of more than $670 million in its fuel costs.

However, over the last two months, the crude oil prices have revived to $55 per barrel, showing signs of recovery due to the large cutbacks on production by all major oil companies. We currently expect oil prices (Brent) to average around $75 per barrel in this year and gradually increase to $85 per barrel over the next two years. Consequently, in our base case scenario, we forecast United’s fuel costs (when expressed as a percentage of passenger revenue) for US operations to remain under 35% over our forecast period as against its historic average of 38%. During the same period, the international fuel costs are estimated to fall more drastically to approximately 31% versus its 5-year average of over 36%. Given the restructuring and cost cutting initiatives undertaken by United, we expect the airline to remain profitable even if the crude prices rise to $70-80 per barrel in the current year. (Will Airlines Begin To Post Losses If Oil Prices Rise In Coming Months?)

See our Base Case Scenario for United here

V-shaped Oil Price Recovery

If we look at a more optimistic oil scenario, where we presume that the demand for crude oil will improve significantly, due to increased economic activity in China and concurrently, the tight oil production in the US will decline, there could be a possibility of a sharper, V-shaped recovery in crude oil prices. Moreover, if the OPEC decides to change its current stance and cut its production, we estimate the crude oil prices to reach an all-time high of over $120 per barrel by the end of our forecast period. In that case, we estimate United’s fuel costs for US operations to rise sharply to 36% trending towards its historical average and its international fuel costs to increase to 32% by the end of our forecast period. As a result, the EBITDA margins of the airline will decline over the next two to three years before reversing to its 2014 levels by the end of our forecast. The price estimate for United in this case would fall to $61 per share, a 12% downside to its stock price in our base case scenario.

See our analysis for V-shaped Oil Price Recovery for United here

Sustained Decline in Oil Prices

Contrary to our V-shaped recovery scenario, the oil price recovery may take longer than expected, if the demand for oil does not improve either because of continued slowdown in the Chinese economy or due to the use of alternative fuels owing to technological advancements. Additionally, if the OPEC continues to operate at its current production levels or alternatively if it plans to increase its production rates to eliminate competition and increasing its market share, the global oil market will experience depressed oil prices for a prolonged period. If this scenario becomes a reality, we expect United’s US fuel costs to fall to 33% and international fuel costs to drop to 30% by the end of our forecast period. Consequently, the airline’s EBITDA margins will escalate to almost 20%, growing at a CAGR of  close to 2% over our forecast period. Thus, we arrive at a price of $75 per share for United’s stock, an upside of 10% to our current price estimate for the airline.

See our analysis for Sustained Decline in Oil Prices for United here

Seat-Surplus due to Excessive Capacity Additions

Now, we look at flying capacity, a key determinant of air fares which in turn drives the profitability of an airline. Large network carriers, including United, have restricted capacity additions over the last few years to match the decline in air travel demand post the financial crisis in 2008-2009. This capacity discipline has enabled these airlines to raise the average ticket fares, which has lifted the industry out of its huge losses (Restrained Capacity Addition Is Key To Sustaining Airline Industry Profits). United, American, and Delta which together control more than half of the total domestic capacity, have indicated their intent to add capacity with restraint over the coming years. However, the recent dip in oil prices that enhanced the earnings of these airlines, may force them to indulge in capacity and price wars to increase their market share.

Thus, we assume a scenario where these carriers resume capacity expansions at a much faster pace. This will probe the low cost carriers (LCCs) such as Southwest, Alaska, and JetBlue and ultra low cost carriers (ULCCs) such as Spirit, Allegiant, and Frontier to aggressively add capacity to improve their domestic market share. Hence, there will be an oversupply of seats in the market which will undermine the ability of these large airlines to charge profitable fares. In such a scenario, we expect United’s domestic business to experience some weakness as its passenger yields will drop sharply to 0.138, while its occupancy rates will decline to less than 84% over our forecast period. Accordingly, we forecast relatively flat EBITDA margins for the airline, converging into a stock price of $63 per share, a downside of almost 10% to our current price estimate for the airline.

See our analysis on Seat Surplus Scenario for United here


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