American and United Could Be Worth a Lot More.
Private-equity participation in the airline business is not typical, but on Monday, the low-cost Canadian carrier WestJet Airlines said it it was being acquired by Onex , a Canadian private-equity company led by the veteran investor Gerry Schwartz.
U.S. airlines reacted to the news, rising about 3.5% on average that day, far better than the 2.3% drop in the Dow Jones Industrial Average. Still, it wasn’t much of a move, especially if private-equity involvement in the airline business becomes a trend.
Onex (ticker: CA:ONEX) is paying $31 a share, a 67% premium to WestJet’s closing stock price on Friday. The deal values WestJet (CA:WJA) at more than its annual sales and almost 25 times estimated 2019 earnings.
If American Airlines (AAL) or United Continental (UAL) were valued at similar multiples of sales, those stocks could rise by about 90%. Delta Air Lines (LUV) shares could rise 20%. Southwest Airlines (LUV) is the one airline in the U.S. that trades at more than 100% of sales.
Market value versus sales is an abstraction. What matters, of course, is how much of a company’s revenue turns into earnings. Southwest is valued higher relative to its sales because it is the most profitable airline in the U.S. or Canada.
Based on WestJet’s price/earnings ratio, however, all four of the largest U.S. airlines could see gains of 100% to 200%. That sounds unbelievable, but don’t forget that Delta, American, Southwest, and United trade for less than 9 times estimated 2019 earnings on average.
It may be unlikely that the largest airlines could be private-equity targets. Still, the implied gains for smaller U.S. air carriers make those stocks look attractive. If someone paid 25 times earnings for Alaska Air (ALK), the stock would trade as high as $142, up 132% from recent levels. Shares in Hawaiian (HA) and Spirit Airlines (SAVE) would rise 275% and 190%, respectively.
This still seems unbelievable. WestJet’s profit margins are depressed, dragging down its earnings and making the deal look more expensive. The Canadian airline once earned 12% operating margins, like Delta does, but analysts predict margins will be just 3% in 2019. That is worse than at any U.S. carrier.
The purchase price looks lower it you assume WestJet’s margins—and earnings—return to historical levels. The price Onex has agreed to would amount to a more reasonable 14 or 15 times estimated “normalized” earnings. Still, valuing the entire U.S. airline sector on that basis would mean those stocks could gain 60% from recent levels.
Those are three ways to think about the Onex-WestJet deal in the context of the U.S. airline industry: comparing price to sales, price to earnings, and normalized price to earnings. Although the last way looks most sensible, any of the three imply that U.S. airline stocks should rise.
But investors haven’t been willing to value companies in the sector more highly, even though consolidation among airlines has resulted in higher profit margins.
Now, at least one investor—Gerry Schwartz, who founded Onex and has led it for thirty years—has made it clear he thinks the industry’s profitability will be permanently higher.
This isn’t his first foray into airlines. He tried to merge an earlier version of Air Canada with Canadian Airlines in 1999, though he wasn’t part of the eventual deal. The combined airline filed for bankruptcy protection in 2003, restructured, and trades today as Air Canada (AC.Canada).
Will airline stocks rocket higher? Who knows. But don’t forget that Warren Buffett’s Berkshire Hathaway (BRK.A) is the largest holder of Delta Air Lines stock and a very large holder of shares in Southwest, United and American as well.