Investor Essentials Daily

Flying could be the worst part of your vacation and your portfolio

July 29, 2022

This summer was supposed to be the summer of returning to travel. Instead, travel has been plagued with the worst parts of the experience, like delays, cancellations, and other unpleasant issues.

Airlines are in a mess, struggling with staffing issues, deep cuts in the pandemic that disrupted the recovery, and surging demand that’s higher than it was pre-pandemic for many routes.

Let’s look at the biggest airline ETF, U.S. Global Jets ETF (JETS), using Uniform Accounting, to find out how the airline industry has been performing.

In addition to examining the portfolio, we’re including a deeper look into one of the fund’s largest current holdings, providing you with the current Uniform Accounting Performance and Valuation Tearsheet for that company.

Investor Essentials Daily:
Friday Uniform Portfolio Analytics
Powered by Valens Research

As travel ground to a standstill, airlines underinvested through 2020 and 2021 when the pandemic brought international travel to a crawl.

After two years of the pandemic, related concerns and restrictions have been relieved. Finally, the opportunity for travelers to make up for lost time after the last two summers arrived.

However, many travelers’ flights were totally disappointing due to delays and cancellations.

Cancellations are up almost 50% compared to 2019, as cost-cutting and underinvestment have finally caught the airlines.

One of the biggest drivers of these cancellations is that airlines are understaffed.

The number of available pilots was shrinking, and airlines saw it coming in 2018 and 2019. Yet, they failed to improve this situation.

With poor organization, scheduling process, and being understaffed, airlines are upsetting both their passengers and their investors.

On top of that, rising jet fuel and other costs are hurting their profitability.

In this context, let’s look into U.S. Global Jets ETF to see how the airline industry has been performing. Have investors jumped away from airlines due to these headwinds and oversold the space, or are the names still too expensive as the industry struggles?

Economic productivity is massively misunderstood on Wall Street. This is reflected by the 130+ distortions in the Generally Accepted Accounting Principles (GAAP) that make as-reported results poor representations of real economic productivity.

These distortions include the poor capitalization of R&D, the use of goodwill and intangibles to inflate a company’s asset base, a poor understanding of one-off expense line items, as well as flawed acquisition accounting.

It is no surprise that once many of these distortions are accounted for, it becomes apparent which companies are in real robust profitability and which may not be as strong of an investment.

See for yourself below.

As we make Uniform Accounting (UAFRS) adjustments to accurately calculate earning power, we can see that the returns of the companies in U.S. Global Jets ETF are at a negative 3%, which means they are losing investor capital every year.

Even though the averages may seem similar between GAAP and UAFRS, there are various companies that as-reported metrics miss the story on.

Once the distortions from as-reported accounting are removed, we can realize that Air Canada (TSX: AC) doesn’t have a ROA of -7%, but is -20%.

Similarly, Allegiant Travel Company’s (ALGT) ROA is actually 14%, not 8%. Allegiant Travel is an American ultra-low-cost airline that operates scheduled and charter flights. It is among the major air carriers in the US and the fourteenth-largest commercial airline in North America.

Delta Airlines (DAL) is another example of as-reported metrics misrepresenting the company’s profitability. With a Uniform ROA of -6%, an as-reported of -2% is misleading and misses the story.

If investors were to consider allocating their capital to U.S. Global Jets ETF, these results would be totally disappointing.

To find companies that can deliver alpha beyond the market, just finding companies where as-reported metrics misrepresent a company’s real profitability is insufficient.

To really generate alpha, any investor also needs to identify where the market is significantly undervaluing the company’s potential.

Once we account for Uniform Accounting adjustments, we can see that many of these companies are strong stocks but have already realized most of their potential.

These dislocations demonstrate that most of these firms are in a different financial position than GAAP may make their books appear. But there is another crucial step in the search for alpha. Investors need to also find companies that are performing better than their valuations imply.

Valens has built a systematic process called Embedded Expectations Analysis to help investors get a sense of the future performance already baked into a company’s current stock price. Take a look:

This chart shows four interesting data points:

  • The Uniform ROA FY0 represents the company’s current return on assets, which is a crucial benchmark for contextualizing expectations.
  • The analyst-expected Uniform ROA represents what ROA is forecasted to do over the next two years. To get the ROA value, we take consensus Wall Street estimates and convert them to the Uniform Accounting framework.
  • The market-implied Uniform ROA is what the market thinks Uniform ROA is going to be in the three years following the analyst expectations, which for most companies here is 2023, 2024, and 2025. Here, we show the sort of economic productivity a company needs to achieve to justify its current stock price.
  • The Uniform P/E is our measure of how expensive a company is relative to its Uniform earnings. For reference, the average Uniform P/E across the investing universe is roughly 24x.

Embedded Expectations Analysis of U.S. Global Jets ETF paints a clear picture of the industry. Wall Street analysts expect over the next few years for airlines to return to profitability, and the market agrees.

While analysts forecast the industry to see Uniform ROA increase to 5% over the next two years, the market is also pricing the industry to see returns rise to approximately the same levels as analysts, which may imply that the airline industry is being correctly priced.

However, there are a couple of companies that may lead investors to be cautious.

The markets are expecting Frontier Group Holdings’ (ULCC) Uniform ROA to rise to 2%. Meanwhile, analysts are projecting the company’s returns to drop to -10%, perhaps disappointing investors.

Hawaiian Holdings (HA) may further disappoint investors as analysts expect their returns to increase to -1% Uniform ROA, while the market expects them to increase their returns to 5%.

Overall, the portfolio reflects the problems the airline industry faces currently, but investors expect the companies to improve their profitability over the next few years.

To sum up, the portfolio is composed of historically strong performers and quality names that can deliver higher profitability in the upcoming years. But before making a decision, investors should consider the recent problems, risks, and valuations to allocate capital accordingly.

This just goes to show the importance of valuation in the investing process. Finding a company with strong growth is only half of the process. The other, just as important part, is attaching reasonable valuations to the companies and understanding which have upside which have not been fully priced into their current prices.

To see a list of companies that have great performance and stability also at attractive valuations, the Valens Conviction Long Idea List is the place to look. The conviction list is powered by the Valens database, which offers access to full Uniform Accounting metrics for thousands of companies.

Click here to get access.

Read on to see a detailed tearsheet of one of JET’s largest holdings.

SUMMARY and United Airlines Holdings, Inc. Tearsheet

As one of JETS largest individual stock holdings, we’re highlighting United Airlines Holdings, Inc. (UAL:USA) tearsheet today.

As the Uniform Accounting tearsheet for United Airlines highlights, its Uniform P/E trades at 28.1x, which is above the global corporate average of 19.3x and its historical average of 8.2x.

High P/Es require high EPS growth to sustain them. That said, in the case of United Airlines, the company has recently shown 41% Uniform EPS shrinkage.

Wall Street analysts provide stock and valuation recommendations that, in general, provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.

We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, United Airlines’ Wall Street analyst-driven forecast is for EPS to decline by 120% in 2022 and grow by 134% in 2023.

Furthermore, the company’s return on assets was -5% in 2021, which is below the long-run corporate averages. Also, cash flows and cash on hand are in line with total obligations—including debt maturities and capex maintenance. Moreover, its intrinsic credit risk is 100bps. Together, these signal moderate operating and credit risks.

Lastly, United Airlines’ Uniform earnings growth is below peer averages, but is trading in line with average peer valuations.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research

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