Using the Price/Sales Ratio to Find Value in the Airline Industry

The airline industry has dramatically outperformed the broader stock market in the past 2 years. Consolidation among U.S. airlines, a general industry commitment to capacity discipline, and now lower fuel prices have all contributed to soaring airline share prices.

Hawaiian Airlines is one airline stock that still appears to be undervalued. Photo: The Motley Fool

Nevertheless, there are still opportunities in the airline industry for self-professed "value investors." The price-to-sales (or P/S) ratio is one tool to identify undervalued airline stocks. Based on this metric, Hawaiian Holdings and United Continental are two airline stocks that value investors should investigate.

Advantages and pitfalls of the P/S ratio

Typically, I do not recommend the P/S ratio as a method of valuing stocks, because it doesn't take profit margins into account. All else being equal, a company with a 30% profit margin should not have the same P/S ratio as one with a 3% profit margin. For any given amount of revenue, a company with higher margins will earn more profit.

As a result, the price-to-earnings (or P/E) ratio is usually more meaningful. After all, investors want companies to maximize long-term earnings, not long-term revenue. The P/E ratio accounts for revenue and profit margin -- because earnings is simply the product of those two quantities.

However, for companies with similar profit margins, the P/S ratio can be useful. It can also be handy for companies that are currently unprofitable and for companies with uncertain long-term margin prospects.

Using P/S ratios for airline stocks makes sense because the massive drop in oil prices since September has radically altered the earnings picture for airlines. Airlines are likely to be much more profitable in 2015 than they were in 2014.

Using 2015 analyst estimates to measure P/E ratios could help somewhat, but airline analysts still have not captured the full impact of lower fuel prices in their financial models. By contrast, falling oil prices will have a much smaller impact on airline revenue than on airline earnings, so airline P/S ratios aren't in flux to the same extent as P/E ratios.

Comparing airlines by P/S ratio

There's nothing magical about a P/S ratio of 1, but that number has been a good "baseline" for airline stocks recently. Ultra-low cost carriers have achieved P/S ratios above 2 thanks to their above-average growth and margins, but the P/S ratios for major carriers like Delta Air Lines and American Airlines have stayed near 1.0 for the past couple of months.

By contrast, Hawaiian Holdings and United Continental stand out for having lower-than-average P/S ratios. This indicates that these two stocks may be undervalued, and merit closer investigation.

Airline P/S Ratio Comparison (TTM), data by YCharts

There's a reason why Hawaiian Airlines and United Continental both trade at a discount to Delta Air Lines and American Airlines from a P/S perspective. Quite simply, Delta and American have had superior margins recently.

If Hawaiian and United are doomed to have permanently lower margins than Delta and American, then their lower P/S ratios would be justified. But if they can close the gap, then they may be undervalued today relative to Delta and American.

Looking deeper

In fact, both Hawaiian and United appear poised to improve their profit margins relative to the industry leaders, Delta Air Lines and American Airlines. Hawaiian Airlines is making significantly faster progress, though.

All airlines will benefit from lower fuel prices this year. Hawaiian Airlines is separating itself from the pack by keeping unit revenue growing as well. This will allow it to post faster earnings growth than rivals with stagnant unit revenue.

On Tuesday, Delta Air Lines reported a 0.8% rise in unit revenue for Q4. American Airlines expects a 0%-2% decline for that same measure. United Continental is in slightly better shape, and recently projected that unit revenue would rise 0.25%-0.75%. Excluding an unusual revenue adjustment in Q4 2013, United Continental's unit revenue growth would be closer to 2%.

United Continental's unit revenue is growing faster than that of Delta and American -- excluding a one-time revenue adjustment from late 2013. Photo: The Motley Fool

By contrast, Hawaiian Airlines has projected that Q4 unit revenue will rise 4.5%-7.5%, aided by growing ancillary revenue streams and the elimination of some unprofitable routes in mid-2014.

If it can maintain this momentum into 2015, Hawaiian will dramatically narrow its margin deficit relative to Delta and American. Adding in its greater growth potential, Hawaiian Airlines stock appears undervalued, with as much as 50% upside in the next year.

The picture is murkier for United. It enters 2015 with slightly more unit revenue momentum than Delta and American, but not nearly enough to close the margin gap. Ongoing cost savings initiatives could help it make further progress in the next few years. But the path to margin parity is much less clear for United than for Hawaiian. This means that its P/S ratio could remain below the peer average.

The article Using the Price/Sales Ratio to Find Value in the Airline Industry originally appeared on Fool.com.

Adam Levine-Weinberg owns shares of Hawaiian Holdings,. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.