United Continental Still Undervalued – 10% Cashflow Yield + 11% Shareholder Yield

By The Acquirer’s Multiple. Originally published at ValueWalk.

One of the cheapest stocks in our Large Cap 1000 – Stock Screener is United Continental Holdings Inc (NYSE:UAL).

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United Continental Holdings, Inc., (United) together with its subsidiaries, provides air transportation services in North America, the Asia-Pacific, Europe, the Middle East, Africa, and Latin America. The company transports people and cargo through its mainline and regional operations. As of December 31, 2015, United operated 1,236 aircraft. The company also sells fuel; and offers catering, ground handling, and maintenance services for third parties.

Airline stocks, including United, got a boost in late 2016 after it was revealed Berkshire Hathaway had added three of the biggest U.S. airlines to its third quarter portfolio. Stocks included — American Airlines Group Inc (NASDAQ:AAL), Delta Air Lines, Inc. (NYSE:DAL), and United Continental Holdings Inc (NYSE:UAL). According to the September filing, Berkshire owned 21.8 million American Airlines shares worth $797 million, 6.3 million Delta shares worth $249.3 million, and 4.5 million United shares worth $237.8 million. While there are a number of airline stocks in our Large Cap 1000 – Stock Screener, today I want to focus on United.

A quick look at the company’s share price history over the past twelve months (below) shows that the stock has risen over 50% to $72.06, just 5% off its 52 week high of $76.80.

(Source, Google Finance)

United recently announced its Q4 2016 and full year 2016 results. A quick look at the company’s quarterly income statements (below) shows that Q4 2016 revenue increased 0.2% to $9.052 Billion from $9.036 Billion for the previous corresponding period. Full year 2016 revenue was down 3.5% to $36.6 Billion from $37.9 Billion for the full year 2015.

(Source, Company reports)

The company also reported that Q4 2016 consolidated passenger revenue per available seat mile (PRASM) decreased 1.6% and consolidated yield decreased 1.2% compared to the pcp. This out-performance versus the company’s initial guidance was due to stronger close-in bookings and yields in November and December. For the full-year 2016, consolidated PRASM declined 5.4% compared to the prior year driven by factors including a strong U.S. dollar, lower surcharges, reductions from energy-related corporate travel, and declining yields.

What’s most notable in the quarterly income statements above is that the company’s net income dropped by 52% in Q4 2016 compared to the pcp, which on the face of it seems quite alarming. The reason for the significant drop can be found in a line item above called Tax Provision.

As you can see, the Tax Provision in Q4 2016 was $487 million compared to just $82 million for the pcp, a difference of $405 million. While the company’s effective tax rate for Q4 2016 was 55% the tax provision was also impacted by a special tax expense of $180 million. The company recorded approximately $180 million of deferred income tax expense adjustments in AOCI, which related to losses on fuel hedges designated for hedge accounting. Accounting rules require the adjustments to remain in AOCI as long as the company had fuel derivatives designated for cash flow hedge accounting. In 2016, United settled all of its fuel hedges and has not entered into any new fuel derivative contracts for hedge accounting.

Also impacting full year profit were a number of special items that are non-recurring and that management believes are not indicative of United’s ongoing performance. These included:

Labor agreement costs and related items: The fleet service, passenger service, storekeeper and other employees represented by the International Association of Machinists and Aerospace Workers (IAM) ratified seven new contracts with the company which extended the contracts through 2021. The technicians and related employees represented by the International Brotherhood of Teamsters (IBT) ratified a six-year joint collective bargaining agreement which extended the contract through 2022. During 2016, United recorded $171 million ($110 million net of taxes) of special charges primarily for payments in conjunction with the IAM and IBT agreements described above.

Severance and benefit costs: During the three months and year ended December 31, 2016, United also recorded $10 million ($6 million net of taxes) and $37 million ($24 million net of taxes), respectively, of severance and benefit costs related to a voluntary early-out program for the company’s flight attendants and other severance agreements.

Impairment of assets: In April 2016, the Federal Aviation Administration (FAA) announced that it will designate Newark Liberty International Airport (Newark) as a Level 2 schedule-facilitated airport under the International Air Transport Association Worldwide Slot Guidelines effective October 30, 2016. The designation was associated with an updated demand and capacity analysis of Newark by the FAA. In 2016, the company determined that the FAA’s action impaired the entire value of its Newark slots because the slots are no longer the mechanism that governs take-off and landing rights. Accordingly, United recorded a $412 million special charge ($264 million net of taxes) to write off the intangible asset.

Cleveland airport lease restructuring: Lastly, during 2016 the City of Cleveland agreed to amend their lease with United, which runs through 2029, associated with certain excess airport terminal space (principally Terminal D) and related facilities at Hopkins International Airport. United recorded an accrual for remaining payments under the lease for facilities that it no longer uses and will continue to incur costs under the lease without economic benefit to the company. This liability was measured and recorded at its fair value when the company ceased its right to use such facilities leased to it pursuant to the lease. United recorded a net charge of $74 million ($47 million net of taxes) related to the amended lease.

As a result of all of the above, the company reported full-year net income of $2.3 billion, diluted earnings per share of $6.85, pre-tax earnings of $3.8 billion and a pre-tax margin of 10.4%. When we exclude special items, United’s reported full-year net income was $2.9 billion, diluted earnings per share of $8.65, pre-tax earnings of $4.5 billion and a pre-tax margin of 12.2%.

With regards Q4 2016, United reported fourth-quarter net income of $397 million, diluted earnings per share of $1.26, pre-tax earnings of $884 million and a pre-tax margin of 9.8%. When we exclude special items, United’s reported fourth-quarter net income was $562 million, diluted earnings per share of $1.78, pre-tax earnings of $857 million and a pre-tax margin of 9.5%.

Strategic Initiatives

United recently recorded its best full-year on-time performance while reporting its lowest number of cancellations, delay minutes and mishandled bags in company history. The company appears to be on track with the new initiatives announced back in November 2016 in which the company stated it expects to unlock $4.8 Billion in value by 2020. These initiatives included:

Introduction of Basic Economy Airfares

This new offering provides customers with the option to pay the lowest fares to their destinations, while still receiving the same standard economy experience, including food, beverage, Wi-Fi and personal device entertainment, with a few key differences. Customers who choose Basic Economy will be assigned seats on the day of departure, be assigned to boarding group five and be permitted only one personal carry-on item that must fit under the seat.

Optimizing Its Network

The company also announced plans to fully optimize its network potential by

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