Wednesday, December 02, 2009

Airlines: Upgrading to Attractive; Bullish on Airline Cycle at Current Levels - Morgan Stanley

Morgan Stanley is out upgrading the Airline sector to Attractive, upgrading AMR Corp (NYSE:AMR) and Ual Corp. (NASDAQ:UAUA) to Overweight from Equal-Weight.

Upgrading Industry View to Attractive on improving risk/reward of the airline “cycle call.” Morgan Stanley notes they have updated their estimates and liquidity projections for 2010 to account for recent trends/news events. Additionally, they are moving their valuation levels to YE10 from YE09 and raising base case valuations across all airlines.

Importantly, the firm expects investors’ liquidity concerns to dissipate in the coming months as investors incorporate the full implications of US Airways’ (LCC) recent liquidity improvements. Now that 1) previously exuberant expectations have normalized as evidenced by price action in the last 1-2 months vs. improving trends and 2) the risk of a liquidity squeeze at a major carrier in 2010 has fallen; firm believes investors will become increasingly willing to bet on the cycle.

Unlikely to get a markedly better entry point in the coming months. Though they believed that airline profitability is improving, they were reluctant to make the “airline cycle call” ahead of 3Q09 earnings like many of their sell-side peers on the belief that investors would be able to get a significantly better entry-point near-term. Since the firm reiterated their In-line Industry View (see Staying on the Sidelines for Now 11/2/09), many of the five indicators they noted they were watching to become more constructive on the space have turned more favorable. Moreover, Morgan Stanley also believes that they are on the cusp of a stream of positive catalysts for the group that will showcase substantial 2nd derivative improvement in revenue and only subsequently will they see evidence of the anemic rebound that has concerned us. Therefore, they believe investors will be hard-pressed to identify a better entry-point for the cycle call in the coming months.

Re-orienting Airline Ratings. Consistent with Morgan Stanley's evolving industry view, they are adding risk to their recommendations. As such, they are upgrading both AMR and UAUA from EW to OW and downgrading shares of ALGT (OW to EW) and ALK (EW to UW).

Upgrading AMR to OW from EW. AMR's recent liquidity-enhancing transactions have placed the company more firmly in the "Survivor" basket, particularly considering industry trends are broadly improving. Though their projected headline EPS losses and difficult union negotiations are risks, the firm believes investor willingness to bet on the cycle using this highly leveraged airline equity is likely to overcome these marginal negatives.

Why Now? As a carrier formerly not included in firm's “Survivor Basket”, AMR is still perceived to have more liquidity risk than they think is appropriate. Furthermore, we believe that the industry is on the cusp of a multi-month series of positive catalysts. Given AMR’s leverage to the cycle, they believe this is a setup for a likely move higher.

UAL Corp. (UAUA, OW) Upgrading UAUA to OW from EW. UAUA’s leverage to the industry revenue cycle and underperformance through the downturn is likely to become a relative positive as investors focus on rapidly improving YoY revenue trends over the coming quarters. Furthermore, recent liquidity injections are likely to improve investor willingness to look through the cycle into 2011, when the company generates significant FCF per MSCO's estimates.

Why Now? Similar to AMR, but with even more leverage and suffering from more negative sentiment with respect to liquidity, in firm's view; UAUA is likely to move higher as investors focused on the airlines with the most leverage to the cycle in the face of positive catalysts.

Notablecalls: AMR and UAUA - 5-7% movers today for sure. Maybe even more. Note Goldman Sachs was positive on Airlines yesterday and the stocks have been pushing higher.

Getting a bump from Morgan Stanley is exactly what the doctor ordered for these to take off again.

AMR can trade to $6.75+

UAUA can trade to $8.75+

Let's see how it works out.

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