Delta Air Lines, Inc. (DAL), United Continental Holdings Inc (UAL): Time to Gain Leverage on Airline Shares?

Airlines have long been considered higher risk investments. With a history of bankruptcies resulting from economic downturns and the volatile cost of fuel being a core component of their business, airline investors have been burned many times before. However, the industry is cutting capacity and reducing competition, thereby allowing airlines to raise fares and other fees. Because of this, analysts are expecting strong earnings increases over the next few years, setting up a series of option plays for investors willing to take on more risk than owning the shares themselves would entail.

Since the earnings increase is expected to occur over the next few years, the options we will take a look at here are the LEAPS (Long-term Equity AnticiPation Securities) that expire on Jan. 17, 2015.

Three big airlines, two option plays

Delta Air Lines, Inc. (NYSE:DAL)

The U.S. airline industry has been undergoing a round of consolidation that is expected to result in three main carriers, Delta Air Lines, Inc. (NYSE:DAL), United Continental Holdings Inc (NYSE:UAL), and US Airways Group Inc (NYSE:LCC) which will take the name American Airlines assuming the merger with American is approved. Delta Air Lines, Inc. (NYSE:DAL) is in the last stages of integration and United Continental Holdings Inc (NYSE:UAL) is still working through the late to middle stages. With integration costs winding down for both these carriers, earnings estimates for the future can be trusted to a greater degree. But, US Airways Group Inc (NYSE:LCC) will inevitably incur merger related expenses, many of which will throw analyst estimates off one way or another due to the unpredictability of these costs. Since these option plays call for more predictable earnings in choosing the appropriate LEAPS, we will focus on Delta Air Lines, Inc. (NYSE:DAL) and United Continental Holdings Inc (NYSE:UAL) options rather than on the less certain US Airways Group Inc (NYSE:LCC) ones.

Analyst estimates

The following data was obtained from Yahoo! Finance and represents the average of 14 to 16 analyst estimates for 2013 and 2014 earnings. Investors who do not believe these earnings are achievable would need to adjust their views on the option plays accordingly.

Airline EPS 2012 est. EPS 2013 est. EPS 2014
Delta Air Lines $1.19 $2.64 $3.01
United Continental ($2.18)* $3.68 $4.89

*United Continental Holdings Inc (NYSE:UAL) incurred numerous one-time merger expenses for 2012.

2014 price targets

Using the above earnings, we can form a general price target based on a P/E ratio. For this analysis, we will use a P/E ratio of 10 as it represents a modest discount to the P/E ratios of Southwest Airlines and WestJet, two airlines typically seen as safer investments than their legacy counterparts.