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The Best Growth Stock In This Surprising Sector Isn't The One You Think

Marshall Hargrave

The airline industry has taken it on the chin over the past few weeks. The NYSE Arca Airline Index was down 6% in just over a week last month on a perfect storm of bad news.

However, the index is slowly climbing higher, demonstrating the resiliency of the airline industry amid a combination of higher oil prices thanks to the conflict in Iraq, a slump in business travel in Central and South America, and downward profit revisions by European operators.

Each of the big three airline stocks are down at least 4% over the past week. Delta Air Lines (NYSE: DAL) is down 8%, United Continental Holdings (NYSE: UAL) is down 5%, and American Airlines (NYSE: AAL) is down 4%.

A slight pullback shouldn't come as a surprise, considering all three stocks were up 47% or more over the past year.

However, despite the pullback, all three are off their lows of the month. This type of bounce in the current environment should be seen as a big positive by investors who have been on the fence about buying airline stocks.

Surprising Strength
Last week, the industry took note of the fact that World Cup fever slowed June business travel, which weighed on airline stocks. However, that should pick up now that the tournament has ended.

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In addition, the bad news out of Iraq appears to be taking a back seat. The spike in oil prices due to the sectarian conflict appears to have been short-lived. Further worth noting, according to Wolfe Research, is that "since 2008 airline stocks and oil prices have moved with each other to the tune of +0.68, a reversal from the trend in 1995-2008 where they had an inverse correlation of -0.64."

The takeaway: In recent years, higher oil prices have actually meant higher stock prices for airlines.

Given the airline industry's past dynamics, much of Wall Street has considered the airline industry "dead money." This had been true for a number of years, but the M&A boom has changed that.

Before the industry's deregulation in 1978, there were nearly two dozen major airlines. With the help of a number of mergers and acquisitions, we're down to just a few national operators. The remaining airlines are now positioned to excel thanks to better pricing power.

The rebounding economy should drive airline passenger demand higher. And as capacity continues to be right-sized (meaning airlines are better matching supply with demand) the major airlines will be able to boost fare prices.

The major airlines also enjoy a large economic moat thanks to the high barriers to entry of the industry. This is mainly due to the high cost of purchasing and maintaining aircraft, not to mention the competition for airport landing slots.

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Best Of The Big 3?
Over the past month, Delta is down 11.7% compared with American Airlines' 4% decline. The biggest laggard is United Continental, which is down close to 14%. (My colleague David Sterman warned StreetAuthority readers back in March that this could happen.)

United has notable exposure to Asia, and any slowdown in the region could lead to more downward earnings revisions for the airline. United is up only 6% this year, underperforming Delta by 29 percentage points and American by 60 percentage points.

Delta happens to be hedge fund billionaire Julian Robertson's largest holding and one that he's held for some time. He also has a small position in American Airlines, having doubled his position during the first quarter.

American also ranks high on Goldman Sachs' list of stocks most loved by hedge funds. The airline ranked sixth as of the end of the first quarter, with 40 hedge funds having the stock as one of their top 10 holdings.

Historically, airlines have traded at price-to-earnings (P/E) multiples in the low to mid-single digits. Yet, even after major industry consolidation, and what appears to be sustainable runway for profitability, a few industry operators still trade at depressed valuations.

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American Airlines is not only the industry leader when it comes to market share, it's also the best from a valuation standpoint. Shares trade at a forward P/E of just 6.8 based on next year's earnings estimates, a cheaper valuation than United at 7.4 and Delta at 10.2.

What's more, not only does American Airlines trade at the cheapest P/E of the three, analysts expect its earnings will grow at a faster rate than the other two. The Street has American's expected earnings growth rate for the next five years pegged at an annualized 40%, which again compares favorably to United at 35% and Delta at 10%.

Delta does trade at a premium, but for good reason: It has the most attractive balance sheet of the three, with an operating margin of 9.4% and a debt-to-capital ratio of only 49%. But Delta's dismal growth expectations makes it a less enticing investment than American.

Risks to Consider: As a group, airlines have seen quite a move upward in recent months, making further year-over-year growth in their stock prices less likely. These stocks are also heavily tied to the broader economy, and any slowdown in a recovery will put pressure on revenues.

Action to Take --> American Airlines has the most upside of the three major airlines. The stock still appears to be heavily undervalued and to have plenty of growth ahead. My price target is $63.50, which would put shares trading at a P/E of 10 on expected fiscal 2015 earnings of $6.35 a share, representing roughly 45% upside.

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