Airline Volatility Cleared for Takeoff?


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Actionable trade ideas for stock market investors and traders seeking alpha by overlaying their portfolios with options, other derivatives, ETFs, and disciplined and applied Game Theory for hedge fund managers and other active fund managers worldwide. Ryan Renicker, CFA

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Airline Volatility Cleared for Takeoff?

  1. 1. EQUITY PRODUCT MANAGEMENTJune 29, 2005 North America Product Management GroupBasic/Industrial Overview Basic/Industrial OverviewIndustry Overview Peter Gallagher 1.212.5261958Industrials & Services Research Monitor pgallagh@lehman.comSector View:New: 0-Not RatedOld: 0-Not RatedInvestment conclusion! Highlights: Airlines, PWER, PCAR, SBL, APOL, PAYXLehman Industrials & Services Research****PLEASE REFER TO FULL COMPANY NOTE(S) on ****U.S. Notes:Equity Derivatives Strategy (0-Not Rated) - Ryan RenickerAirline Volatility Cleared for Takeoff?We believe the lingering uncertainty surrounding the ultimate impact that strong crude oil prices could have on airline shareshas yet to be fully discounted by the options market. Investors wishing to express directional viewpoints on AMR and / or CALshould consider buying out-of-the-money puts (bearish) or calls (bullish). One risk to a long put position is that oil pricesdecline, causing companies that have exposure to oil prices to rally. Investors can hedge much of this oil-specific exposure byselling (the relatively expensive) calls on the S&P500 Energy Select Sector SPDR (XLE), which 1) has relatively high impliedvolatilities versus the market and 2) would likely decline during a declining oil price scenario. In contrast, a risk to a long callposition on the airlines is that oil prices continue to rise. Investors can hedge much of this exposure by selling puts on the XLE.Alternatively, investors should consider going long volatility through either straddles or strangles (long vega). Buying longer-dated volatility in AMR is likely the most efficient way of obtaining vega exposure to the airlines, as its long-dated (12-month)implied volatilities are 1) near 1-year lows versus the S&P500 and 2) low relative to AMR short-dated volatilities.Power-One Inc. (PWER - $5.92) 1-Overweight/1-Positive - Yuri Krapivin, CFADigital Power Has ArrivedWe are initiating coverage of PWER with a 1-Overweight rating and a $7.50 price target. Digital power conversion productsare likely to be the next "big thing" for the power management industry. PWER seized an early lead in digital powertechnologies. PWER is pioneering digital power management technologies and has established a 2-3 year lead over itscompetition. We believe digital power supplies will become standard products in the coming years. We think PWER could seea meaningful sales contribution from its digital initiative beginning in 2007. We believe PWERs financial performance is aboutto improve dramatically as the company completes the final leg of a multi-year restructuring effort. We established 05, 06,Lehman Brothers does and seeks to do business with companies covered in its research reports. As a result, investorsshould be aware that the Firm may have a conflict of interest that could affect the objectivity of this report.Customers of Lehman Brothers in the United States can receive independent, third-party research on the company orcompanies covered in this report, at no cost to them, where such research is available. Customers can access thisindependent research at or can call 1-800-2-LEHMAN to request a copy of this research.Investors should consider this report as only a single factor in making their investment decisions. PLEASE SEE ANALYST(S) CERTIFICATION(S) ON PAGE 3 AND IMPORTANT DISCLOSURES BEGINNING ON PAGE 4 1
  2. 2. EQUITY RESEARCHand 07 EPS ests of ($0.12), $0.15, and $0.30, respectively. Given the technological leadership and improving EPS outlook,we believe the stock has a significant upside. Our $7.50 price target is based on 25x our 07 EPS est. of $0.30.PACCAR Inc (PCAR - $69.73) 3-Underweight/1-Positive - Joel G. TissGreat Company, Still Risky StockPACCARs EPS should peak in 2006. While recognizing PACCAR is the premier truck manufacturing company probably inthe world, with 2007 EPS set to drop and sequential comps turning negative in 1Q 06, we continue to see downside riskmeaningfully outweighing upside potential over next 18 mos. Price target increase and EPS increases all near term. Potentialthat stronger near term trends accentuate 2007 downturn over the 40% unit decline now estimated. Raising our overall truckbuild forecast for 2005 from 305K to 330K and in 2006 from 320K to 335K based on the still significant truck industry backlog(6 months at least) and high build rates in 1Q. PCARs shares have underperformed year to date 15% (vs. S&P down 1%).What could make our negative call wrong is if 2008 and 2009 see a very strong build snap-back over 300K annual units whichrequires a very strong economy--and that is too far out to take on downside risk of PCAR shares at this point. Including mostof the cash in our $75 price target results in a 12-18 month target methodology of 9x our peak estimate of $7.50 ($67.50) plusabout $8 of cash on the balance sheet as we assume at least $2 of cash or a little more will have to be used just to run thecurrent business.Symbol Technologies (SBL - $9.67) 1-Overweight/2-Neutral - Scott Schneeberger, CFACo. Restructures, We Lower Target & Est.We are reducing our PT on SBL to $12 from $17, our 05 EPS est. to $0.29 from $0.44, & our 06 EPS est. to $0.55 from$0.68. After the close last night, SBL announced that it was reducing revenue guidance for 05 from the "low end of 10%-15%"to 3%-6%, primarily due to an anticipated continual in the economic & retail trends seen in 2Q05, ie, an April/May swoon inretail capex followed by a slow June recovery. SBL will take a restructuring charge of $75-$95m in 05 (incl. decr. its workforceby 700 employees) - which is est. to save SBL about $15m/q in 06. SBL also stressed its focus on strategically placingsalespeople to access new geographic regions & verticals. Our SBL growth thesis has been based on a recovery in U.S. retailcapex (which is being tested right now), expansion into new vertical & geog. Mkts (slowed by the previous focus on legal,acct. & corp. gov.), &, in 3-5yrs, RFID. Clearly SBL needed to take action to move these g drivers along, in view of the slowerthan expected retail spending environ. this spring. Unfortunately, this 2nd guidance change in since May now puts SBL in the"Show Me" stage. Price target based on lowered 21.5x multiple on our updated 2006 EPS estimate of $0.55.Apollo Group, Inc (APOL - $79.13) 1-Overweight/1-Positive - Gary E. Bisbee, CFAAdditional Thoughts on 3Q05: Reit 1-OWYesterday, Apollo reported a solid Q with 3Q05 EPS of $0.77 (up 37% vs. $0.56) exceeding our and the street est. of $0.74by $0.03. Upside driven by lower selling & promotional expense and lower share count. However, the shares fell 1.4% due toslight revs and enrollments miss and fears S&P cost controls wont be sustainable. Total enrollments grew 23.5% to 295.5K,slightly below our 297.5K est. Online enrolls continued their robust growth to 154.5K (up 41%), slightly below our 154.8K (41%gr.) est. Campus enrolls grew 9% to 141.0K, 1.7K below our est. While a bit below our ests, campus growth rate was stablesequentially (a positive). Revs of $619mm missed our $627.7mm est by $9mm and the low-end of guidance by $3mm.APOLs consolidated op. margin improved 170 basis points y-o-y to 36.9%, above our 35.8% est. Selling exp. fell to 19.1% ofrevs (vs. 20.8% y-o-y and 22% est.). At 30x and 25x CY’05/’06 EPS, APOL shares reasonably priced in our view. Reit 1-OW.Paychex Inc (PAYX - $33.01) 1-Overweight/2-Neutral - Gary E. Bisbee, CFAAddl Insights After Call and 8-K; 1-OWAfter releasing strong 4Q04 results Monday night, yesterday Paychex provided an upbeat FY06 outlook on its earnings calland through an 8-K filing. Shares rose 10% vs. a 1% gain for the S&P 500. Although payroll revenue growth (ex float) couldslow modestly in FY06, strong growth in interest income and HR services will likely more than offset any deceleration inpayroll. In addition, management is taking an ultra-conservative view on float income, assuming the Fed Funds rate will stay at3.0% through F06. We now estimate 19% EPS growth to $1.15, with 12% growth coming from top-line increase, 5% growthdue to margin expansion, and 2% growth via a lower y/y tax rate. We reiterate our 1-Overweight rating and are modestlyraising our price target from $36 to $37, which is based on 30x our CY06 EPS estimate of $1.23.Happening Today:Morgan Stanley Business & Professional Services Conference – New York, NY 2
  3. 3. EQUITY RESEARCHAnalyst Certification:Each research publication excerpted herein was certified under Reg AC by the analyst primarily responsible for such report as follows: Ihereby certify that: 1) the views expressed in this research report accurately reflect my personal views about any or all of the subjectsecurities referred to in this publication and; 2) no part of my compensation was , is or will be directly or indirectly related to the specificrecommendations or views expressed in this report.Other Team Members:Bryan Schleppy 1.212.526.7325 3
  4. 4. EQUITY RESEARCH FOR CURRENT IMPORTANT DISCLOSURES REGARDING COMPANIES THAT ARE THE SUBJECT OF THIS RESEARCH REPORT, PLEASE SEND A WRITTEN REQUEST TO: LEHMAN BROTHERS CONTROL ROOM 745 SEVENTH AVENUE, 19TH FLOOR NEW YORK, NY 10019 OR REFER TO THE FIRMS DISCLOSURE WEBSITE AT Disclosures:The analysts responsible for preparing this report have received compensation based upon various factors including the Firm’s totalrevenues, a portion of which is generated by investment banking activities.Related Stocks: Ticker Price (06/27) RatingAMR Corp AMR 12.25 2-Equal weightContinental Airlines CAL 13.64 3-UnderweightPower-One Inc. PWER 5.92 1-OverweightPACCAR Inc PCAR 69.73 3-UnderweightSymbol Technologies SBL 10.47 1-OverweightApollo Group, Inc APOL 79.13 1-OverweightPaychex Inc PAYX 33.01 1-OverweightGuide to Lehman Brothers Equity Research Rating System:Our coverage analysts use a relative rating system in which they rate stocks as 1-Overweight, 2- Equal weight or 3-Underweight (seedefinitions below) relative to other companies covered by the analyst or a team of analysts that are deemed to be in the same industry sector(the “sector coverage universe”). To see a list of the companies that comprise a particular sector coverage universe, please go addition to the stock rating, we provide sector views which rate the outlook for the sector coverage universe as 1-Positive, 2-Neutral or3-Negative (see definitions below). A rating system using terms such as buy, hold and sell is not the equivalent of our rating system.Investors should carefully read the entire research report including the definitions of all ratings and not infer its contents from ratings alone.Stock Rating1-Overweight - The stock is expected to outperform the unweighted expected total return of the sector coverage universe over a 12-monthinvestment horizon.2-Equal weight - The stock is expected to perform in line with the unweighted expected total return of the sector coverage universe over a12- month investment horizon.3-Underweight - The stock is expected to underperform the unweighted expected total return of the sector coverage universe over a 12-month investment horizon.RS-Rating Suspended - The rating and target price have been suspended temporarily to comply with applicable regulations and/or firmpolicies in certain circumstances including when Lehman Brothers is acting in an advisory capacity in a merger or strategic transactioninvolving the company.Sector View1-Positive - sector coverage universe fundamentals/valuations are improving.2-Neutral - sector coverage universe fundamentals/valuations are steady, neither improving nor deteriorating.3-Negative - sector coverage universe fundamentals/valuations are deteriorating.Stock Ratings From February 2001 to August 5, 2002 (sector view did not exist):This is a guide to expected total return (price performance plus dividend) relative to the total return of the stocks’ local market (i.e. the marketwhere the stock primarily trades) over the next 12 months.1-Strong Buy - expected to outperform the market by 15 or more percentage points.2-Buy - expected to outperform the market by 5-15 percentage points.3-Market Perform - expected to perform in line with the market, plus or minus 5 percentage points.4-Market Underperform - expected to underperform the market by 5-15 percentage points.5-Sell - expected to underperform the market by 15 or more percentage points.Distribution of Ratings:Lehman Brothers Global Equity Research has 1707 companies under coverage.41% have been assigned a 1-Overweight rating which, for purposes of mandatory regulatory disclosures, is classified as Buy rating, 33% ofcompanies with this rating are investment banking clients of the Firm. 4
  5. 5. EQUITY RESEARCH42% have been assigned a 2-Equal weight rating which, for purposes of mandatory regulatory disclosures, is classified as Hold rating, 7% ofcompanies with this rating are investment banking clients of the Firm.17% have been assigned a 3-Underweight rating which, for purposes of mandatory regulatory disclosures, is classified as Sell rating, 84% ofcompanies with this rating are investment banking clients of the Firm.This material has been prepared and/or issued by Lehman Brothers Inc., member SIPC, and/or one of its affiliates (“Lehman Brothers”) and has beenapproved by Lehman Brothers International (Europe), authorized and regulated by the Financial Services Authority, in connection with its distribution in theEuropean Economic Area. This material is distributed in Japan by Lehman Brothers Japan Inc., and in Hong Kong by Lehman Brothers Asia Limited. Thismaterial is distributed in Australia by Lehman Brothers Australia Pty Limited, and in Singapore by Lehman Brothers Inc., Singapore Branch. This material isdistributed in Korea by Lehman Brothers International (Europe) Seoul Branch. This document is for information purposes only and it should not be regardedas an offer to sell or as a solicitation of an offer to buy the securities or other instruments mentioned in it. No part of this document may be reproduced in anymanner without the written permission of Lehman Brothers. With the exception of disclosures relating to Lehman Brothers, this research report is based oncurrent public information that Lehman Brothers considers reliable, but we make no representation that it is accurate or complete, and it should not be relied onas such. In the case of any disclosure to the effect that Lehman Brothers Inc. or its affiliates beneficially own 1% or more of any class of common equitysecurities of the subject company, the computation of beneficial ownership of securities is based upon the methodology used to compute ownership underSection 13(d) of the United States Securities Exchange Act of 1934. In the case of any disclosure to the effect that Lehman Brothers Inc. and/or its affiliateshold a short position of at least 1% of the outstanding share capital of a particular company, such disclosure relates solely to the ordinary share capital of thecompany. Accordingly, while such calculation represents Lehman Brothers’ holdings net of any long position in the ordinary share capital of the company, suchcalculation excludes any rights or obligations that Lehman Brothers may otherwise have, or which may accrue in the future, with respect to such ordinary sharecapital. Similarly such calculation does not include any shares held or owned by Lehman Brothers where such shares are held under a wider agreement orarrangement (be it with a client or a counterparty) concerning the shares of such company (e.g. prime broking and/or stock lending activity). Any suchdisclosure represents the position of Lehman Brothers as of the last business day of the calendar month preceding the date of this report.This material is provided with the understanding that Lehman Brothers is not acting in a fiduciary capacity. Opinions expressed herein reflect the opinion ofLehman Brothers and are subject to change without notice. The products mentioned in this document may not be eligible for sale in some states or countries,and they may not be suitable for all types of investors. If an investor has any doubts about product suitability, he should consult his Lehman Brothersrepresentative. The value of and the income produced by products may fluctuate, so that an investor may get back less than he invested. Value and incomemay be adversely affected by exchange rates, interest rates, or other factors. Past performance is not necessarily indicative of future results. If a product isincome producing, part of the capital invested may be used to pay that income. © 2005 Lehman Brothers. All rights reserved. Additional information isavailable on request. Please contact a Lehman Brothers entity in your home jurisdiction.Lehman Brothers policy for managing conflicts of interest in connection with investment research is available at, earnings per share forecasts and price targets contained in the Firms equity research reports covering U.S. companies are available disclosure information on companies covered by Lehman Brothers Equity Research is available at 5