By: Steve Smith
Concerns over overcapacity are overblown as Delta demonstrates restraint with recent reduction.
In 1988 Warren Buffett made a major investment in USAir and was losing a bundle, leading him to call the airline industry a bottomless pit and write in Berkshire’s annual report, “a durable competitive advantage in the airline industry has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.” He never invested in another airline again. Indeed, airlines have historically been among the worst investments ever.
Even though the industry has been around for nearly 100 years, the way we fly is unlikely to change for the next 20 and I believe the airlines are in the early stages of being a reliably profitable industry. And the stocks are still being priced too cheaply on fears it will turn back into the bad old days.
For decades, since deregulation, airline stocks have been a lousy investment. The industry was fraught with too many players, demanding unions, unstable fuel costs, and executives who lacked fiscal discipline. This combination engendered a “boom and bust” cycle that was ruinous for long-term investors. So what changed to drive the airlines to new heights in the past five years? To put it simply three things have finally occurred; Consolidation, bankruptcy and capacity rationalization.
These did not come easy, in fact it took the dual crisis of 9/11 terror attack and the great recession of 2008 to provide the economic do-or-die impetus for structural operational changes. In the wake of these twin challenges the airlines finally wrung out excess and have been flying high ever since.
In fact, in the 5 years from January 1st 2010 through December 31st, 2014 the NYSE Airline Index (XAL) gained 264%, making it the best performing sector of the S&P 500, which gained 105% during the same period. In 2015 however, the airline stocks reversed course, losing 23% and after a brief bounce the slide continued in 2016 and has accelerated the past few weeks. It, along with many of the individual components, are now near an important support level.
The question now is can the airlines reclaim their new found status as an investable industry or will they once again be shunned and facing sinking stock prices?
One of the key questions to arriving at our answer is whether the reaction to airline management decisions to add capacity is an over-reaction that masks improved fundamentals. First it’s important to provide some historical context.
The deregulation of the airline industry in 1978 changed the airline industry landscape forever. After 1978, airlines were allowed to compete in an unregulated market, which meant fewer permits, and a capitalistic market to compete in, which drove ticket prices down. With new companies jockeying for a larger slice of the market, increased competition led to capacity increases and price cutting, which eventually doomed the industry. Most airlines either capitulated or got consolidated into other airlines. A total of 183 airlines went bankrupt since 1978.
Then with industry having right sized but still not profitable 9/11 followed by the oil spike in 2008 blew the final death knell for the industry. Today, just 4 major airlines exist with over 85% market share. Such concentration has never existed in the US airline industry.
With three out of the four largest airlines having gone through bankruptcy within the last 10 years, these companies used the process to become stronger, leaner and more profitable by discarding unnecessary assets, cutting excess headcount, implement wage cuts and negotiating on pension liability – none of which would have been possible had they not gone through bankruptcy.
Executives at all 4 airlines now claim to understand the importance of keeping capacity in check. Since 2007, the industry has significantly fewer seats while demand has continued to increase. This capacity rationalization has given US airlines pricing power. For the first time since 1990, we are seeing pricing increase by ~20% over the last 5 years. Rather than fighting for market share, airline executives say they are focused running their operations for efficiency and profitability.
So what happened in 2015 to spook investors? As the economy has continued to improve, travel has picked up and the U.S. airline industry is expected to face its busiest summer this year. According to a forecast by American Airlines, approximately 222 million passengers will fly on U.S. airlines this summer.
Too Much of a Good Thing?
To meet this anticipated demand for travel, U.S. carriers have responded by raising the number of available seats by 126,000 per day (4.6%) during 2015. The trend was viewed as bad news by airline investors, who had been enjoying somewhat of an ideal situation for generating profits. Scarce capacity kept fares high – while low energy prices put a lid on costs. American Airlines (AAL) CEO Doug Parker increased investors’ concerns when he declared airlines were expanding capacity too quickly. If system-wide capacity grows more quickly than passengers demand, this could result in falling airline ticket prices, and in turn, lower margins.
Indeed, airline stocks sold off sharply in early March when carries reported big increases in capacity during the first quarter of 2016. The numbers were a bit shocking: Virgin America(VA) added 21%, United Continental (UAL) added +7% (U.S.), Allegiant Travel +23%, JetBlue (JBLU) +20%, Southwest Airlines (LUV) +14% and Delta Air Lines (DAL) +11%. Capacity continued to be added through the second quarter albeit at a much lower single rate.
The immediate thought was, “here we go again!” As soon as profitability rises, and the outlook turns sunny, airlines add capacity to increase their market share, unions make unaffordable wage demands and/or new competitors enter the market generally promising lower prices. But this time discipline seems to holding. In fact on Monday Delta came out and said it was reducing capacity which help lift shares by some 3% that day.
Also, while fares have come down they have done so only modestly; data analytics company Hopper showed airline fares will average about $249 through the end of the year, which is around 2.8% cheaper than in 2014, and 6.8% cheaper than in 2013. But even that might be pessimistic as fares rose by 2.1% though the first 5 months of the year according to Bureau of Labor Statistics.
A more important and promising metric is revenue per mile (RPM) as it speaks to profitability per flight. So even if fares come down slightly (revenue per passenger) given more people are being crammed into more cost efficient planes the bottom line profits will improve. In the first two months of 2016, Southwest Airlines generated RPMs of 17.7 billion (up 9.8% year over year) and ASMs of 22.4 billion (up 11.1%), leading to a load factor of 78.2% (up 80 bps). We can see profitability trends remain very positive.
Overall Fundamentals Still Sound
Meanwhile key fundamental factors remain in place: Fewer airlines, more travel, no large-scale price wars, reduced union and pension expenses and low fuel costs. These factors have enabled airlines to continue to generate positive free cash flow, which they are using to buy back stock and increase dividends, rather than buying more planes and irrationally adding capacity, or growing for growth’s sake.
Also important is that most of the major carriers have renegotiated and signed new labor agreements with the various unions. This was expected to get contentious as labor gave many concessions during the past decade of struggle and re-organizations. Now with them raking in the profits the workers wanted a well-deserved raise. Both sides have come to their senses and new 5-year deals are mostly in place.
The other main input cost is fuel, which is likely to stay low for a while. Although it has rebounded sharply from the lows it still remains cheap on an historical basis. The fact is most airlines had the good sense to at least hedge a good portion of the next two years needs near current levels.
On the whole the industry should continue to see solid 10%-15% top and bottom line growth. Yet the stocks still trade a deep discount with p/e ratios in the low to mid-single digits; AAL and UAL are the cheapest with a 2.3 and 2.7 p/e respectively. This mostly due to a large international exposure, which leaves it vulnerable to global economies and also competing with heavily subsidized sovereign airlines.
For this reason I’m partial to Southwest (LUV), even though it carries a higher p/e of 7.8x next year’s earnings. I think it’s a well-managed company with strong domestic routes and the chart shows good support near the $41 level.
I’m targeting a purchase of the September 42 Calls for $3.00 per contract.
I expect shares can be back above $50 by the end of the summer.
By the way, Warren Buffett held most of his stake in USAir through its various permutations for another 20 years before finally unloading it in 2007. He turned a small profit.