By: Steve Smith
When it was revealed Warren Buffet’s Berkshire Hathaway took stakes in all four major airlines – American Airlines (AAL), United Continental Holdings (UAL), Southwest (LUV) and Delta Air Lines (DAL) – it sent shares surging and shockwaves among the investment community.
Why was this move such as surprise? Buffett famously swore he’d never invest in airlines on the belief it was a flawed business model. For those that don’t know the backstory, here’s the nugget.
In 1988 Buffet 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.” And until yesterday’s announcement he never invested in another airline again.
So what caused him, or more likely one of his empowered deputies, change their minds and make a significant and presumably long term investment in the sector? A little history and analysis is in order.
Even though the industry has been around for nearly 100 years, the way we fly has not changed in 20 (and is unlikely to for the next 20) and the planes will still be of the same size and fly at subsonic speed, believe the airline industry is in the early stages as a profitable investment vehicle.
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%.
But there has a nice recovery since it bottomed in late January 2016 and it is now approaching the old multi-year highs.
I think with price consolidation to digest recent gains the group can resume its ascent.
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.
Deregulation Created Speculation
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 have used the bankruptcy process to become stronger, leaner and more profitable by discarding unnecessary assets, cutting excess head count, 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. U.S. vs. International Airlines Internationally however, the story is different as competitors continue to be irrational.
International government-operated carriers are not run for profitability; instead they are run because nations take pride in having their own national, well-recognized carrier. This leads to running of unprofitable routes and puts pressure on other international carriers. 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 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 that 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%, Delta Air Lines (DAL) +11%
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. Operational discipline gives way to irrational competition and an oversupplied market. As investors, we are concerned whether the cycle is being repeated. And with jet fuel prices unlikely to fall further we are worried about whether this is a time of ‘peak profit’ for airlines.
So is this increased capacity driven by one-off events or is the industry going back to its bad ways? At this point, we think it’s the former. A significant amount (~50%) of the increase in capacity relates to the repeal of a law that placed restrictions on direct flights out of Dallas-Love Field airport. The repeal opened up the Dallas market, and Southwest and Spirit added direct flights from Dallas-Love Field to destinations around the country – which they could not previously do. Much of the other capacity increases come from “upgauging”. This refers to using larger aircraft and/or refurbishing older airplanes to increase the number of seats. This increases the average seat per mile (ASM). While this does increase capacity, it makes the airlines more productive. So upon detailed examination, our assessment is that the increases in capacity are less harmful in the long run than the headline numbers suggest.
While fares in fact 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 1.2% during the January and February period 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 that to buy back stock and increase dividends rather than buying more planes, and irrationally add 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. And it is likely to stay low for a while, And even if it doesn’t most airlines have had the good sense to at least hedge a good portion of the next two years needs near current levels.
Thanks to the underperformance of the stocks many airline shares now trade at large discounts to the market, implying potential catch up and a long way to run. For example Southwest and American, which trade at just 9.2x and 7x next years’ earnings despite estimates for 21% and 17% growth respectively.
I’m partial to JetBlue (JBLU), which is not one of airlines Buffet invested in, for its focus on U.S. and South America and the fact that when new management came last year they made a commitment to being more shareholder friendly. The chart as it just recently cleared resistance at the $19 level and appears poised for a new leg higher.
But if you wish to get broad exposure to the entire airline sector and reduce stock picking risk then I’d recommend buying the U.S. Global Jets ETF (JET). It is relatively new, having launched in April 2015 but has decent liquidity and trading volume. The fund is designed to track the investment performance of the U.S. Global Jets Index, which tracks commercial airlines, aircraft manufacturers, and airport and terminal services companies around the world. The index is constructed by first selecting the largest nine U.S Airlines according to market capitalization and about half dozen of supplier such as Boeing (BA).
History teaches us to be vigilant. Accordingly, we must monitor a number of macro and carrier-specific factors so that we can identify potential risks – changes in fuel prices, irrational increases in capacity, harmful union demands, a breakdown in fiscal discipline, and/or unwise squandering of profits rather than returning it to shareholders. While there may be some bumps along the way, they are generally on the right path. And if they remain on this path they should reward investors in the long run.
By the way, an underreported fact is Warren Buffet 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.