History weighs heavily on the minds of airline investors, keeping a lid on stocks’ valuations. Yet the industry has undergone enormous change over the past decade, so it’s possible that the market isn’t giving airline stocks a fair shake.
There has been plenty of reason for concern. Multiple bankruptcies, oil- price shocks, labor strife, and too rapid capacity growth are high on the list. It wasn’t so long ago that Warren Buffett said the best way to become a millionaire was to start out a billionaire and buy an airline.
The smart money, it seems, avoids airlines. Perhaps it shouldn’t.
For starters, the four largest U.S. carriers, including their regional affiliates, have about 80% of the domestic market. The business is still competitive, but the sector looks more like an oligopoly now. Economic theory suggests having a handful of companies control most of the market leads to better profits.
So the structure of the industry favors airlines now. What about oil, capacity, and labor?
Oil is a dotcom-era issue
Oil prices don’t really matter for the sector. That may surprise investors. Energy prices are certainly important. The four major U.S. airlines have spent more than $140 billion on jet fuel over the past five years, about 20% of sales. That’s a lot, but everyone pays roughly the same amount for fuel, so as long as prices are stable, airfares adjust and no airline has a competitive advantage—or disadvantage.
The playing field wasn’t level at the turn of the century, when oil prices went from $20 a barrel to $140 between 2001 and 2008. The rapid rise was problematic—higher ticket prices hurt demand—but a bigger deal was differences in fuel-hedging policies among airlines.
Southwest Airlines (LUV) has always hedged fuel. As prices escalated at the turn of the century it was a hefty benefit. From 2002 to 2008, Southwest’s hedges earned the low-cost airline more than $3.2 billion—close to the carrier’s aggregate operating profit over that span. Precisely defining the impact on domestic fares is difficult, but ticket prices would have had to rise for Southwest to earn similar margins in the absence of hedges.
“One of the main reasons we hedge our oil is to protect against unexpected events,” a Southwest spokesperson tells Barron’s. “We’re one of the few in the airline industry that has an active fuel hedging program—at least in the United States. We think it’s the wise and prudent thing to do.”
That is probably correct. But as long as prices are stable, the cost of jet fuel shouldn’t affect airline stocks in the long run.
Too many seats? Forget it.
Airline profits are a function of supply and demand. When capacity grows too fast, profit margins start to fall. U.S. capacity growth, however, is slower than in the past, and generally matches increases in overall demand. Low-fare carriers, such as JetBlue (JBLU), for instance, are growing more slowly after pushing into the market at the turn of the century.
Since the end of the financial crisis, growth in total airline capacity has lagged behind the increase in consumer spending 80% of the time. Modern airline management teams, it appears, are more concerned with margins than with market share.
Don’t sweat over labor
Wages and benefits, like fuel, account for a huge portion of an airline’s costs. The four largest U.S. carriers spend about 27% of sales on labor. But every airline is in the same boat, limiting the effect on any one carrier.
“[Airline labor negotiation] is almost pattern bargaining now,” American Airlines (AAL) CFO Derek Kerr tells Barron’s. “There won’t be a labor-cost advantage.”
American has been dealing with labor strife recently. Its mechanics have been working without a contract since 2018. But Kerr doesn’t believe a new contract, even if it includes higher pay rates, will hurt American in the long run. Everyone will end up paying mechanics, pilots, and flight attendants similar wages.
Things are better than they were for the sector. And the changes are reflected in carriers’ financial statements. Profit margins have improved and debt is lower. Delta Air Lines (DAL), American, and Southwest now pay dividends. Debt issued by Delta and Southwest is rated at investment grade.
What hasn’t changed is the amount people are willing to pay for airline stocks. The sector still trades for less than 8 times estimated 2020 earnings, a 60% discount to other consumer- discretionary stocks in the S&P 500 (.SPX).
Most investors, it seems, can’t break free of the history, although one has. Warren Buffett, the originator of the airline quip, is now a huge holder of airline stocks with big stakes in the four largest U.S. carriers: Southwest, Delta, American, and United Airlines (UAL).
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