Image Source: Amy McTigue
We’ve said it before, and we’ll say it again: the airline industry is not well-suited for long-term investors. The industry that we’re talking about is the airline industry and includes companies such as United Continental (UAL) and JetBlue (JBLU), not the aerospace industry and its constituents such as Boeing (BA) and Precision Castparts (PCP), which are involved in aircraft-making and have fantastic business models. More on commercial aerospace here >>
Today, we’re reiterating our view that most airline stocks should be viewed as nothing more than boom-or-bust, speculative vehicles. Perhaps the biggest issue with airlines is that the factors that drive their revenue and costs are largely out of their control. In other words, an airline can’t do much to guarantee profits through the course of the cycle. An airline’s costs are a function of fuel prices and labor–and we don’t need to remind you of the difficulty of predicting crude oil prices (XLE, USO)–while an airline’s revenue is almost entirely dependent on the trajectory of the economy (passenger travel) and the actions of others’ capacity decisions.
The relationship between capacity and demand growth, as measured by the industry’s load factor, has had a mixed history, and while such false warnings of excess capacity (available seat miles) have happened before, it seems as though the industry is moving itself toward another potentially sticky wicket…yet again. For several years now, airlines have been realizing the benefits of positive economic trajectory in the form of increased passenger travel, but have they now begun to grow capacity too quickly, a dynamic that inevitably pressures prices and real yields?
American Airlines Group (AAL) CEO Doug Parker doesn’t think so.
The enthusiastic and flamboyant roll-up artist, who merged America West into US Airways and then that combined entity into American Airlines Group, claims the industry has learned its lesson from past examples of companies growing too quickly ahead of passenger demand growth. In situations when airlines flood the market with ‘seats,’ certain routes that have too many flights are then priced aggressively to capture demand. This results in each flight operating at a less profitable level between city pairs.
Southwest Airlines (LUV) has been toying with its expected expansion of available seat miles for 2015, initially raising the targeted growth rate from 6% to 7%, then to 8%, then back down to 7%. Management brushed this off as nothing more than approximations that caused a reaction, but the firm also said the US economy isn’t growing as rapidly as it had originally expected. Southwest, American Airlines, and other participants appear to be telegraphing their capacity moves, so as to not upset the delicate balance of supply that has paved the way for airline industry profits in recent years.
The International Air Transport Association (IATA) projects the global airline industry’s net profit margin will increase from 2.2% to 4% in 2015, mostly due to shrinking fuel costs. In its semi-annual report, released mid-year, the IATA noted that due to the strengthening US dollar, North American airlines are expected to realize much higher profit margins than their Asian and European counterparts, on a US dollar basis. Though the “correct” measure of an airline’s true weighted average cost of capital (WACC) may vary, the industry is on track to generate economic value for investors in 2015 for the first time in history, according to the IATA.
Image Source: IATA
Here’s the key takeaway: the notion that it has taken nearly seven years of positive economic growth from the March 2009 panic bottom (read: peak of cycle) coupled with significantly reduced input costs (jet fuel)–both of which were of no doing by the airlines themselves–to produce a positive economic profit for the first time ever should be enough to convince you that the airline industry is not really an investable universe of equities.
A savvy industry observer may even argue that the airlines are simply getting lucky with the current supply/demand balance and that the group will surely become overzealous yet again as it has so many times in the past. Bulls (“longs”) will pound the table that “this time is different” because, in their view, industry consolidation has eliminated the factors that created the value-destroying capacity growth trends and the price wars of yesteryear.
But how can that be? As recently as a few weeks ago, American Airlines’ CEO Doug Parker vowed that he will “compete aggressively” to match low-fare rivals. It doesn’t sound like the industry has “it” figured out just yet, and if it takes a perfect operating environment for the airline industry to generate a shred of economic profit, as it might do in 2015, how can we point readers in the direction of this industry?
We can’t. We’re staying grounded, and we think long-term investors should, too.