Airline valuations are incredibly low but the risks are also high, especially if a recession arrives.
Demand fell by 20% and stocks fell by more than 90% in 2009.
The global long term outlook is very positive with demand expected to double in the next 15 years.
In his 2007 letter to shareholders Warren Buffett stated that airlines are the worst sort of business because they require significant capital to engender growth and earn little or no money. He continues that creating a durable advantage has been elusive since the days of the Wright Brothers and even concludes that “if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.”
So, why should we even write about airlines? Well, because there is always the question of how cheap can a bad business be and if money can be made by investing in it, by going long or short. Even Buffett was tempted by airlines and invested in US Airlines in 1989 by purchasing convertible debt. He did not make any money but neither did he lose. This article is going to give a snapshot of the current situation and analyze the risks and rewards of investing in airlines.
As the sector is practically always in some kind of turmoil, there is no long lasting ETF to take as an example of how the sector has done. The only ETF that is a pure sector play is the U.S. global JETS ETF made of 70% U.S. airlines with the rest is spread among global airlines and plane manufacturers. The ETF is young as it was founded in April 2015, but is a great example of the industry’s volatility.
Figure 1: JETS ETF performance since inception. Source: Yahoo Finance.
Even if the S&P 500 is again near its all-time high, the airlines ETF is close to its all-time low. The ETF’s PE ratio of 7.28 is what makes many investors tempted by the sector and the potential returns, but the low PE ratio is due to the low oil prices that have been a strong tailwind for airlines in the past year. The average daily spot price for oil in 2015 was $52 per barrel while it was $99 in 2014. As oil makes up about 25% of airline costs, the price decline significantly increased profit margins. For example, American Airlines Group’s (NASDAQ: AAL) gross margin increased by 20% and brought a current PE ratio of 2.6.
Such low PE ratios could mean two things, either the market is crazy and can’t see value or something bad is going to happen and therefore the low prices. The reasons for the low prices and low PE ratios are the BREXIT, expected macroeconomic turmoil and higher oil prices, but nobody knows if any of those risks will ever materialize.
The historical chart of AAL shows how bad or good an airline investment can become if done at the right or wrong time.
Figure 2: AAL 10-year chart. Source: Yahoo Finance.
The losses tell us to be careful, but the upside tells us to be daring.
The global outlook for air traffic is positive and one of the most positive ones we have yet seen here. Airline traffic has doubled every 15 years and is expected to double again in the next 15 years.
Figure 3: World annual traffic. Source: Airbus.
This growth is mainly going to come from emerging markets as they are expected to grow at an annual rate of 5.8%, while advanced economies are expected to grow at “only” 3.8% in the next 20 years. The full potential for the airline industry can be seen from the trips per capita chart below.
Figure 4: Trips and GDP per capita. Source: IATA.
As most of the global population is far below the average number of trips per capita in the developed world the expected increase in the global middle class will for sure bring the above mentioned doubling of air traffic in the next 15 years. India is still below 0.1 flights per capita.
But there are some negative shadows on the positive future outlook. The growth for airlines is not going to be a smooth one as there are always threats from terrorist attacks, strikes like the current ones in Europe, higher oil prices, fierce competition from low cost carriers, various BREXITs and the worst case of all for airlines, a recession. A recession is always very detrimental as business and people immediately save on flying. In 2009, demand fell by more than 20% and with pretty much all the costs being fixed, all airlines suffered a big blow.
Figure 5: Great recession impact on airlines. Source: Wall Street Journal.
Now that we know what the risks and potential rewards are, let us see what the pros and cons are of various investing opportunities
There is always the possibility to directly invest in an airline. On top of the above mentioned systemic risks like a recession or fierce sector competition, investing in an individual airline comes along with company specific risks like strikes or plane crashes that can quickly erase all the gains of an investments. To avoid specific risks, the already mentioned U.S. global JETS ETF is a good idea but then the returns will also be in line with the general market which is still very elastic to the global economy and political turmoil.
A more stable investing opportunity is to invest in aircraft manufacturers like The Boeing Company (NYSE: BA) or the Airbus Group. But the cost of such an investment is also higher with both companies having a PE ratio of 17.5.
Air traffic is going to grow in the future thus there will be great investing opportunities, but the volatility brought by the sector and economic elasticity is a big warning. Investors must not forget that there are practically no barriers to enter the business and no switching costs for customers which brings intense rivalry. Such an environment brings low margins and losses; since the 1978 airline deregulation, the industry as a whole has lost $35 billion.
As for investing, risk adverse investors should not invest in the sector and risk taking investors should carefully analyze the situation, be ready to withstand losses of more than 50% and create a strategy which can seize the upside opportunities created by potential and sharp price declines.
Let us finish with a nice quote from Herb Kelleher of Southwest Airlines that clearly describes the fierce competition in the industry: “If the Wright brothers were alive today, Wilbur would have to fire Orville to reduce costs.”