Most of us who have invested in airline stocks would view the headline with skepticism or outright contempt. Historically airline stocks have experienced large volatility due to an array of factors like constantly fluctuating fuel prices, frequent labor disputes, enormous debt levels, and high capital costs. From time to time we have bled money fist over hands on these stocks. Now it is payback time. I believe things have come full circle and it is time to make some money from the airline stocks. There are several reasons why the industry is returning to profitable ways.
Over the last several years there has been a wave of consolidation in the airlines industry. The most prominent ones include Delta's (DAL) purchase of Northwest Airlines in 2008, Southwest Airlines' (LUV) acquisition of AirTran in 2011, and United Airlines' (UAL) merger with Continental Airlines in 2011. The most significant impact of this consolidation has been an increase in the load factor. Historically the load factor for U.S. carriers ranges from 65 to 75 percentages. But in 2011 the average load factor was 83%. This implies that there are more passengers per flight helping the airline carriers realize higher revenue. Consolidation has also led to a better competitive environment. In the past, airlines have sabotaged themselves by unprofitably expanding capacity, adding routes and engaging in price wars in bids to gain market share. But this is not the case anymore. Companies are focusing on increasing their profitability in markets where they have a stronger presence rather than engaging on turf wars.
Almost one-third of the costs incurred by airlines are fuel costs. So managing the fuel costs is an integral part of maintaining or improving profitability. Airline companies have taken proactive steps to control the fuel prices. These include but are not limited to:
- Use of technologically advanced fuel-efficient aircraft. For instance, according Boeing (BA), the new 787, which incorporates a new wing shape and composite body shell, should reduce fuel consumption by up to 20 percent.
- Acquisition of oil refineries. In April, Delta announced that it would buy an oil refinery in a bid for a long-term solution to skyrocketing fuel costs. Delta expects that this move will help save about $300 million annually. This is a new trend in the industry and several companies are touted to follow this trend.
- Airlines have also used hedging as an effective way to counter the impact of fluctuating fuel prices. Southwest's aggressive fuel hedging has helped the airline avoid some of the pain of the recent airline industry downturn resulting from high fuel costs. Between 1999 and 2008, Southwest saved approximately $3.5 billion through fuel hedging.
Airline companies have increased their revenue by charging for ancillary services like checking in additional bags, priority seating, extra leg space and so on. The revenue from the ancillary services has become critical to the bottom lines, keeping airlines out of the red even when fuel prices are high. In 2011, such revenue rose to an estimated $32.5 billion worldwide, up 43.8 percent from the estimated $22.6 billion a year earlier, according to the Amadeus Worldwide Estimate of Ancillary Revenue.
The four top earners in this category are United Continental ($5.2 billion), Delta ($2.5 billion), American (AAMRQ, $2.1 billion) and Southwest ($1.2 billion)
The Standard & Poor's Dow Jones U.S. Airlines index gained 31.1% in 2012, beating Standard & Poor's 500-stock index by nearly 15 percentage points. It is time to get on the caravan for airline stocks, but it is meant for the long journey so caution is the word for travelers planning to hitch a short ride.
Note: This is a qualitative analysis of the airline industry and the industry trends. Further quantitative and qualitative due diligence is required in selecting stocks and determining investment timing and volumes.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.