Few sectors are as unloved by most investors as the airline sector. Multiple bankruptcies, and a history of at-best inconsistent profits have scarred many investors, and turned a host of investors away from the sector. But, as the past year has demonstrated, this has been a mistake. We have been bullish on airlines for some time, recommending that investors buy shares of four different airlines. The response to our articles has been mixed, with many investors arguing that investing in airlines is little more than a fool's errand, one that will inevitably end in losses. So far, that has not been the case. Below we detail the performance of our airline sector recommendations (data is accurate as of the close of trading on March 19).
Airline Recommendation Performance vs. S&P 500
Airline | Ticker | Publication Date | % Change Since Publication | % Change in S&P 500 Since Publication |
Alaska Air Group | ||||
Delta Air Lines | ||||
Hawaiian Holdings | ||||
US Airways Group | LCC |
Aside from Hawaiian Holdings, investors who followed our recommendations to purchase shares of Alaska Air Group, Delta, and US Airways have earned returns far in excess of the S&P 500, and we believe that in the long run, these 3 stocks (as well as Hawaiian Holdings) will continue to generate profits for investors. While many investors still do not trust airlines, we believe that over the course of 2013 and 2014, the sector will begin to win over more investors. As earnings rise, P/E multiples will as well as investors become more confident in the sustainability of those earnings. In our view, the merger of US Airways and American Airlines signals the end of the sector's consolidation. But, even as this era ends, an era of stability is set to begin.
Bankruptcy: Healing the Scars of the Past
Perhaps the biggest obstacle to attracting more investors to the sector is convincing them that one unprofitable quarter does not signal an imminent Chapter 11 filing. With the bankruptcy filing of American Airlines, every legacy carrier in the United States has now been through bankruptcy, streamlining their operations and creating cost structures that are more competitive in the long run. And consolidation (more on that later) has reduced competition amongst the legacy carriers. With the merger of American Airlines and US Airways, there will now be only three legacy carriers in the United States: United (UAL), Delta, and American Airlines (which will succeed the US Airways brand). Over the past several years, legacy airlines have been rebuilding their balance sheets; strengthening their cash reserves and paying down debt to ensure that they can withstand macroeconomic stress far better than their histories suggest they can. On a sector-wide basis, billions in debt has been repaid over the past five years and we break down the five-year change in sector balance sheets below, utilizing data from the 11 largest publicly traded American airlines (note: debt includes long-term capital lease obligations).
Airline Sector Balance Sheets: Legacy Carriers (in Millions of Dollars)
United Continental Holdings* | Delta Air Lines | US Airways Group | |
2008 Cash & Investments | |||
2008 Debt | |||
2008 Net Cash (Debt) | |||
2012 Cash & Investments | |||
2012 Debt | |||
2012 Net Cash (Debt) | |||
5-Year Decrease (Increase) in Net Debt | $2,653 | $2,469 | $338 |
*2008 balance sheet data combines figures for UAL Corporation and Continental Airlines; United Continental Holdings assumed the debts of its predecessor companies.
Airline Sector Balance Sheets: Non-Legacy & Regional Carriers (in Millions of Dollars)
Southwest Airlines | Alaska Air Group | JetBlue Airways | Hawaiian Holdings | Allegiant Travel Company | SkyWest | Republic Airways Holdings | Spirit Airlines | |
2008 Cash & Investments | ||||||||
2008 Debt | ||||||||
2008 Net Cash (Debt) | ||||||||
2012 Cash & Investments | ||||||||
2012 Debt | ||||||||
2012 Net Cash (Debt) | ||||||||
5-Year Decrease (Increase) in Net Debt | $1,674 | $983.8 | $600 | ($229.706) | $91.811 | $164.896 | $275.889 | $615.067 |
Over the past five years, the three remaining legacy airlines have made net debt repayments of over $5.4 billion and the eight non-legacy carriers have reduced (or in the case of Alaska, Allegiant, and Sprit increased net cash) net debt by nearly $4.2 billion. Our bullish thesis on the airline sector does not extend to every single airline in the industry. However, airline equities as a whole will benefit from industry-wide deleveraging, for investor confidence will increase as airlines continue to strengthen their balance sheets. This deleveraging is set to continue. Many non-legacy carriers have net cash on their balance sheet, and are set to increase this buffer against macroeconomic stress in 2013 and 2014. And legacy carriers are continuing to pay down debt. Delta has been among the most aggressive airlines in its commitment to paying down debt, and the synergies between American Airlines and US Airways, should they in fact materialize, will likely lead to accelerated deleveraging at the combined company. Industry-wide deleveraging will do more than increase investor confidence in the financial viability of the industry. It has the potential to attract a new class of investor, for the industry is poised to begin returning capital in a more meaningful way. Traditionally, the airline industry has not been about return of capital, since, as many investors are likely to jest, there was never any capital to return. However, this does not hold true for every airline. Alaska Air Group, which has one of the strongest balance sheets in the sector, has been buying back stock at a fairly aggressive rate, with its current buyback plan allowing for nearly 10% of the company's shares to be repurchased. And Delta, despite its continued commitment to deleveraging, has stated that it is looking at returning capital to shareholders, with an announcement set to occur in June. We view deleveraging in this sector as a virtuous cycle. As debt is repaid, interests costs decline, freeing up more capital for internal investments. And, as net debt levels continue to fall, interest rates on potential new debt are likely to be below historical levels, for creditors are likely to be more comfortable in lending to the industry.
While industry-wide deleveraging is a material positive for the industry, it is not the only factor that will lead to continued profits for airline investors. The end of the era of airline mergers will set the stage for a more profitable, more stable industry, and offers the potential to finally bring peace of mind to airline investors:
Not Merger Madness, But Merger Rationality: Stronger Legacy Airlines Mean Stronger Industry Returns
When the merger between US Airways and American Airlines is complete, there will be only three legacy carriers remaining in the United States, down from as many as six just a few years ago (Delta, Continental, United, Northwest, American, US Airways). Consolidation will, over the long run, lead to increased profitability for the three remaining carriers, as it reduces competition among international routes, and leads to economies of scale in the domestic market. And stronger legacy carriers are a positive for non-legacy carriers.
Many investors view the airline industry as deeply unprofitable on an aggregate basis. And we admit that there have been years where that has been the case. However, despite the fact that legacy carriers have caused these years of unprofitability, non-legacy carriers have been penalized alongside their larger brethren. We offer 2008 as proof of this. Soaring fuel costs and a weak economy saddled legacy carriers with billions of losses. Delta lost over $500 million in 2008, United and Continental together lost over $1.4 billion, and US Airways lost over $800 million. However, for carriers such as Allegiant and Republic Airways, 2008 was a year of record profits. In fact, of the 11 airlines we covered in the previous section, only four were unprofitable in 2008 (Delta, United, and US Airways, and JetBlue). The seven remaining airlines all posted profits in 2008, despite a confluence of headwinds that would make it seem as if such an outcome was impossible.
It is true that on a combined basis, the industry lost billions in 2008. But that is due to the enormous losses suffered by legacy airlines that year, and consolidation has reduced the odds of such losses from occurring in the future. We outline the reasons why below.
- Reduced competition: According to The Economist, the three remaining legacy airlines (when considering American and US Airways as one airline) control 65.9% of the domestic market. Capacity discipline, alongside carefully measured expansion, has allowed airlines to deleverage all while investing in new fuel-efficient planes (or used planes in Delta's case) and services designed to keep business travelers from switching to low-cost carriers. With the three remaining legacy carriers controlling nearly two-thirds of the market [when Southwest (LUV) is added, the market share of the four largest airlines (combining American and US Airways) rises to 78.2%], anti-trust regulators are unlikely to approve additional mergers within the industry for the time being. While airline mergers are a positive in the long run, they are fraught with integration risk in the short run, and additional mergers beyond that of American and US Airways may damage investor confidence if they are not properly executed. Are we suggesting that there will never be another airline merger? Not necessarily. There are still a good deal of regionally focused airlines that may see a merger as a way to increase their long-term profitability and growth potential. But, for the time being, we believe that the era of meaningful consolidation in the airline industry is at an end, and that the focus of management teams across the industry will turn toward running their existing businesses, and not toward mergers & acquisitions.
- Gap with low-cost carriers narrows: Now that every legacy airline has gone through bankruptcy, their gap with low-cost carriers, especially Southwest, has narrowed. And consolidation among legacy carriers has led to expanded route maps, both domestically and internationally. For many travelers, the advantages of flying with an internationally focused airline trump the savings potential of a carrier such as Southwest or Spirit.
- Rational competitive decision-making: US Airways CEO Doug Parker has been a champion of industry consolidation, viewing it as essential to the success and profitability of the industry as a whole. On multiple earnings calls, Mr. Parker has noted that one of the factors that are helping the industry overcome its past sins is a shift away from simply focusing on market share at all costs. To him, there has been a clear trend of airlines, particularly at the legacy level, shying away from measuring success by their market share to measuring success by their profitability and share price.
- Labor peace: Historically, few industries have had as tense of a relationship between labor and management as the airline industry. Multiple bankruptcies, controversies over pensions, and difficult contract negotiations have served to damage the labor-management relationship throughout the industry. For years, few airlines, besides Alaska Air and Southwest, have actively focused on ensuring that their employees are genuinely pleased to be working for them. However, in recent years, that has changed. Delta has turned its focus to creating peace with its unions as it seeks to heal its balance sheet, and US Airways ensured that it had the support of American's unions before it inked its merger agreement with American Airlines. Much of the turmoil between labor and management in this industry, especially at the legacy level, has stemmed from sporadic profitability, which forced airline employees to make sacrifices they did not view as necessary. However, consolidation will strengthen the profitability of the three remaining legacy carriers, and is likely to bring about labor peace. When airlines are consistently profitable, it inevitably reduces tension between labor and management, and allows management teams to focus on competing in the marketplace, not resolving internal disputes with employees.
Conclusions
We understand that many investors are likely to be skeptical of the airline industry, even after the meaningful progress that has been made over the past several years. Billions of debt has been repaid over the past five years, and deleveraging is set to continue as airlines maintain a fine balance between investing in their business and strengthening their balance sheets. And with the number of legacy airlines set to fall to three once American Airlines and US Airways merge, industry-wide profits are likely to rise in the long term as competition is reduced. Healthier airlines will lead to further peace between management and airline employees, and with many management teams now focused on shareholder returns rather than market share, airline investors should benefit. After years of turmoil and uncertainty, we believe that the airline industry is poised for an era of stability. In the long run, we think that an investment in the airline industry will be a profitable one. The airline industry of today is nothing like the industry of even a few years ago. And as more investors come to realize this fact, we believe that share prices of many companies within the sector will continue to rise.
Disclosure: I am long DAL, UAL, LCC, ALK, HA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
