Airlines Pair Trade

The straight six-week market rally has been accompanied by a drop in the market's volatility. As you can see from the chart below, the Chicago Board Options Exchange's Volatility Index (VIX) has come down from its peak at 80 set on Oct 20, 2008, to the current level of 35. Though it is still much higher than the average 10-20 range, at least the market looks much more stable than before.

click to enlarge

Source: Yahoo Finance as of 04/16/09

According to a recent issue of CFA Institute Magazine, now that volatility has subsided, asset managers have returned to the market and are cautiously implementing trading strategies in a search for value.

One of the popular long-short strategies is Pair Trade. A pair trade is the taking of a long position in one security together with an equal short position in another that is strongly correlated with it, usually within the same industry.

I used to work in the aviation industry for an Israel based US public company. Based on my knowledge and most recent data, my strategy is to short major passenger airlines and long package carriers (such as UPS and FedEx). The following provides summary data for those companies:

Source: Yahoo Finance as of 04/16/09

I want to short major passenger carriers based on the following reasons:

1. Due to the discretionary nature of business and leisure travel spending, airline industry revenues are heavily influenced by the condition of the economy. The March 2009 monthly traffic results released by the International Air Transport Association (IATA) titled Freight Stabilizes, Passenger Drops. In its financial forecast published in March 2009, IATA expects cargo traffic to fall by 13%, passenger traffic to be down 5.7% and airline revenues to decline by 12%. On April 16, 2009, The Wall Street Journal Online reported that Southwest Airlines (LUV) CEO Gary Kelly said he's "not ready to call the bottom just yet," despite signs that air traffic has started to stabilize (reported this week by AMR as well) after a sharp downturn earlier this year.

2. The industry remains heavily indebted and has significant obligations (including substantial pension funding obligations). None of those major passenger airlines in the table above have positive operating cash flow. On contract, UPS and FDX are still profitable. Standard & Poor's just placed SouthWest (one of the best run airlines) on credit watch with negative implications after it posted its first quarterly loss since 1991. The equity value of the AMR Corporation, parent of American Airlines, and United Airlines (UAUA) is negative: their liabilities are more than their assets.

3. Airlines may also be significantly affected by changes in fuel prices, which may be very volatile. Due to the competitive nature, airlines may not be able to pass on increased fuel prices to customers by increasing fares.

However, there are also bright sites for this industry:

1. Though February premium airfare plunged 21% from a year ago, that was a more normal cyclical slump – falls of more than 20% have been experienced in past downturns.

2. A slowing decline in travel deterioration between Europe and the Far East may be a tentative sign the drop off has hit a floor. According to IATA, Europe to Far East premium travel declined 19.6% in February compared to 21.2% in January.

3. Lower oil prices should bring about substantial fuel cost savings in 2009. IATA estimates airlines’ fuel bill will fall $52 billion this year to 25% of operating costs.

4. Airlines have been able to shrink capacity in line with the fall in demand, and are forecasted to turn large 2008 losses into a small 2009 profit. For example, FedEx Corporation said this past Monday that it will permanently remove 14 jets from service as part of an overall plan to reduce capacity in the current recession.

The only major passenger carriers in North America that still has positive operating cash flow is WestJet Airlines (WJAVF.PK), which is listed in Toronto. WestJet’s fleet is comprised of a 76 Boeing Next-Generation 737 aircraft (737-600, 737-700 and 737-800). It basically clones what SouthWest does: low fare, pure type of fleet for easy maintenance and crew training, etc.

As always, you can certainly play with ETFs instead. Claymore/NYSE Arca Airline (FAA) is the 1^st and only airline ETF, which began trading on January 26, 2009. Its assets, however, are only $2 million.

Another related one is iShares Dow Jones Transportation Average (IYT). IYT includes companies in airlines, trucking, railroads, air freight, transportation services and industrial services. With asset of $212 million, its top 3 holdings are BURLINGTN N SANTE FE (BNI) 11.7% , UNITED PARCEL 10.3% and FEDEX 8.8%.

Disclose: I have a short position on UAUA and a long position on UPS.

Comments

[Positroll:]

What about local carriers? E.g. PNCL? Looks extremely cheap at the moment (below $2) given their tangible book value of > $7 AND they have positive cash flow, too ... Now if they only could agree on a contract with their pilots ...
PT
Disclosure: Long PNCL

Apr 20 05:59 AM

[notsosmart:]

you want to be a millionaire,start as a billonaire & invest in airlines.by the ceo of virgin.

Apr 20 03:13 PM

[ybtrader:]

you missed the short by about two months.......the airlines are currently trading at nearl lows...the upside risk is much worse

Apr 20 07:04 PM