By Basili Alukos
The domestic airline industry has been one of the worst-performing industries in history, cumulatively losing money from its inception. The past decade proved to be particularly trying, as the 9/11 attacks, the oil-price surge, and the 2008 recession forced the industry to adopt and change course abruptly. Impressively, the domestic industry survived the past three years without any major bankruptcy, and the shares have rallied substantially since, causing us to rethink both our valuations and our thesis on the airline industry. In this piece, we analyze the financial effect of oil prices, explore the financial burden of the 9/11 fees, and explain our thoughts on the industry's current valuation.
Rising Oil Prices
The airline industry has endured substantial obstacles in the past, but rising oil prices over the last decade proved nearly disastrous. When the major legacy carriers emerged from bankruptcy beginning in 2005, business plans forecasted oil prices of $80 per barrel, and some industry participants commented how difficult it would be for the industry to cope with oil prices above $100 per barrel. Although airlines have traditionally offset rising fuel prices through ticket price increases, we believe intense competition has stopped the industry from passing along the entire increase.
The chart below shows the fuel consumption statistics for the U.S. domestic airline industry since 2000, and our cost variance analysis broken into two parts: gallons consumed and price per gallon.
Over this span, we estimate that the industry spent an additional $27 billion in fuel costs based on higher oil prices. As fuel prices increased, however, the industry did not sit idle. As the chart above shows, by reducing gallons consumed the airline industry saved $6 billion in fuel costs over the past decade, almost entirely by improving fuel efficiency.
In the chart below, we dissect the gallons consumed variance between change in industry capacity and fuel efficiency, as measured by improvements in available seat miles per gallon.
click on charts to enlarge
Thus, despite any capacity expansion over the previous cycle, the industry managed to save nearly three billion gallons of fuel by grounding older aircraft and improving fuel consumption via such actions as adding winglets and removing excess weight. Consequently, available seat miles per gallon increased nearly 20% to 60 miles per gallon, from 50 miles per gallon in 2000.
Looking ahead, the airline industry is pursuing alternative fuel sources aggressively; some of the world's largest carriers have already conducted test flights with synthetic fuel. In addition, engine and airplane manufacturers claim that the next generation aircraft should deliver 20%-30% better fuel efficiency versus today's fleets, suggesting that fuel-economy gains should continue going forward.
9/11 Security Fees
Even nearly a decade after the horrific 9/11 attacks, the airline industry still operates at a heightened level of security, as the December 2001 failed shoe bomber attack and numerous diverted aircraft serve as constant reminders of the risk of flying. To enhance security at our nation's airports, the government imposed, among other things, a 9/11 Security fee on passengers of domestic and foreign air carriers for air transportation that originates at airports in the United States. The fee, collected at the time the ticket is bought, is $2.50 per enplanement and is imposed on not more than two enplanements per one-way trip.
The chart below, provided by the Transportation Security Administration, shows that the TSA has collected more than $13 billion in proceeds since the inception of the 9/11 fee through 2009, and we estimate that TSA will collect another $12 billion over the next six years.
True Cost for Security
That said, we believe the true toll for the airline industry is far less than the above $25 billion since the economics of taxes suggest that both the customer and the supplier burden part of the tax, and our discussion below attempts to quantify what is the potential cost to the industry.
We admit that the $2.50 surcharge represents a fraction of an average ticket price, and that the entire industry should have the capacity to increase its fares and not have passengers balk at the increase. However, the industry sells perishable inventory, and high operating leverage presents a massive incentive to discount tickets and fill seats. Moreover, we view flying as a commodity product, so passengers are driven by price because they are mostly indifferent about which airline they fly.
As such, we believe the industry often lowers prices to fill seats--numerous reports that price increases to the tune of $5 to $10 have failed further corroborate our thoughts--and thus we think that even a nominal tax could result in a similar failure.
That said, we believe that certain low-density routes and most business travelers are not price sensitive, and that customers will accept most price increases, although the substantial declines in business travel after the Internet bubble burst and the 2008 recession indicate that even business passengers can be price sensitive. We believe leisure passengers are most sensitive to price increases and that the industry must subsidize their 9/11 fee or risk losing demand.
Arriving at Our Revenue-Loss Assumptions
Aside from our negative view of the industry's economics, we arrived at our revenue-loss estimates using a two-tiered approach. First, based on our above discussion, we assumed that the industry could pass through 100% of the fare increase for business travelers due to their price inelasticity and that the airlines would split the cost evenly with leisure travelers.
With these basic assumptions as our starting points, we calculated the monthly price changes from the Bureau of Labor Statistics' Airline Airfare Index from January 2001 to October 2010 and compared them to the Consumer Price Index to gage the industry's success at outpacing inflation. During this 119-month span, the airline airfare index outpaced overall inflation for only nine months (or 6% of the time), suggesting that the industry is ineffective in pushing price. Therefore, we adjusted our starting assumptions downward and arrived at the revenue lost assumptions below.
Based on this analysis, we estimate that the 9/11 taxes may have cost the airline industry $5 billion to $6 billion of lost revenue from 2002-09, and we estimate that the continuation of the 9/11 fee may cost the industry $4 billion to $5 billion from 2010-15--as shown in the chart below. Stated differently, our analysis implies that the airline industry has the ability to pass through roughly 60% of the cost increases.
As if these costs aren't enough, the failed Christmas Day bomb attempt in 2009 renewed the government's effort to increase airport security measures, and the current administration has proposed to increase the tax $1 per year beginning in 2012, to $5.50 in 2015. The government claims the rate increase is necessary since the current fee has remained unchanged since 2002, and current collections cover only 36% of the TSA's costs. We estimate this tax increase schedule would result in the airlines losing an additional $3 billion in revenue between 2012 and 2015, bring the combined estimate of revenue loss from the 9/11 fee to between $7 billion and $8 billion through 2015.
Our Current Take on Valuation
Aside from the unforeseen events, such as terrorist attacks or weather-related stoppages, the substantial amount of operating and financial leverage innate in the airline business present various outcomes for the potential residual value of an airline's equity. For instance, adjusting the midcycle load factor (utilization) by 1 percentage point changes our fair value estimate for some airlines by upwards of 20%.
To understand present market valuations, we assumed that the current share prices reflect the accurate future performance of each firm, and calculated the implied discount rate the market assigns to each firm during a nominal growth period (referred to as perpetuity value), then compared this rate to a discount rate that we believe is sufficient to capture the risk associated with an airline.
Using the companies' reported financial data as of Sept. 30, 2010 and the ending November market capitalization, we've calculated the implied enterprise values below.
Next, we constructed a simple two-stage valuation model. For the first stage, we created a three-year forecast period using current market estimates and made three simplistic assumptions-- capital expenditures equal depreciation, working capital needs mostly offset cash collections, and income taxes do not apply due to the massive historical net operating loss carryforwards. We discount this free cash flow over a three-year period using a 10% weighted average cost of capital. The chart below shows the market's estimated value of each airline during our first stage.
In the second stage, since we already calculated the implied enterprise value, we derive the remaining value of the firm by subtracting our estimated value of each firm during the first stage from the implied enterprise value (see chart below).
Thus, we derive the market's implied perpetuity value of each airline--see remaining company value column above.
In the chart above, we calculate the implied perpetuity divisor by dividing our discounted expected free-cash-flow estimate for year four (or the first year of stage two) by the remaining company value. Stated differently, we use current prices to determine the discount rate the market is using to value the future prospects of the industry. We also converted the implied perpetuity divisor into an exit multiple by dividing the remaining company value by our projected year-four free cash flow estimate.
Our simple exercise shows that there are pockets of undervalued (United, Southwest, US Airways, Alaska and AirTran) and overvalued (Delta and AMR) stocks within the industry. Before investors place their money in the undervalued camp and short the overvalued bucket, we caution that our perpetuity value process is likely more appropriate for companies that possess strong competitive advantages and have traditionally generated returns on invested capital that are at least equivalent to their cost of capital over the long term--two conditions that almost all airlines fail to pass.
To that end, the three major mergers since 2008 (Delta-Northwest, United-Continental, and recently announced Southwest-AirTran) are substantial positives for the industry, as these three companies will account for nearly 65% of the domestic airline capacity compared to around 40% heading into the recession. Moreover, the concerted reaction by all airlines to implement ancillary fees (although Southwest remains committed to its bags fly free campaign) suggests rationality is permeating the industry.
While these actions augur well for the industry and our thoughts about competitive advantages in the space, we still think the poor characteristics of the industry, including low barriers to entry and nonexistent customer switching costs, will prevail and we're not ready to upgrade any of our moats or moat trends. High fuel prices and restrictive credit spared the industry from any meaningful new startups or substantial expansion during the 2008 recession, but we view these impediments as transitory at best. Until we gain better confidence that the airline industry has evolved into a more rational industry, we believe investors should view these companies as mere trading instruments, and not long-term value investments.
Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.