Steer Clear Of Airline Stocks, Don't Be Fooled By Near-Term Commentary

by: Valuentum

Whenever we see a bullish article on airlines such as this one, we are compelled to remind individual investors that airline stocks are merely speculative bets on changes in the direction of crude oil prices and the economy. As we outline in our airline industry primer:

As many airline executives may attest, both unit revenue and unit cost are largely out of their control. For one, air travel service is largely commodified and suffers from substantial and intense fare competition driven by severe price transparency and the unavoidable concept of perishable inventory -- when a flight takes off, empty seats cannot be filled. Such a combination is the weight that keeps real pricing (yield) growth from being sufficient to meaningfully alter the long-term economics of the industry. To do this day, network airlines are still forced to match fares offered by low-cost carriers or suffer even greater revenue declines. Fare increases can only be sustained if they are matched permanently by low-cost peers [like Southwest or JetBlue (NASDAQ:JBLU), for example].

Further, with barriers to entry primarily limited to capital costs (any U.S. carrier deemed fit by the Department of Transportation can operate passenger service in the U.S.), it's safe to assume that we haven't seen the last domestic start-up, even after the most recent failure of upstart Skybus. The mere existence of interested, economically-tied parties (like Boeing, for example) seem to suggest that new entrants will always pose a threat to dump unwanted capacity on otherwise healthy routes. Perhaps unsurprisingly, one can even tap Boeing's expertise in launching an airline: Starting an Airline. The poor performance of systemwide -- domestic and international -- real yields (pricing) across U.S. airlines is displayed in the chart below, a trend that is very unlikely to change anytime soon:

(Click to enlarge)

As an airline's unit revenue is pressured by intense pricing competition, its unit cost is significantly impacted by the price and volatility of jet fuel. According to the Air Transport Association, jet fuel now represents more than a quarter of industry operating costs, surpassing labor expenses as the largest cost item. Although airlines may hedge fuel to some extent, such a strategic move is financial and should not be viewed as an operational boost or any sort of sustainable competitive advantage. And due to the presence of low-cost providers, network carriers have traditionally found it difficult to hike fares or charge additional fees sufficient enough to pass along these rising energy costs.

Though we've made some money trading put options in the Guggenheim Airline ETF (NYSEARCA:FAA) and AMR (AMR), the parent of American Airlines, in our Best Ideas Newsletter, we maintain that airline stocks are not long-term investments, regardless of what sell-side analysts or respected journals may posit.

The stories about shedding capacity, rightsizing route structures, pursuing ancillary revenue streams (checked baggage, etc.) are not new news. These modest and relatively inconsequential improvements in industry dynamics have been around for years, and perhaps Barron's has best summed it up by revealing the performance of such stocks since then:

AMR, parent of American Airlines, is down 57% this year to about 3.50, not much above its 2009 low. Delta (NYSE:DAL) is off 40% to 7.50; United Continental (NYSE:UAL) has fallen 25%, to 18; Southwest (NYSE:LUV) has dropped 37%, to 8.25; and JetBlue (JBLU) is off 37%, to 4.15.

As subscribers to Valuentum know, we were ahead of the move on AMR, and we continue to believe that the firm's shares are practically worthless, as we wrote in this May 17 article published on Seeking Alpha (we have since closed our put position, however). As for the other domestic carriers, we maintain that investors should steer clear of the group.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.