Airlines Ready For Take-Off?

by: Brett Korsgaard

The airline industry has generally made for better theater than for profitable long-term investing. The industry is seemingly plagued with a “built-in” propensity for bankruptcies, mergers and a variety of Wall Street financial engineering to sustain whatever airline is in need of a lifeline.

There are exceptions to be sure (Southwest Airlines (NYSE:LUV) perennially the most stable of the bunch) but generally the business model with inherent high fixed costs, reliance on volatile fossil fuels and seemingly intractable labor issues is a recipe for instability and the feast or famine nature of its profitability. Yes, the airline business is inherently a “lousy” one and there is really not much that can be done about it. You can take the best management team in the world and apply it to this industry and you will still be hit with more turbulence than your worst trans Atlantic flight. There are just too many variables that can impact the fixed costs of this business to guarantee a smooth landing for long-term investing.

Market Volatility Hitting Airlines Unnecessarily

For investors taking a short to mid-term time horizon, however, there are plenty of ways to make money in this business. I am not a trader by nature but there are times when pessimism creates troughs that are terrific entry points. I believe that now we are at one of those inflection points where an investment may make sense.

Volatility in the equity markets have hit the airlines particularly hard. This has happened in the face of increasing demand for air travel as pent up demand consumers who have held back on travel during the recession are taking to the skies. Couple this with three years of capacity cuts and you have an industry that may be on the cusp of generating strong profits off increasing revenues. Anyone traveling knows that load factors (industry parlance for how much of an airline's passenger carrying capacity is used) are way up as airlines have scrambled to become more efficient with capital in the wake of rising fuel costs.

Fuel Prices A Wild Card

With the long-term price of fuel likely to rise, the latest sell-off in commodities (including oil) gives the industry breathing room to hedge fuel costs at lower prices. The markets seem to be ignoring that this protracted drop in fuel prices is a golden opportunity for the industry. Couple this with aggressive investment and adoption of biofuels by the U.S. Air Force and Navy and you have a potential game changer for the industry. If biofuels can be manufactured cheaply and at scale, who knows where the long-term profitability of the industry might be. While this could be a boon to biofuel makers such as Amyris (NASDAQ:AMRS) and Gevo (NASDAQ:GEVO) it gets a heck of a lot more interesting for an industry that has been held hostage by high prices of oil from unstable sources.

Airlines: Ready for Take-Off

Airline Current Price PE Ratio Summary
United Continental (NYSE:UAL) $20.52 17 Merger is generating huge economies of Scale. Global footprint unmatched in the industry.
Delta Airlines (NYSE:DAL) $7.95 25 2nd largest airline will enjoy benefits of scale, reach.
American Airlines (AMR) $3.14 - Under funded pension liability and high debt load are issues. Priced accordingly however and with ample liquidity.
Southwest Airlines (LUV) $8.63 13 Low cost culture and still biggest and best in its "short haul" flight niche
Alaska Airlines (NYSE:ALK) $57.98 7 Best fuel hedging position in the industry. Stable grower.
US Airways (LCC) $6.10 4 5th largest airline. Lost in the shuffle, but valuation and low expectations compelling.

The above list is a good reference point for those looking to do further research for investment purposes. Most of these airlines present compelling values at this juncture and it is likely just a matter of time before that value is unlocked by changing investor sentiment. Of course, history has shown that it is better not to get too greedy with gains should they materialize.

Disclosure: I am long AMRS.