Why Airlines Aren't Taking Flight - Bezek's Daily Briefing

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Includes: LUV
by: Ian Bezek

Summary

Markets were quiet following the 3-day rally.

Airlines continue to see their shares struggle despite the drop in oil and rise in industry profits.

Why Southwest outperformed in the past, and probably won't in the future.

After the explosive three-day rally, stocks took a breather on Thursday. Markets were slightly negative, with the exception of the Nasdaq (NASDAQ:QQQ) which had a larger loss on the day.

Following such a large rally, it's natural that markets should pause for a day or two. Next week will be pivotal for determining whether or not the bulls can build upon this momentum-changing move.

Since there really wasn't much that caught my eye on the day, let's zoom out a bit and discuss the continuing woes of the airline industry despite the huge tailwind from oil prices.

Airlines: Still Not Ready For Liftoff

A recession is when you have to tighten your belt; depression is when you have no belt to tighten. When you've lost your trousers - you're in the airline business.

- Sir Adam Thomson

If the Wright brothers were alive today Wilbur would have to fire Orville to reduce costs.

- Herb Kelleher, Southwest Airlines

If we went into the funeral business, people would stop dying.

- Martin R. Shugrue, Vice-chairman Pan Am.

Airlines are a legendarily bad business - once of the worst imaginable. Let's consider for a second what makes a good business.

The normal answer would involve some of the following criteria: Strong moat, limited fixed costs, high margins, strong brands, resiliency in economic downturns, good labor relations, etc.

What defines airlines? They score points on precisely zero of those criteria. They're pretty much the textbook example of everything wrong with a business.

Airlines have (generally) no moat. If your routes are doing well, competitors will come in with their own planes and charge less than you. Airlines have huge capital costs. You can buy airplanes. A new Boeing (NYSE:BA) 747-800 costs you roughly $350 million a pop. Or you can lease them, tying you into long-term contracts that you must service, come hell or high water.

And high water comes frequently for the airline industry; the aviation sector is among the most badly impacted by economic problems. Both business and leisure travel demand drop sharply at the slightest economic headwind, and cargo volumes also decline. You also have unique risks including terrorism, infectious disease outbreaks, weather/natural disasters and so on.

Airlines also have hideous brands. They're well-known, generally, by the public. But not in a good way; airlines are often up there with cable companies and the IRS in terms of people's most hated institutions to deal with. As President George Bush Sr. put it after leaving office:

The thing I miss about Air Force One is they don't lose my luggage.

Airlines are also struck by uniquely terrible labor relations. I'm not exactly sure why, but airlines are known for being hit by profoundly ugly and ruinous strikes. These continue to this day, witness Republic (NASDAQ:RJET) - which was until recently a well-performing stock - almost getting bankrupted by labor strife last year.

Oil Prices Are Low - So What?

American Airlines (AMR) in particular has been an extremely hot stock idea. I've seen numerous folks write it up as their top idea over the past 18 months. The company's fundamentals have, on the face of it, greatly improved over the past year. Earnings rose from $5.70/share in 2014 to $9.12/share in 2015. That's huge!

With shares trading at $40, you're now looking at a 4 PE ratio. Yes, you read that previous sentence correctly. So how far is American stock up?

AAL Chart

AAL data by YCharts

If you guessed 0%, you win. Since the collapse of oil prices began, shareholders in American have been rewarded with precisely nothing apart from the 1% dividend yield. And American was supposed to be the best airline option, given that firm's decision not to hedge oil prices, leaving it to capture the entire move downward as gravy for the bottom line.

So why hasn't the stock gone anywhere? First, let's discuss a key idea. PE ratio isn't nearly as important in airlines as in many other sectors. Airlines generally carry such large debtloads that even earning a huge profit on equity doesn't matter all the much once you zoom out and compare those earnings to the debtload.

In American's case, despite minting money - on an earnings basis - over the past two years, the company continues to take on huge amounts of additional debt. The company's overall debtload has risen by $3 billion to almost $20 billion total outstanding during this oil bust.

Cynical investors see an airline, even while making record profits, still taking on more debt to buy yet more planes and assume things will end badly yet again. At some point oil will go back up, the record profits diminish, but the debt will still be there.

And on the revenue side, things are starting to getting dicey. Because, as always, airlines manage to cut fares to the bone in pricing wars that end up hurting everyone, regardless of broader economic conditions. This latest oil bust is being used as an excuse to again drive ticket prices through the floorboards. For example, take Dallas:

Virgin America Inc (NASDAQ:VA)., caught up in a Dallas fare war, said it will fly out of the city with empty seats rather than sell tickets at rates so deeply discounted it can't make money.

The pricing battle began in 2014 when Southwest Airlines Co. and Virgin added flights after restrictions at Dallas Love Field were lifted and ultra-discounter Spirit Airlines Inc. increased service from nearby Dallas-Fort Worth International Airport, American Airlines' biggest hub. Carriers trimmed fares to fill seats that flooded the market.

While that's no longer the case, the "very toxic fare environment" has continued, said Virgin America Chief Executive Officer David Cush [...]

One-way fares of $30 from Dallas to destinations along the U.S. West Coast and $41 walk-up fares from Dallas to New York's LaGuardia Airport were among those Virgin America cited from a recent review of airline data filed with the U.S. Transportation Department. There's no indication when the battle might end, and "everyone is feeling the pain," he said.

To put that in perspective, a walk-up bus fare from Dallas to Houston yesterday with Greyhound cost $31. Or you can get a walk-up fare on an airplane to faraway New York for ten bucks more. That's a silly price. Even if oil were free, the airline is likely still losing significant money fulfilling that ticket.

Why do airlines always create too much capacity? It's a commodity business and there's little to nothing to stop airlines from oversupplying routes.

To the extent that any airline can get a durable edge, it comes from the network effect. If your airline serves more unique destinations than competitors and has more daily flight frequencies than competitors on key routes, you may earn passenger loyalty. To get the biggest network, you have to aggressively add capacity. Which naturally leads to overcapacity and crushing losses once the economic good times end.

Southwest: The Difficult To Repeat Exception

Southwest Airlines (NYSE:LUV) was one of the top performing stocks of the 1980s and 1990s. Its history of paying a steady dividend (and merely avoiding bankruptcy) has made it the airline that's different from all the rest in most people's minds.

Unfortunately, Southwest is no longer a unique airline, and it should no longer be expected to have unusually strong returns. Its vast outperformance was the result of special circumstances.

Until 1978, the airline industry was regulated heavily by the government. Airlines had to apply for permission to fly new routes from a transportation board, and airlines were not allowed to compete on price with each other.

The legendarily attractive waitresses and good plane food were airlines' way of competing back then, since they couldn't compete on price as they do now.

While the quality of airline customer service has collapsed since 1978 when airlines deregulated, it is worth considering that airline fares have hardly risen in nominal terms since 1978 despite 38 years of inflation along the way. Before declaring airlines a "market failure" consider the benefit to price in customers along with the loss of service quality.

With that said, Southwest was unique in that it wasn't regulated by the federal regime. This was because Southwest was an intra-state airline, meaning that all its operations were contained within the state of Texas prior to deregulation. Thus, it could sidestep the interstate commerce clause and avoid federal regulation.

This provided it several unique benefits. Primarily, since it was a regional Texas carrier, it never developed the bloated cost structure, labor problems, and pension burdens that would sink the bigger players once ticket prices collapsed following deregulation.

Southwest also got a special dispensation in its usage of Dallas Love airport, while most other airlines were forced to move to the geographically less convenient then-new Dallas Fort Worth airport.

Southwest also made some well-timed fuel hedges that insulated it from the oil shock the rest of the industry faced in the past decade.

However, as Southwest has grown, it has become less and less unique. Much of the particular Southwest corporate culture has eroded as the airline has become larger and more like its peers. The airline is no longer a true low-cost carrier, and has far fewer cost advantages versus the legacy carriers.

Southwest is a well-run airline, but the unique position it had coming out the 1978 deregulation has long since faded, and it no longer has the one-time advantage from fuel hedges either. Southwest stock stopped rising continuously in the year 2000 and has been a much more ordinary stock since then.

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

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.