Let's Take Off With The Airline Industry For A Potential 800% Upside

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Includes: AAL, CPA, DAL
by: George Atuan, CFA

Summary

The sector has famously destroyed shareholder value, as ROIC < WACC since 1993.

43 operators have gone bankrupt since 2001.

More consolidation leads to more rational players.

Operators are not re-engaging in price wars; the best indicator is that, while oil prices plummeted 50%, prices have increased 10-30% in the last two years.

I estimate ROIC to improve up to 4.4%, leading EV to appreciate up to 165% and equity up to 800%.

As Jerome Hines once said:

"The only proper way to eliminate bad habits is to replace them with good ones."

So why do I bring this up in an article about the airline industry? It is well known that airlines are the best companies at destroying shareholder value. The cause has been their bad habit of competing on price. But I think this "bad habit" is being replaced with a good one, as I explain later in this article. I believe that airlines globally are entering in a new cycle, where the new business economics seem more attractive. By following the tips at the end of the article, you may find very interesting investment opportunities.

At least since 1993, ROIC (return on invested capital) (0.3%-7.1%) has consistently been lower than the cost of capital (7.5%-9.3%) (source: Bloomberg); this could mainly be explained by the high rivalry that has caused aggressive price wars.

We can understand why airlines have destroyed value by opening up ROIC. The airline industry returns are dictated by the same six factors as other industries: local tax levels, margins, pricing, utilization, working capital management and capex efficiency. We won't discuss taxes, as that depends on the jurisdictions where the carrier operates rather than its operational efficiency. The remaining factors could be understood through four metrics: EBIT margin, Yield, Load Factor and Invested Capital per ASK. These factors, including the tax rate, explains the level of ROIC for the company. The math is pretty simple,

ROIC = NOPAT / Invested Capital

= (1 - tax) x (EBIT / Revenues) x (Revenues / RPK) x (RPK / ASK) / (ASK / Invested Capital)

= (1 - tax) x EBIT Margin x Yield x Load Factor x 1 / Invested Capital per ASK

EBIT Margin

There are two main factors affecting margins: fuel cost and labor. These costs represent on average 60-67% of the total cost of an airline (Source: Bloomberg). Some people believe that the type of airline (Low Cost Carrier or Network) is the main factor explaining those margins. However, data suggest that both type of operators can have high margins as long as they can control costs such as Copa (NYSE:CPA), American (NASDAQ:AAL) and Delta (NYSE:DAL) (source: Bloomberg).

The increase of oil prices in the past years have increased costs dramatically. The effects were mitigated temporarily through fuel hedges. As those hedges couldn't protect the airlines forever, costs escalated. Most countries allowed airlines to add a 'fuel surcharge', but some countries such as Brazil demanded the airlines to pass the fuel cost increases through the ticket price rather than utilizing a surcharge. Even with that help, the airlines were in trouble as the high rivalry forced them to offer competitive ticket prices. In a nutshell, airlines ended up transferring any cost savings to the customers and never had the opportunity to recover profitability.

So, why do I believe this is changing soon?

Have you noticed that even with the 50% drop in oil prices, airline tickets have stayed the same?

I would dare to suggest that this is indicating the start of a new dynamic in the industry, especially in the U.S. Since 1979, 53 U.S. airlines have filed for Chapter 11. In addition, in the past decade we have witnessed more than 43 bankruptcies and consolidations in the sector globally (source: Bloomberg). This resulted in a more consolidated market with operators that understand the consequences of price wars. Also, these surviving operators inherited routes with fewer operators. Some routes are just operated by two or even just one airline.

Even though most current hedges are higher than current oil prices, within 2015 and 2016, those hedges will expire. Thus in 2017, airlines should receive the full benefit of lower fuel prices. As fuel cost represents approximately 15% of the total costs (source: Bloomberg), the EBIT margin enhancement should range between 750-1000 bps.

A note about labor cost. While labor and related taxes typically represent 47% of the costs, in Brazil they are 44% higher. That is due to some labor laws such as a limit of 85 hours per week compared to 105 globally. This leads to the need to hire more people.

The secondary benefit is that newer airplane models tend to be more cost-efficient. They use less fuel per seat and optimize space among other things. A case in point, for example, the Airbus A321 seats 220 passengers (~50 more than the A320) and lowers the CASK by ~9%. The same goes for the B787-9 model that seats 313 passengers (~80 more than the B767) and lowers CASK by 21%.

Yield

Yield is the revenue per sold seat per kilometer, simply put, it is an indication of price. Following the same train of thought as above, yields should improve in the coming years due to the pricing power the operators enjoy - especially in the monopolistic routes. A simple practice that I follow is to track a couple of high traffic routes (e.g., Toronto - New York) and check the same flight (90 days in advance) every 30 days. If you carry this exercise, not only will you notice the few options available (Air Canada, AA, Delta and Porters Airlines), but also you notice that the prices have increased 10-30% in the two years in which oil prices plummeted by 50%. Some food for thought don't you think?

Load Factor

Load factor is an indicator of utilization. For example, a load factor of 70% means that a 100-plane sold 70 seats for that flight. The break-even load factor for most airlines lies in the range of 60-70%. Operators generally aim for a load factor of 85-90%, any higher and the operator would lose flexibility and revenue management optimization while any lower and the operator is leaving money on the table and lowering its margins.

The lower competition per route will allow operators to better manage the supply per route, those they would likely increase load factors to the theoretical optimum of 85-90%. The load factor could be increased by either increasing demand or lowering supply. As I believe that operators won't attempt to fill the seats offering deals so as not to trigger a price war, most likely the operators will gradually decrease supply. This will take around two years, as the most efficient way is by not renewing expiring leases and old planes - which takes me to my next point.

Invested Capital per ASK

As demonstrated in the table below, while the newer models are 16-39% more expensive, the cost per seat is 2-11% cheaper, as the new models have more seats. (Sources: Specs for A320, A321, B767 & B787-9)

Thus, as the operators renew their fleet with these "cheaper" models and retire the most-expensive ones, the capital invested per ASK should decline by 2-8%, depending on the magnitude of their working capital.

Risks

Predicting the future is pretty tough. In the short term, demand may be weak in emerging markets as their currencies depreciate. The weak demand may trigger carriers to ignore their past pains and go back to their old habits of competing with price and/or expanding supply irrationally.

Conclusion

In the beginning, I mentioned how returns of airlines depend on EBIT Margins, Yields, Load Factor and Invested Capital. In this short article, I have tried to argue why each of those elements should improve in this industry in the medium term. Of course, we do not know how the market will behave in the future but if this hypothesis is correct, according to my estimates, the ROIC in the industry should improve between 1.2-4.4%. It appears as a marginal improvement in ROIC but that minor improvement translates to a 45-164% increase in the value of the industry and, depending on the structure of companies, can be as high as 8x increase in equity value for some airlines. Definitely an interesting sector that deserves a deeper look.

In my next article, I will discuss the investment thesis of a LatAm airlines in greater depth. Having said that, there are many opportunities out there. When looking at airlines, I would:

  1. Prefer companies that debt composes at least a third of its structure (including off balance sheet leases), but no more than three quarters.
  2. Rather than looking at LCCs, prefer operators with clear cost-cutting strategies. Also, I would focus on carriers that have higher KM per flight, as it means less staging time and costs.
  3. Prefer carriers with monopolistic routes. You can use any travel search engine such as kayak.com and ensure that they have no more than one competitor in its main routes.
  4. Check how efficient the companies were in controlling the supply (ASK) during rough periods. Prefer companies that were more agile in reducing ASK.
  5. Check what percentage of its fleet is scheduled to be renewed in the next three years; prefer carriers with higher renewal rates.

Disclosure: I am/we are long LFL, CPA.

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.