The airline industry looks like an easy pick for some investors. Trading the airline industry used to be pretty easy, but now airline stocks trade more like tech or biotech stocks, pretty hard to predict. You’re probably thinking, “People fly all the time, right?” Therefore, should always be a demand for airline tickets. Despite the expected steady demand for airline tickets, demand has been hard to predict as of late, and investors should conduct proper diligence of the industry and know potentials risks and benefits.
Let’s take a look at what were the main catalysts for growth in the airlines industry recently, as well as the current valuations and the future projections for the industry.
Catalysts Affecting Growth
The airline industry significantly depends on macro conditions and economic cycles.
- Decreasing oil prices helped airlines to reduce costs and boost net income since mid 2014. Oil prices traded in range in early 2017 and have limited upside potential at this point. High levels of supply and slowing economic growth in China puts downward pressure on oil prices. This allows airlines to continue benefiting from higher capacity coupled with lower fares.
Source: Market Realist
- Number of passengers has been gradually increasing over the years for both domestic and international travel. “Leisure” travel volume exceeds “business” travel significantly. After the economic slowdown in 2009, the airlines industry reversed and saw an uptrend in demand, and the trend continued to rise thereafter. Current macroeconomic conditions have had positive effects on the airline industry: low level of unemployment claims and decent levels of inflation boosted airline traffic. In addition, President Trump intends to improve job numbers and economic production domestically. Those factors are premiere catalysts for airline industry’s continuing growth.
- Industry consolidation played an important role in the recent performance in airline stocks. The airlines industry has experienced some major M&A activity within last decade, after the economic slowdown: US Airways with American West Airlines in 2005, Delta Air Lines with Northwest Airlines in 2008, United with Continental in 2010, Southwest with Air Train in 2011 and last but not the least American with U.S. Airways. This M&A Activity helped to reorganize the industry, increase market share and boost profits. Four major carriers created what would be considered an oligopoly, which helped with capacity discipline and lower fares, and in turn airlines were able to generate higher earnings.
- Although the current economic conditions are favorable for airline stocks, there are some risk factors inherent to the industry. One of those factors is seasonality. The chart below shows that Summer months in addition to the holiday season during the Winter time have highest level of air traffic. Increasing leisure traveling helps airlines to increase cash flows and earnings in the second and third quarters. Companies need to make sure that generate enough cash flows in these quarters to ensure sustainable operating performance in the weakest quarters.
- Another considerable weakness is that industry is highly capital and labor intensive. Airlines should invest a lot of capital to upgrade their fleet, as well as provide sufficient maintenance to the carriers. In addition, airlines pay airports high fees for using their terminals and gates. Moreover, labor unions are strong and they tend to negotiate the deals, which are highly beneficial for the pilots and the crew, and in turn, this could increase the costs for airliners.
- Valuations of major airline companies are still low, even at current price levels compared to the entire industry and the overall equity market.
- Price to earnings ratio is an essential fundamental factor which identifies how fairly a security is
priced with regards to its earnings. With Price to Earnings indicator at 11.48 level for the airline industry and around 20 for equity market, American Airlines, Delta and United still look attractive with Southwestern lagging behind by a small margin. However, LUV has significantly higher growth perspectives than its competitors.
- Improving conditions were also recognized by such famous investor as Warren Buffet. In the 13F filing last year, Berkshire Hathaway revealed the long position with more than $1B total investment in AAL, DAL and UAL. Additionally, a stake in LUV was acquired after the filing.
Delta airlines (DAL) current stock valuation
Delta has the strong support on the street with low PE levels and great value at current prices.
Source: Delta’s Investors Presentation
Delta has strong efficiency ratios, and it was able to provide return on equity (ROE) of 31.13%, which is higher than the industry average, which was around 27%. Delta has also a Debt/Equity ratio at 0.6, while industry average was 1.3. The company has Investment Grade credit rating. Additionally, Delta had an interest coverage ratio 11.20, proving that it has enough cash to pay its liabilities.
Investors with low risk tolerance can consider it for their portfolio. Delta pays 1.65% dividend as well, which might be attractive for income investors. Delta confirmed that it is going to increase dividend by 50% to an annual rate of $1.22 per share starting in September. Delta’s officials also authorized a 5M share buyback program, which is expected to be concluded in 2020.
Source: Delta’s Investors Presentation
Airline stocks might look as questionable investments, as they’re dependent on economic cycles and seasonality. However, the current economic environment and relatively stable oil prices support the potential growth in the industry. Despite the significant rally at the end of the year, securities are still priced at attractive valuations. Investors might consider it as opportunity to diversify their portfolio with stable airline stocks.