{"id":30919,"date":"2023-07-03T15:36:20","date_gmt":"2023-07-03T19:36:20","guid":{"rendered":"https:\/\/ifintechworld.com\/news\/u-s-airlines-are-too-cheap-why-this-rebound-looks-real\/"},"modified":"2023-07-03T15:36:23","modified_gmt":"2023-07-03T19:36:23","slug":"u-s-airlines-are-too-cheap-why-this-rebound-looks-real","status":"publish","type":"post","link":"https:\/\/ifintechworld.com\/?p=30919","title":{"rendered":"U.S. Airlines Are Too Cheap, Why This Rebound Looks Real"},"content":{"rendered":"
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Thesis<\/h2>\n

Last week Delta (DAL) provided bullish guidance for the rest of the year. Since the entire US airline industry has been surging. While you might think you missed the boat or plane, airlines still have a long way to go before reaching their 2019 valuation multiples.<\/span><\/p>\n

Airlines have struggled to regain profitability for the last 2 and a half years. But the problems that hurt them, high oil prices and low utilization, are largely behind us now. Once airlines regain their pre-pandemic profitability I believe they should boast 20%+ earnings yields in an industry that is not as bad as most investors believe.<\/p>\n

A recipe of growing demand and rationalized competition can fuel airlines to a strong next eighteen months and beyond in my view. While the industry will remain capital intensive I expect airlines to earn above their cost of capital over the next 10 years just as they did the 10 years before COVID.<\/span><\/p>\n

Airlines, am I crazy?<\/h2>\n

It is a common refrain among investors that airlines are bad businesses. Many avoid the industry altogether, considering airlines giant capital incinerators. But is a US airline actually a bad business?<\/p>\n

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\"Chart\"
Data by YCharts<\/figcaption><\/figure>\n<\/p>\n

The three airlines that were in the S&P 500 for the ten years leading up to COVID all strongly outperformed the index. There is survivorship bias in this sample but, there is no reason a well-run airline cannot perform well. This outperformance was not a result of multiple re-rating. Improvements in the stock prices were largely attributable to improvements in fundamentals on a per-share basis.<\/p>\n

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\"Chart\"
Data by YCharts<\/figcaption><\/figure>\n<\/p>\n

Investors have missed the rationalization of the industry. Compare this chart of major commercial US airlines in 1980, shortly after de-regulation.<\/p>\n

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\"Graphic<\/span>
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Major US airlines 1980 – Annual passenger miles in millions (American Business History Center)<\/span><\/p>\n<\/figcaption><\/figure>\n<\/p>\n

To the same chart from 2019 right before COVID.<\/p>\n

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\"Visual<\/span>
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Major US airlines 2019 – Annual passenger miles in millions (American Business History)<\/span><\/p>\n<\/figcaption><\/figure>\n<\/p>\n

Increased competition between airlines and new entrants is also limited by airport capacity. The US has not added a new major airport since 1995. While there are constant projects to upgrade existing airports many are running out of space while travel demand continues to grow. Airlines with existing slot assignments at high-value congested airports are advantaged against new entrants to the market.<\/p>\n

Growing demand<\/h2>\n

Consumer demand for air travel has been in secular growth since consumer air travel has been available. Total US plane embankments grew at a 2.7% CAGR between 2002 and 2019 while the US population grew at only a .9% CAGR. Combine this growing demand with a continuously smaller number of competitors and we have the set up for a more profitable industry. One way to see this is the improving utilization rates of US airlines over time. The following graph shows the number of available seat miles divided by how many of those seat miles were actually sold<\/p>\n

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\"Availabel<\/span>
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Available seat mile utilization rate (FRED economic data)<\/span><\/p>\n<\/figcaption><\/figure>\n<\/p>\n

Since selling an additional seat on an already scheduled flight is almost 100% incremental revenue, this trend leads directly to more profitable operations for airlines. The difference between a 70% utilization rate and a 90% utilization rate is huge.<\/p>\n

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\"Chart\"
Data by YCharts<\/figcaption><\/figure>\n<\/p>\n

While there is a long-term trend towards higher utilization rates in the short term this trend may be even more pronounced. The industry is facing a shortage of both planes and pilots. If demand continues to grow but airlines cannot keep up for the next several years, profit margins could exceed pre-pandemic levels.<\/p>\n

Oil prices, a critical variable<\/h2>\n

2022 was supposed to be the year that airlines re-emerged but an explosion in oil prices ruined the party. About 25% of an airline’s operating expenses are fuel. It is the most volatile part of their cost structure. The volatility is especially painful because airlines sell many of their tickets in advance. If an airline pre-sells a ticket 6 months in advance and the price of oil rockets higher it can wipe out the entire profit margin of the flight.<\/p>\n

The good news is we are seeing the opposite happen so far in 2023. Oil prices have collapsed this year while the fares paid by passengers for flights have remained elevated compared to 2019.<\/p>\n

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\"Cost<\/span>
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Cost of airline tickets compared to the price of Jet Fuel indexed to 2000 (FRED economic data)<\/span><\/p>\n<\/figcaption><\/figure>\n<\/p>\n

The cost between jet fuel prices and passenger fares has a large impact on the profitability of airlines. 2016 was a banner year when it came to airline profit margins for this reason. So far 2023 looks like 2016 when it comes to the relationship between jet fuel prices and airline passenger fares.<\/p>\n

While the near term looks positive for this price spread the longer term picture is more complicated. An investor needs to have some sort of view of oil’s medium-term price range. If oil’s medium-term average price is over $100 a barrel it could cause issues for airline profitability. In my mind, this is the most significant risk to the thesis. Investors can help address this risk by having some energy exposure in their portfolio. A pairing of oil and airline stock will likely see one or the other outperform with plenty of room for both sides to do well thanks to low valuations on both sides of the pairing.<\/p>\n

Picking favorites<\/h2>\n

A simple way to play improved performance for airlines would be the US Global Jets ETF (JETS). However, we can try to do better by looking at historical performance and current valuations for US airlines.<\/p>\n

Below I’ve charted the average return on invested capital from 2015-2019 vs cumulative revenue growth from 2015-2019. Ideally, we’d like airlines that grow while earning good returns on invested capital.<\/p>\n

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\"2015-2019<\/span>
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Data per YCharts\/Visual author’s work<\/span><\/p>\n<\/figcaption><\/figure>\n<\/p>\n

Based on this chart Spirit Airlines (SAVE), Alaska Airlines (ALK), and Southwest (LUV) look the most interesting.<\/p>\n

Next, let’s take a look at the relative valuation of Airlines in 2019 compared to their current valuation. Data per YCharts.<\/p>\n

<\/span><\/p>\n\n\n\n\n<\/colgroup>\n\n\n\n\n\n\n\n\n\n\n\n\n
<\/td>\n2019 EV to Revenue<\/td>\nTTM EV to Revenue<\/td>\n<\/tr>\n
AAL<\/td>\n0.716<\/td>\n0.677<\/td>\n<\/tr>\n
ALGT<\/td>\n2.065<\/td>\n1.397<\/td>\n<\/tr>\n
ALK<\/td>\n0.947<\/td>\n0.633<\/td>\n<\/tr>\n
DAL<\/td>\n0.976<\/td>\n0.85<\/td>\n<\/tr>\n
HA<\/td>\n0.471<\/td>\n0.282<\/td>\n<\/tr>\n
JBLU<\/td>\n0.777<\/td>\n0.507<\/td>\n<\/tr>\n
LUV<\/td>\n1.187<\/td>\n0.721<\/td>\n<\/tr>\n
SAVE<\/td>\n1.017<\/td>\n0.716<\/td>\n<\/tr>\n
SNCY<\/td>\nN\/A<\/td>\n1.49<\/td>\n<\/tr>\n
UAL<\/td>\n0.734<\/td>\n0.645<\/td>\n<\/tr>\n
ULCC<\/td>\nN\/A<\/td>\n0.49<\/td>\n<\/tr>\n<\/table>\n

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