"Should you buy airline stocks?" has been a popular searched keywords in recent weeks. Even the "Oracle of Omaha", Warren Buffett, decided to call it quits on its investments in the US airline stocks. A total of $10 billion worth of airline stocks!
In this article, we’ll discuss our thought process on how we think the airline industry will play out, the impact from lower jet fuel prices, the CARES act & warrant dilution, timeline to return to normalisation and many more. Our goal is to build consensus on the global airline industry and what investment actions we can take today.
The chart below refers to the US Global Jets ETF (JETS). This includes key players of the global airline industry, including airline operators and manufacturers from all over the world. The chart updates automatically in real-time.
First, a brief overview on the airline industry. Historically, the airline industry has been extremely volatile. It has been cyclical, energy dependent, LCT (labour, capital and technology) intensive, highly regulated and extremely competitive. In addition, it’s subject to the fortunes of the economy, jet fuel volatility and natural disaster. The latter is a constant reminder of how the industry is having to face another layer of uncertainty, despite already operating in an extremely challenging business environment.
We start by exploring what drives global demand for air travel.
The shape of recovery of global passenger demand
The key driver of the airline industry is the passenger demand. The more the merrier. As a result, predicting what level of passenger growth is crucial to making money in this sector. As if it’s not complicated enough, the pandemic introduced another angle to this: “When will this return to normal?”
To answer this, we breakdown the factors affecting demand for air travel going forward.
First, GDP per capita may offer a glimpse to the trend of air travel growth in the future. Loosely speaking, this is a proxy for the income level of the population. Intuitively, this make sense, as air travel is considered a luxury good that scales with income level. In fact, the correlation between GDP per capita and passenger growth is +0.9, suggesting the strong relationship.
With record level of unemployment and the death toll of coronavirus remain fresh in our minds, we struggle to see how passenger numbers would recover by end of 2021. That is, of course, on the assumption that no vaccine has been proved effective by then.
Second, social distancing measures means returning to full capacity in the near term is akin to the Chicago Cubs winning the World Series. For example, an Airbus 320 can carry up to 180 passengers. Assuming the 2-metre (or 72'') social distancing rules in place, this alone would reduce available capacity by 1/3.
The question “When will passenger level return to normal” is a tough one to answer. Looking at the TSA’s daily checkpoint numbers, we estimate that passenger travels will regain 50% of its pre-coronavirus level by end of 2020. This also takes into the social distancing measures we mentioned earlier. Our estimate is based on TSA’s available data and extrapolating it towards the end of the year.
The groundings of 737 MAX passenger airliner
In March 2019, the Boeing 737 MAX passenger airliner was grounded worldwide, owing to the events that took the lives of 346 people. For major airlines (except for Delta), the immediate impact was a significant reduction in capacity. This is largely offset by lessor assistance, extended leasing and short-term leasing of aircraft. Nonetheless, it wasn’t a smooth ride.
While airlines have indeed been compensated for lost revenue by the manufacturer for the groundings of the 737 MAX airliners, COVID-19 changed the game entirely for the industry.
Currently, aircrafts are grounded because of pandemic-led travel restrictions. As a result, the “lost revenue” that has to be compensated until the 737 MAX can be operational again may not be in effect, ie not paid to airlines. This is because it’s now the travel restrictions that are preventing airlines to operate rather the grounding of the 737 MAX airliners. For example, Southwest has already been compensated $428m due to the grounding of 737 MAX. But further compensation may now be limited.
Lower jet fuel costs
In general, fuel cost is around 20% of airlines’ total revenue. In fact, this has remain fairly constant despite the fluctuations of oil prices. Airlines achieve this via hedging. In simple terms, this means to buy jet fuel at a specific date at a pre-agreed price today.
The nature of air ticket sales means that airlines have to price-in fuel prices for future flights today. Consequently, this can caused fluctuation in ticket prices due the volatility oil prices. This is where fuel hedging plays its role. In particular, hedging delivers certainty and stability of jet fuel price, hence, consistent ticket pricing.
Hedging is done via the use of options, futures and other derivatives to create a known fixed price for jet fuel in the future. It follows that Delta (DAL) is able to consistently keep aircraft fuel prices to be no more than 20% of its revenue over the past years.
If we assume that jet fuel costs is approximately 20% across the industry, with an operating margin of 10% say. Then it follows that, a 10% decrease jet fuel prices (assume immediate pass through), would increase operating margin to 12%, a +2% increment in absolute terms. Of course, this is just a rough estimation, given the complexity and varied hedging programmes used by airliners.
While it’s positive, we would be cautious on two fronts. First, the benefits of lower fuel prices will only come through in the medium term. Secondly, given travel restrictions, taking advantage of today’s lower fuel prices will be challenging.
The CARES Act
The global airline industry has undergone massive cash burn issues of late. With governments across rushing through a bailout scheme for companies, many previously implemented initiatives such as climate conditions are being pushed aside. For a list of European airliners bailout, see here. In Asia, Singapore Airlines secured a $19 billion funding from Temasek Holdings, a state-owned fund. In addition, Cathay Pacific, Hong Kong’s flagship carrier, also secured a $5 billion funding from the Hong Kong government.
The US is, of course, not an exception. Here’s a table of airline companies receiving aid authorised under the Coronavirus Aid, Relief and Economic Security Act (CARES Act).
The CARES Act provides $32 billion for US airline industry, of which $25 billion is allocated for passenger air carriers. The table above highlights the total funds received from the US government. For example, American Airlines received a total of $5.8 billion, which includes a grant of $4.1 billion and the other $1.7 billion in the form of low-interest loan.
Interestingly, there are two additional conditions for those who received aid under the CARES Act. First, companies are prohibited from laying off or cutting pay rates of employees until Sep 30 2020. Despite the aid, companies are offering its employees voluntary redundancy and leave options. This is a strong signal of the industry’s pessimism on the speed of returning to normalisation. In fact, some executives are suggesting that airliners will shrink permanently. We could expecting further layout on the 1 Oct later in the year.
Secondly, the aid also comes with an embedded warrant issued by the companies to the government. The right-hand side of the table summarised the key stats of the warrants for each companies.
A warrant gives the holder a right to buy shares at a pre-determined price. Upon exercising the warrant, companies will issue new shares. Consequently, the issuance of new shares can dilute earnings per share and share price. We summarise our scenario analysis on possible warrants dilution on each companies.
One of the setbacks from receiving government aid is the flexibility of its capital return policies. Consequently, this fundamentally changes the dynamics of the industry. In exchange for the aid received, stock buybacks and dividends may cease for years to come. As a result, this only adds further to the unattractiveness of investing in the airline stocks today.
In fact, major US airlines have been paying out ~$45 billion in dividends and share buybacks from 2014-2019, only to be asking the government for $50 billion bailout due to the pandemic.
Airline stocks investable universe
A list of global airline stocks for your convenience. Please leave us a comment if you think we should be adding any new names.
Should you invest in airline stocks today?
Short answer, no. Here’s what we've discussed so far.
- Passenger numbers may return to normal quicker than the market expects, but, social distancing measures means that growth remains subdued
- Compensation for “lost revenue” for the grounding of 737 MAX airplanes may be limited now due to the travel rules in place
- Lower oil prices is one of the positives in the pandemic for the industry. Despite this, airlines aren’t able to effectively capitalise on this as they can’t fly in full capacity either. Hedging future jet fuel contracts could see benefit coming through only 18-24 months from today.
- Government bail-out may not be sufficient to stem the structural changes of the industry.
- In exchange for receiving government aid, dividends and share buybacks may cease for the foreseeable future.
For the reasons discussed, we do not think investing in airline stocks today is a sound choice, especially after the tremendous rally since March/April lows. At current valuation, its risk/reward is neutral at best. Don’t forget that dividends and stock repurchase are now out of the window for the foreseeable future!
At the time of writing, we would require a 40-50% margin of safety of today’s prices to make it an attractive investment. This is risk management 101!
Never had the industry faced a time more challenging than what we are experiencing today. Companies will need to adopt a leaner fixed-cost model to survive the paradigm shift. Global demand for air travel will eventually return. Until then, the billion dollar question is “when”. Your guess?