MIAMI — Airline investors in the United States are leaving money on the table. We’ve now had more than a year of oil prices averaging $50-60 a barrel or lower, and the West Texas Intermediate (WTI) crude just dropped beneath $35 a barrel. So it’s high time for airline investors to stop getting spooked at the mere whisper of capacity increases.
For too long, airline investors have punished airlines through their stock price for any increase in capacity, perceived or real, that took an airline outside of certain bounds. A very good example of this came in May 2015, when Southwest Airlines Chief Financial Officer (CFO) Tammy Romo hinted at plans to take capacity growth beyond the accepted 7% to a range between 7% and 8%. Combined with comments from American Airlines CEO Doug Parker about “aggressively” matching low-cost rivals, Romo’s comments led to a sudden and sharp dip in the share prices of both Southwest and other US airlines. A few days later, Southwest pulled back its comments and reiterated a 7% cap on capacity growth in 2015 and its share price rebounded accordingly.
Unlike many commentators, we don’t see anything wrong with a company’s shareholders attempting to affect strategic decision making by generating movements in the company’s share price. Outside of annual shareholder meetings, most small and mid-size shareholders have few levers outside of selling a portion of their shares and driving down prices in aggregate to exert any kind of control over a company that they are ostensibly the owners of.
Far from a situation of “holding an airline hostage,” this type of indirect influence on strategy is better termed as “an airline’s owners affecting strategic changes that they believe to be in their own self-interest.” But our defense of the institution and right for shareholders to take such action does not insulate them from criticism about what they perceive to be their self interest. And in this case, airline investors are dead-wrong about what exactly is in their self interest.
PRASM is not the “one true metric” of an airline’s financial success
The key driver behind the current mentality of current airline investors is the idea that low growth or declines in passenger revenue per available seat mile (PRASM) portends poor profitability in subsequent quarters. Historically speaking, profits and PRASM have had a direct correlation, so investors reason that since US carriers’ PRASM figures have been falling since the fourth quarter of 2014, the return to huge losses must be right around the corner.
This is misguided. PRASM is a useful metric but it isn’t the be-all and end-all of an airline’s existence. We do not quibble with the historical usefulness of this metric, but the utility of this technique in an environment where fuel prices are declining is limited. And the drop in fuel prices has been nothing short of precipitous, with a similarly large effect on cost per available seat mile (CASM).
Indeed as Judson Rollins of the Skywriter Aviation site noted back in August,
Falling RASK doesn’t matter if CASK falls even faster. It makes no sense to forgo profitable flying just to optimize your system average RASK (or PRASK).
Instead, airlines, like any business, should be focused on profit or even free cash flow maximization. In today’s fuel environment, which means putting up more capacity than they currently are and not leaving profitable flying on the table. This might even mean trading off some margins in the interest of maximizing total cash returns. Would you rather have 20% margins on total revenues of $10 billion ($2 billion) or 19% margins on revenues of 11 billion ($2.09 billion) in a quarter? Right now, airline investors are literally leaving hundreds of millions of dollars on the table annually – money destined for their own pockets – by not accepting slightly higher capacity growth?
Companies are priced-based on multiples of earnings or free cash flow, not margins. And airline investors would do well to remember that their dividends as well as share price appreciation come from profits and cash flow, not from PRASM.
Shifting fundamentals of the oil market point to a multi-year period of sub $60/barrel oil
The drop in fuel prices, far from being a temporary blip as many predicted, has instead proven to be surprisingly leggy. Shale oil producers in the US have proven surprisingly resilient in the face of a price war instigated by Saudi Arabia and the Organization of Petroleum Exporting Countries (OPEC), and they continue to move up the learning curve to bring down the cost of production for shale-based crude.
Even if the shale producers are weakened, the lower cost segment of the market is far from operating at a peak. Iran’s re-entry into the global market post nuclear-deal could boost supply, as would an end to hostilities with the Islamic State. And even if OPEC elects to tighten supply, a spectrum of shale operators and wells with breakeven cost ranging from $40-60 would quickly re-enter the market, keeping prices capped at a relatively affordable $60/barrel. And this is before the positive shock of ever-improving shale oil technology is taken into account. Any reading of the global oil market points to the idea that prices will be lower than $60 for an extended period of time (3+ years).
A new definition of capacity discipline
Much has been made of the airline industry’s turn towards capacity discipline since 2008, and that newfound discipline has certainly been a welcome change for an industry that spent much of its post-deregulation life deepening the troughs and falling short of the peaks of the business cycle due to over-exuberant capacity growth.
But this is not the same airline industry as 20 or even 10 years ago. For one thing, we are now in an airline oligopoly and regardless of what that portends for consumers, it means that the potential for irrationally high capacity growth is lower (since there are fewer players overall and plenty of profitability to be had in tacit cooperation). More importantly, the airlines’ network planning teams are no longer staffed by the same planners that chased market share off a cliff in the 80s, 90s, and early 2000s.
This new generation has come of age in an era where the benefits of capacity discipline have been illustrated loud and clear throughout the formative years of their careers. We spoke with several network planning team members at various US carriers in preparation for this story and came away reassured that they still very much believed in the virtues of and were planning for a future defined by capacity discipline.
But many of them shared the opinion, as do we, that the definition of capacity discipline needs to be a sliding scale. Fuel is the single largest cost borne by an operating airline (between 30-40% in 2014 for most US carriers) and accordingly a precipitous drop in fuel prices changes the frontier of what routes are possible for US airlines to profitably operate.
At $35 a barrel, fuel prices are now at a level where we could have two years plus of 10% capacity growth from everyone in the market including the legacies and still deliver 12-15% operating margins with an extra $3-4 billion in overall profits (assuming no recessions). Most of the carriers aren’t trying to grow capacity at that level – they’re nowhere close. So the more modest capacity growth plans offered by most US airlines are correctly classified as “disciplined”
To be clear, I’m not saying that airline investors need to accept illogical or unreasonably high capacity growth figures – there is still virtue in capacity discipline. But the target figure for “discipline” needs to move when fuel declines. Airline investors need to get comfortable with a few percentage points of capacity growth and targeted defensive moves in key markets against ULCCs by legacies.
Airlines have the ability to add capacity in a low risk manner by extending retirement timelines
In fact, for airline investors, the added capacity is extremely low risk, because it can be largely achieved by extending retirement timelines for older aircraft. US carriers have a sizable aging fleet which is currently being phased out, such as Southwest’s 737-300s, American’s Mc Donnell Douglas MD-80s or Alaska Airlines’ Boeing 737-400s. But while these aircraft are simply uneconomical when oil is over $100/barrel, they are given a new lease of life at current prices.
By keeping these aircraft around for longer and delaying retirements until the next scheduled heavy maintenance check, airlines could add more marginal routes and boost capacity to capture additional profits that are on the table. And since these aircraft are usually owned or fully depreciated, if the price of oil spikes, the economy tanks, or the competitive situation in the US airline industry dramatically shifts, the airlines can simply cancel the marginal routes, re-assign newer aircraft to core routes and park the older jets. In this sense airlines and their investors would get the best of both worlds: the extra profits from incremental flying with the ability to avoid major losses with a quick draw down if things go bad. This is a no-brainer and could be extended over several years if conditions remain positive.
Airlines have established themselves as high quality industrials but are treated as buggy whip manufacturers
Everything that US airlines have done over the past five years indicates that they have more than established themselves as high quality industrial stocks or at the very least high quality transportation stocks. Price to earnings ratios for such stocks ranges from 15-20 times projected earnings (P/E) for the following year in the US (forward P/E)
Here are the estimated 2016 forward P/E figures for the US airline industry.
Alaska – 11.2
Delta – 8.0
Hawaiian – 10.0
JetBlue – 9.9
Southwest – 10.5
Spirit – 10.1
United – 6.8
Virgin America – 7.9
That’s good for a sparkling forward P/E of 9.0, implying that US airlines are undervalued by about 40% in a range from 25% (Alaska) to a whopping 55% (American). Usually, the only time this type of undervaluation is justified is when an industry is in danger of fading out from use in society due to a long run shift (hence the reference to buggy whip manufacturer). The rise of Cisco’s WebEx aside, it’s pretty clear that this isn’t the case for the airline industry (at least not until the Hyperloop becomes reality), so there really is no justification for these valuations. But until airline investors toughen up and stop jumping at the mere whisper of capacity growth, we fear that this chronic undervaluation will persist. The sad irony is that it is the airline investors themselves that are potentially losing billions of dollars in share price appreciation and dividends as a result of their stance.