In a Million Dollar Nutshell ? How to Invest in Airline Stocks ?
Out of 158 industries, airlines are seen as the ugly ducklings! Even investment-grade airlines are relatively high risk because prospects oscillate with turbulent ‘big picture’ forces. Some investors hope that the large, mainline airlines will be resilient, but there are many better long-term compounding businesses. Airlines are quite simple to get your head around, however. Economic prosperity and fuel prices are the gears turning their multiples, the early stages of an economic recovery rallying airlines trade upwards. Low jet fuel prices are potentially an additional boost, but when the economy tanks and oil expensive, that can be a deadly pinch. When investing, learn to avoid bad airlines. Bookmark the ones you can tolerate, and those will be candidates for investment when you see a powerful aviation climate primed to fly. This primer will now elaborate on what that climate looks like!
Let’s Fully Unpack How to Invest in Airline Stocks!Disclaimer: I do not own any airline investments at the time of writing. Disclaimer: chrismorrissey.money does not provide financial advice. All content is purely informational. Consult independent advice.
Believe it or not, there’s a reason why you have so little leg room. Airliners parked in the desert is a real business model, and there’s a way to win with airlines on the stock market. Southwest Airlines will be our case and point during this primer. In the context of this famous airline, currently around $50 dollars on the S&P 500, I’ll introduce aviation. We’ll cover its passengers, low cost carriers versus legacy carriers, crude oil and all the other industries upon which these stocks hinge, supply and demand, and many other factors you need to take into consideration when buying an airline stock. This is your airlines primer, let’s get started.
Transportation Industry Group
Airlines belong in the industrials sector, moving both people and freight. I recommend you make a runway out of learning airlines, then railroads, then trucks, and then ships. You’ll benefit from economies of learning. Below is the free and complete guide to rail, but for now, let’s stick to airlines.
3 Types of Airline Stock
If you’re not travelling by helicopter or by hot air balloon, you’ve got three choices. These are the three types of airline stock out there:
The first step to analysing an airline stock is to determining its category. There’s no point comparing a low-cost carriers competitive advantages against that of a legacy, like Delta vs Ryanair. Delta is focused on winning share from United and American. Ryanair are focused on winning share from Spirit and Flybe. They even serve different customer segments. We cool? Cool.
The Airline Business is Brutal
After the Wright Brothers changed the world in 1903, things like routes flown and ticket prices were strictly controlled by the powers at be. Airline leaders didn’t have much control over their airlines, and stayed that way for decades until 1978, when deregulation passed and the shackles really came off the industry. Everything changed.
Free market competition begun and the number of airlines doubled in five years. Testament to how difficult it is to make it in the airline business, over 150 bankruptcies have been declared since 1978. We shareholders rarely get anything out of bankruptcy, but the airlines commonly use Chapter 11 to reorganise themselves and go again.
We don’t invest on “hopefully’s,”, but “hopefully” airlines have shaken the water off their back and learnt to steady their businesses (I can tell you they have).
US Airlines Are The Best ??
U.S. airlines generate around 45% of the world’s profits with only about 20% of the world’s passengers. The carrier we’re going to use as a case study to investigate how to invest in airline stocks is a U.S. airline, Southwest . I’ve picked it because it offers a long term, risk conscious investor a reasonable package . Before Southwest, no risk-averse investor would have touched an airline.
Southwest: An Example to All Airlines ?
Founded by one of the great leaders and pioneers in aviation management, Herb Kelleher, Southwest is one of the most admired companies on the S&P 500. We’re not cigar-but investing here, scraping the barrel for cheap stocks. This is an airline that’s defied all expectations.
Southwest Airlines is a low cost carrier airline. It’s not an ultra low or a legacy carrier, instead opting to offer somewhat low fares for somewhat low frills. It has flight routes in the United States and to nearby international countries, but it won’t take you from L.A. to Sydney. As routes are shorter (2 hours long on average and not crossing oceans), it’s a point-to-point airline rather than a hub-and-spoke airline . That means the flights go straight to their destination, not stopping and connecting to hub airports.
Compared to airlines as a whole, Southwest trade at a premium. That’s unsurprising given the success of the firm! 45 years of running profitability is a feat achieved by no other airline, so Southwest make the perfect guinae pig for our analysis. The main airline index fund is DJUSAR. That’s a basket of all airlines pooled together, so you can buy into that fund and track airlines passively.
How Airline Investors Make Money ?
If we buy a piece of Southwest, a share of its planes, routes, hangers and brand, the bankruptcy lawyers will be peering over our shoulder asking where the money will coming from. Currently at Southwest, 90% of it comes from airfares . That’s common. It means booking a plane ticket .
There are 2 types of people booking plane tickets. There are the flyers travelling for leisure, such as families going on holiday. And then there’s the business travellers, such as executives going to meetings. Neither type of customer buys plane tickets for their own sake, it’s a mode of transport. The business travellers are less price sensitive than the leisure travellers, but factors such as reliability and flight schedules are key for both types of flyer. Other needs and wants are not nearly as important.
The other 10% of Southwest’s revenue is what we call ancillary revenue. Ancillary revenue could be selling air miles, which are great for liquidity because they’re sold well in advance of actual travel. 20% of air miles go unused anyway, but ancillary revenue could also mean selling in-flight meals, premium economy class perks and other kinds of extras.
Airline Stocks Are a Play on Outside Macro Forces ?
Every business on this planet exists on one interconnected web. Through the global mesh of supply and demand, everyone is everyones stakeholder to some degree. In the case of airlines, these businesses are indirectly but seriously contingent on activities elsewhere in the world. To be honest, buying a position in Southwest isn’t really buying a position in Southwest. It’s half a position in Southwest, and half a position on trends elsewhere. You need to know what these trends are.
Tourism is Airline Demand ⛱
One in ten jobs on this planet are related to travel and tourism, and half of all tourists travel by air. The eagerness of Americans to take holidays realllly matters to Southwest. The more tourism, the more demand, and the best sign of eagerness is however well the US economy is doing . If the economy is doing well, business travellers will also be spotted more frequently in airport lounges!
There are millions of indicators for the health of the economy, but the general sentiment should be obvious in the markets. There’s a big correlation between all those indicators and how much money an airline can make. Vitally too, these indicators are not controlled by the airline! As owners of airline businesses, we’re at the mercy of forces larger than the human brain can even naturally comprehend for our earnings! That’s a bad thing because those forces are hard to forecast.
Check Your Airline Has Enough Seats ?
For our analysis of Diageo, supply simply meant the number of drinks the company could brew up. That’s the everyday meaning of supply for a business; quantity. For our analysis of an airline, supply means capacity. Capacity to carry people must be kept on point with demand to fly if we’re going to invest in an efficient airline. The main measure of capacity is available seat miles.
The lack of legroom that you hate comes from airlines trying to fit more seats on their planes to increase their available seat miles figure. Southwest just upgrade to bigger aircraft. Alternatively, an airline might try and fly more which also increases air miles, and one of the tactics to do this is being a point-to-point airline rather than a hub-and spoke-airline. That means your aircraft won’t sit in plane jams on the tarmac all the time (at the hub airports).
In the winter, planes are sometimes put out of service in the desert where they won’t rust. Google the pictures, I’m not joking. This is a real strategy to increase capacity when it’s needed because the dry climate slows down rusting, and those plans can be stored away safely until flyer demand ramps up again. This is very expensive, which is why Southwest only retire their planes in the desert. Most planes in the desert are scrap (desert boneyards).
It’s easier to increase available seat miles than to shrink them , and that’s very important to remember. All of these strategies are aimed at controlling the growth of available seat miles. The load factor metric shows how loaded up the planes are with paying customers, and around 84% is about right. It’s good to have some capacity in hand, so aim for a similar load factor with the airlines you analyse yourself.
Oil Can Get on Our Badside ?
Electric planes are not yet in the skies, so airlines still rely on fuelling their fleet with jet fuel. It’s price per gallon is all over the place as an unpredictable commodity in this world. If an airline buys lots of oil volume wise, it’s because it believes it will be flying lots to meet lots of demand, doing more business, and making more money on their top line.
If Brent Crude oil prices have jumped and an airline has to pay a lot for that oil, then oil can easily tear into our operating costs and take up a larger percentage of those operating costs. That will squeeze margins, squeeze free cash flow, and squeeze the returns on airline stocks.
Exposure to crude oil then means exposure to quite a lot of risk, so the Southwest CEO will walk up to the hypothetical counter for crude oil with a big shopping list of things he or she needs. That includes kerosene, heating oil, and anything else he needs to get his airline literally off the ground!
The oil seller at the counter might say “$64 dollars for a barrel of oil”. The CEO will say “okay, okay. $64 dollars for a barrel of oil,” and pay $64 dollars. But before leaving, the CEO will make sure that the next time oil is needed, there are no unwelcome surprises if crude oil prices have gone up. The airline will hedge, saying “we promise to pay a premium on top of $64 dollars, we’ll pay $66 dollars. And for paying that premium we want the assurance that when we come for oil again we can pay that price again. $66 dollars.” That’s what hedging means. And the CEO could say, “for 1 year, 2 years, or 10 years,” as long as a higher premium for the longer assurance is wanted.
Some airlines don’t hedge. They theorise that as the economy does better and more people engage in tourism with the airlines naturally making more revenue, crude oil prices will actually follow the same projection. Oil prices are supposed to trend with the economy and so there’s a natural hedge going on. When both profits and oil prices are moving in the same direction, the profits will offset the high fuel prices. Therefore, they don’t see the need to to hedge. They don’t feel the need to pay the $2 premium as per our example.
If the CEO makes this deal and then crude oil prices in the world go down to $56, he or she won’t be able to participate in that. The $66 a barrel is locked in, the airline unable to reap the benefits of lower oil prices. Meanwhile, another airline CEO behind in the queue may not have hedged at all. So when their airline goes up there, if crude oil prices have dropped, they’ll get an advantage on the previous airline.
Any advantage like this can be deadly. Why? Because it allows that airline to lower their prices and beat the poorly hedged airline on price. As I said before, both leisure and business travellers are price-sensitive.
However, if crude oil prices have increased, the tables turn.
So To Hedge or Not to Hedge?
That is the question. Hedging is a conservative play aimed at bringing more control back to the airline. Over a 10, 15, 20, or 30 year timeframe we’re likely to see unpredictable things happen. It’s for that reason that Southwest choose to hedge, wanting assurance. What do you want? You’re the investor, you own the airline. Do you want to not want to be hedging oil prices at the time of reading this? Or, thinking longer term in a safer fashion by going for an airline such as Southwest that consistently hedges no matter what? It’s a personal preference. All airlines have a hedging philosophy that ought to be well laid out in their annual reports and 10K filings.
Investors Cockpit of Airline Metrics ?
As airline investors there are a whole range of financial stress tests that we can apply. There are some that help us make money and some that help us not lose money. Our knowledge of available seat miles will come in handy here.
First, I’m going to bring in MASM. MASM. This is simply the margin that the airline achieves for each of it’s available seat miles. Margins of course are just the difference between revenues and costs, so working backwards, you can deduct that the margin for your airline is made and lost in its dual, aggregated ability to make revenues and control costs. Comparing passenger revenue per available seat mile ( PRASM ) and CASM (cost per available seat mile). Compared to peers, PRASM and CASM should be impressively high and low, respectively!
As potential buyers of airline stocks then it should come as good news when management upgrades the fleet to lower maintenance costs or for fuel efficiencies that will lower cost per available seat mile. Another thing to add is that an airline’s average time flying (or stage length) is important.
The longer you spend in the sky, the less your cost per seat mile.
So, cutting routes that are too short helps airlines improve margins, as well as becoming members of airline alliances like Star Alliance or OneWorld. That helps them cost share. These are the things to look out for, but changes can’t be made overnight of course.
The next metric has to be revenue per employee. In light of the heavy union power in this industry and the supposed lack of pilots, drill this down even more into passenger revenue per pilot . You want there to be no great difference between the productivity of their pilots versus that of their other employees, giving us a clue that they are at-least not suffering any productivity losses, if not any lack of pilots whatsoever. Onto return on invested capital!Return on invested capital (ROIC) is a metric heavily relied upon by investors and airlines alike. 10-15% is a favourable range for an airline to achieve, so long as that’s above the cost of capital. I delve more into what this means in the latter lessons of The Best Investing Course Out There (which is entirely free).
Debt Does Not Belong in the Skies ?
If an airline has a consistent investment grade rating, it will cherish it. It’s such a rarity given the rough nature of their industry. Cash flow to debt ratio is worth a look, telling you if they can service their debt and comfortably take it on to accelerate their growth. Cash reserves, too, are useful numbers at the bottom of the cash flow statement. Over a five, ten, or fifteen year time frame there are going to be industry shocks . Make sure your airline is more ready to deal with those shocks than other airlines in the same sub-industry (low cost carrier, legacy etc.).
If you want a multiple, use EV/EBITDAR over the P/E because of how it normalises the different lease structures that airlines use when they want to lease a plane (which is what most do). It makes airline versus airline comparisons easier. Airlines are very, very cyclical because the economy is cyclical and appetite for flying follows the economy. A modest 4-8 EV/EBITDAR suggests that we’re at a peak in the cycle, compared to the average benchmark of 10-15. Investors in that case are not willing to pay for what’s next in a future investment, which would be a trough for airlines, and probably a recession. This is the weakest time for industrials and airlines.
When said trough comes and everyone’s freaking out over “losses” in the stock market, put the magnifying glass back over Southwest and other airlines you like. You’ll probably see some brave souls starting to pay higher multiples again, so give it a while and investors will start paying a premium for whatever earnings again in droves. That’s because of what they believe is coming next in the cycle, an economic recovery! This is typically the strongest time for industrials and airlines , which is why you see investors rotating in during the early recovery stages and driving multiples higher. See my railroads primer for a complete strategy as to how to invest with this cycle effectively. The same strategy applies to the railroads.
Now go and enjoy a well earned pint, and get amongst those airline stocks if you dare!