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Street Patrol
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| | Street Patrol
Are airline stocks cleared for takeoff?
We went looking for reasons to buy the major carriers. What we found was an industry with $70 billion in revenues, but no profits and a business model that dates to the Wright brothers.
By Robert Walberg
At a time when the economy is roaring ahead, consumer confidence is high and corporate spending is on the rise, one would expect airline stocks to take flight. Not true. In fact, the Dow Jones U.S. Airlines Index ($DJUSAR) is the worst performing major industry measure over the last three months, posting a loss of 16%.
Why are the airline stocks struggling at a time when other travel-related industries such as cruise lines, casinos, lodging and restaurants are posting solid gains? One explanation for the groups struggle could be that investors, more than passengers, are shying away due to the recent spate of terrorist threats. Considering that a number of international flights have been grounded in recent weeks, there is probably some merit to the argument.
Yet major companies recent load factor data -- the percentage of available seats that are filled with paying passengers -- suggests that air travel is actually on the rise.
Oil prices take a bite
Another reason cited for the sectors sluggish performance is the rise in oil prices. Since late September when OPEC announced that it was cutting its official output limits by 900,000 barrels a day, U.S. crude prices have shot up by more than $8 per barrel, or roughly 30%. This weeks explosion at a natural gas plant in Algeria only exacerbated the situation, sending crude to its highest level since the United States invaded Iraq last March. It doesnt take a rocket scientist to figure out that higher fuel costs are bad news for the airline industry.
But just how bad? According to a spokesman for AMR Corp. (AMR, news, msgs), the parent of American airlines, the average spot price for a gallon of jet fuel has jumped by 16 cents over the past couple months. That might not seem bad compared to the jump in crude prices, but according to AMR every one cent rise in jet fuel translates into an annual jump in costs of about $30 million. Ouch!
Led by AMR, several airlines have raised their fuel surcharges by $3 for one-way travel to combat the rise in prices. In this price-sensitive industry, it will be interesting to see if the higher surcharge sticks or if competition will force those companies that have adopted the practice -- United Airlines' parent UAL Corp. (UALAQ, news, msgs) and Continental Airlines (CAL, news, msgs) -- to reverse course. It should be noted that AMR tried a similar move last month, only to drop the surcharge when other carriers failed to follow suit.
A third reason often cited for the groups sluggish performance of late is that the industry simply got ahead of itself during last years sharp February-to-November rally, which saw stock in the long-haul carriers gain an average of 265%. There is no doubt that the group was overextended technically back in November. I would even agree that the group ran ahead of its near-term earnings potential, as most of the major airline companies will post another large loss this year.
More investing commentary on MSN Money
$70 billion in revenue
However, when using sales as your benchmark, the groups valuation was never outrageous.
To the contrary, as you can see from the table below, the long-haul carriers sport a combined market cap of only about $18 billion despite revenue projections of nearly $70 billion. The resulting price-to-sales multiple of 0.26 is relatively low, even for a cyclical industry such as airlines.
| Airline Industry Valuation | | Long-haul carrier | Current year est. revenue, billions | Current year est. earnings or loss | Market cap | | AMR Corp. (AMR, news, msgs) | $17.44 | ($10.04) | $2.23 billion | | Continental Airlines (CAL, news, msgs) | $8.82 | ($3.41) | $1.13 billion | | Delta Air Lines (DAL, news, msgs) | $14.60 | ($4.12) | $1.41 billion | | Northwest Airlines (NWAC, news, msgs) | $9.43 | ($6.68) | $1.13 billion | | Southwest Airlines (LUV, news, msgs) | $5.93 | $0.36 | $11.97 billion | | UAL Corp. (UALAQ, news, msgs) | $13.58 | N/A | $170.72 million |
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Obviously, the troubles that have gripped the industry since the World Trade Center attacks of Sept. 11, 2001 contribute to the low price/sales valuation. But when you have an industry capable of generating nearly $70 billion in revenues during tough conditions, imagine what the revenue picture might look like during a prolonged industry upturn. And if the macro environment for the sector were to improve steadily over the next few years, the price-to-sales ratio would escalate substantially from here.
However, if the industry is to enjoy an extended upturn and concurrent jump in share prices, a few things need to happen. Lets start with the obvious. First, the worldwide economic recovery must stay on course. Second, fuel prices need to stabilize or drift lower. Third, there can be no major terrorists incidents related to air travel. Fourth, corporate spending must continue to rise.
The problems run deep
If all of these factors were to align favorably for the industry over the next several quarters, share prices would almost certainly reverse and go higher. But before I would be inclined to chase any rally in the airline group, no matter how dramatic, I need to see signs that the group has come to terms with its longer-term and structural problems of high labor costs, mediocre customer service and poor pricing strategies.
I simply dont understand how the airlines figured they were going to make a profit by increasing their largest cost, which is labor, while maintaining or even cutting their average ticket price. This was the lunacy that plagued the airline industry even before the tragic events of 2001.
While the industry has aggressively cut labor costs over the last one to two years -- as it always does during industry downturns -- I see little evidence that any of the major players, with the notable exception of Southwest Airlines (LUV, news, msgs), have developed a successful pricing strategy. What we continue to see is a confusing tiered pricing structure that results in lousy margins, and more often than not alienates its primary customer base -- the business traveler. Clearly, a business that cant turn a profit on nearly $70 billion in revenues has some big structural problems that demand big changes.
So far all weve seen are the usual adjustments -- slash labor costs, maintain or reduce capacity and increase fees. The lack of creativity on the part of management has been disappointing. Failure to understand the basic problem -- average ticket prices are just too low to consistently turn a profit -- never ceases to amaze me. Either we need to see fewer carriers, or the ones on the endangered list, such as UAL, need to get more creative in changing their business models.
Wait for something new
Whether the carriers try a subscription-based model for their business customers in which corporations could pay a flat monthly fee for unlimited seat access, or they adopt a more simplified pricing structure based on length of travel rather than duration of stay or advanced booking, the industry needs to do something new. Without such changes the industry will simply get smaller. Theres been too much red ink for too long to come to any other conclusion than the business model is broken and doesnt support the current industry dynamics.
Would those companies that survive a shakeout be in a stronger position than they are today due to the simple fact of reduced competition? You bet. But the problem from an investment standpoint is determining which companies would be left standing, and which would fail. With the notable exception of Southwest, which has proven that it can turn a profit in bad times as well as good, there is not a major long-haul carrier that has distinguished itself enough in its decision making to warrant long-term consideration on the part of investors.
Could the stocks rally from here if economic conditions remain bullish for several consecutive quarters? Of course. However, do you really want to invest in companies with flawed business models and unimaginative, uninspired management teams? This time your answer should be no. The airlines should be grounded from most long-term investors portfolios.
Editor's Note: At the time of publication, Robert Walberg did not own or control shares in any of the stocks mentioned in this column.
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