Can Airline Stocks Continue Soaring? 3 Pros, 3 Cons

by Susan J. Aluise | September 30, 2013 10:50 am

Can Airline Stocks Continue Soaring? 3 Pros, 3 Cons

Airline stocks have had a great run in 2013, and investors who were lured by the sector’s attractive valuations over the last 12 months have been handsomely rewarded with strong returns. Just consider this quick rundown of the biggest names:

Still, the airline industry has a well-deserved reputation for being a tough place to make money, as Warren Buffett pointed out at Berkshire Hathaway’s (BRK.B[7]) annual shareholder meeting back in May. “Investors have poured their money into airlines and airline manufacturers for 100 years with terrible results,” Buffett said, adding that airlines have been “a death trap for investors.”

So can airline stocks continue to gain altitude, or is it time for investors to buckle up and return their tray tables to an upright position? Here are three pros and three cons:

Pros

Air Travel Growth: Air travel is subject to the same short-term fits and starts that hammer other consumer cyclical businesses, but air travel is still slated for strong growth over the long haul. An international market forecast from Airbus (EADSY[8]) released last week predicts that the commercial aircraft fleet will double over the next 20 years, riding the tide of air travel growth of nearly 5% a year between now and 2032. A side benefit for airlines: Those new planes EADSY and rival Boeing (BA[9]) are building will be vastly more fuel efficient than current fleets, giving carriers a big break on fuel costs.

Fee Income: Ancillary revenue from baggage and change fees, upgrades and other such initiatives just keeps on rising. It hit $27.1 billion in 2012[10] and, these days, ancillary revenue can account for more than 38% of a carrier’s revenue. Most airlines are exploring new revenue streams as well — particularly with enhanced in-flight entertainment options[11].

Profitability: On top of that, North American airlines are expected to post their strongest performance this year. The International Air Transport Association[12] (IATA) recently raised its 2013 profit projections among carriers in the region to a total of $4.9 billion, up from the previously forecast $4.4 billion and more than double the $2.3 billion profit of 2012.

Cons

Margins: Then again, the airline industry has notoriously thin margins. As Brian Pearce, IATA’s chief economist, put it: “In 2012, airline profits were $7.6 billion. It boils down to airlines making just $2.56 per passenger. Clearly, any increase in costs, a rise in government taxes or a drop in demand will eradicate that slim profit margin very quickly. And even without those dynamics, $2.56 is not enough to pay investors who are risking considerable sums of money.” In fact, IATA says investors would get $17 billion more per year if they put their money in equities and bonds of a similar risk profile outside the airline industry.

Federal Budget Woes: Fears of a government shutdown have raised another valid concern for the industry, considering lower travel as a result of sequestration already has pinched airline revenues. A shutdown could affect government-related travel by employees or contractors. And if passports are not processed, airlines could face cancellations on profitable international trips.

Middle East Crisis: Jet fuel accounts for 35% to 40% of airlines’ costs and very small price increases can flip an airline’s profit to a loss fast. Although oil prices trended down slightly on Friday amid stepped-up diplomatic overtures to Syria and Iran, the region remains a powder keg — and there are an awful lot of matchbooks at the ready. Plus, perhaps a more significant risk involves internal troubles in Egypt that potentially could disrupt tankers’ transit through the Suez Canal. Last month, militants attacked a China-owned container ship in the canal, but were unsuccessful either in damaging the ship or closing the critical shipping choke point. But the incident paints a stark picture of how easy it could be to wreak havoc on industries, like airlines, that are dependent on oil.

The Verdict

Airlines have had a spectacular run so far this year, and many are still trading at ridiculously low multiples. That said, the airline business balances on a razor’s edge and even a gentle wind from the wrong direction can pitch a stock into the red.

If you’re in now, it’s probably a good time to take profits. And if you’re contemplating establishing a new long position, hold off for a bit because there’s bound to be a pullback — perhaps a sharp one — in the next couple of months.

As of this writing, Susan J. Aluise did not hold a position in any of the aforementioned securities.

Endnotes:
  1. DAL: http://studio-5.financialcontent.com/investplace/quote?Symbol=DAL
  2. UAL: http://studio-5.financialcontent.com/investplace/quote?Symbol=UAL
  3. LUV: http://studio-5.financialcontent.com/investplace/quote?Symbol=LUV
  4. JBLU: http://studio-5.financialcontent.com/investplace/quote?Symbol=JBLU
  5. LCC): http://studio-5.financialcontent.com/investplace/quote?Symbol=LCC)
  6. AAMRQ: http://studio-5.financialcontent.com/investplace/quote?Symbol=AAMRQ
  7. BRK.B: http://studio-5.financialcontent.com/investplace/quote?Symbol=BRK.B
  8. EADSY: http://studio-5.financialcontent.com/investplace/quote?Symbol=EADSY
  9. BA: http://studio-5.financialcontent.com/investplace/quote?Symbol=BA
  10. $27.1 billion in 2012: http://www.ideaworkscompany.com/wp-content/uploads/2013/09/Press-Release-81-Ancillary-Revenue-Yearbook-2013.pdf
  11. in-flight entertainment options: http://investorplace.com/2013/08/5-airlines-offering-hot-in-flight-entertainment-innovations/
  12. International Air Transport Association: http://www.iata.org/pressroom/pr/Pages/2013-09-23-01.aspx

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