Should You Invest in Airline Stocks?

These are the best ways to evaluate airline stocks and determine which ones belong in your portfolio

Most airline stocks have not rewarded their shareholders well in the first quarter of 2019. With the second crash of Boeing’s (NYSE:BA) 737 MAX, dark clouds have also rolled in over the industry. However, Q2 is likely to bring more cheer for investors in this area, which presents some interesting opportunities for investors.

Should You Invest in Airline Stocks?

But before you consider investing in airline stocks, you need to understand the cyclical as well as the long-term factors that drive their prices.

The following is an in-depth breakdown of the airline space:

Airline Industry: Drivers of Change

Since the first flight in 1903, the commercial air industry has grown to become one of the biggest industries in the world. In recent years, the demand for air travel has been increasing faster than both the domestic and global GDP levels.

In 2019, the International Air Transport Association (IATA) expects 1% 0f world GDP to be spent on air travel and that North American airlines will perform best globally with a forecast 6% net post-tax profit margin. In the U.S., a strong economy, low unemployment and increased consumer spending have been the recent tailwinds for the industry.

There are several crucial drivers of change that affect the industry directly as well as airline management. These factors include:

  • societal developments (such as urbanization and demographic changes)
  • economy (such as the price of oil, business cycles and volatility)
  • technology (such as aircraft development, cybersecurity, or the role of social media in customer engagement)
  • environment (such as regulation of emissions and noise pollution)
  • politics (such as government decisions on airspace ownership, regulatory changes, trade protection, and national or regional response to terrorist threats).

Within this context, airlines are under constant pressure to improve performance, ensure passenger safety, increase efficiency, become technologically advanced and at the same time, excel in customer satisfaction.

Types of Airlines

Thanks to a wave of mergers since 2005, in the U.S., four airlines — Delta Airlines (NYSE:DAL), American Airlines (NASDAQ:AAL), United Continental Holdings (NASDAQ:UAL) and Southwest Airlines (NYSE:LUV) — control about 80% of U.S. airline commerce.

These network airlines rely on the hub-and-spoke system, where the hubs serve as a base and transfer airports to get passengers to their final city. The U.S. 1978 Airline Deregulation Act initiated the liberalization of air transport as well as the cooperation between airlines. In 1988, the European Union followed the U.S. with an E.U. directive that began liberalizing the internal aviation market. Such deregulation resulted in the rapid growth of the global airline industry.

Increased liberalization coupled with globalization has encouraged major airlines to create or join inter-carrier alliances. Currently, the three largest passenger alliances are the StarAlliance, SkyTeam and Oneworld. For example, United is a member of StarAlliance, Delta belongs to SkyTeam and American is part of Oneworld.

Over the past three decades, the airline industry globally has also witnessed the increased market share of low-cost carriers (LCCs). In the U.S., there are low-cost carriers like Southwest Airlines and JetBlue (NASDAQ:JBLU). A sub-category within this sector is the ultra-low-cost carriers (ULCCs) like Spirit Airlines (NYSE:SAVE).

As European airlines, Ryanair (NASDAQ:RYAAY) and easyJet (OTCMKTS:ESYJY) have made strides when it comes to growth. Although these airlines initially focused on the U.K. and Ireland, all of continental Europe now witnesses the growth of the ultra-low-cost segment.

The most successful services have been to leisure destinations that previously lacked reasonably priced direct routes (such as travel destinations in Spain, Italy and France). These airlines have seen exponential growth in total traffic and have captured a substantial market share from the traditional large network carriers. Industry analysts are expecting a similar growth story in the U.S., while the millennials opt out for carriers like Spirit as they try to save on their travel costs, especially to shorter destinations.

In other words, the airline industry is a dynamic and highly competitive industry, offering investors opportunities to pick stocks that have significant growth potential.

Valuing Airline Stocks

The economics of running an airline are quite complex. However, at the end of the day, like any other business, airlines need revenues to cover operating costs and become profitable.

The airline business is capital intensive and substantial investment is needed to accommodate traffic growth. The industry’s two largest operating costs are fuel and labor. Increased costs in either one of them usually have a direct effect on the price of airline stocks.

The sources of operating revenue include passenger, cargo, excess baggage and other transport-related revenue.

When valuing airline stocks fundamentally, investors usually pay attention to several industry-specific terms that describe an airline’s fundamental performance.

Available seat miles (ASM) is the preferred measure of capacity in the airline industry. For example, an airline with a single plane of 200 seats that flies 5,000 miles per day is generating 1,00,000 ASMs a day.

Revenue passenger mile (RPM) measures airline traffic, showing how many passengers an airline carries as well as how far they travel.

Load factor is the percentage of seats filled by fee-paying passengers over a certain period. In general, analysts would like to see higher load factors.

Passenger revenue per available seat mile (PRASM) is a unit of efficiency. It is the division of operating income by available seat miles (ASM). In general, higher PRASM is better.

Yield is the average fare per passenger per mile. Yield is a dynamic metric, as it varies for different market segments and different seat classes.

Revenue per available seat mile (RASM) is an important metric for valuing ultra-low-cost carriers. It is similar to PRASM, but it includes all sources of revenue. These sources may include extra fees for baggage, seat selection, food and drink on board and the use of Wi-Fi. Generally, airline companies that have a high RASM are known to have more efficient operations and achieve profitability.

Cost per available seat mile (CASM) measures an airline’s cost in relation to its capacity. Its focus is on expenses impacting an airlines bottom line.

Analysts highlight the importance of economic activity such as GDP levels on air traffic growth and profit levels. In other words, an economic slowdown or a recession usually leads to reduced traffic and lower yields, especially in business-related travel. Individual leisure travel also decreases.

Therefore, Wall Street regards the industry as cyclical. Cyclical stocks, such as airline stocks, rise when the economy is growing and fall when the economy slows down. Fewer passengers and fewer flights lead to declining revenue and profits for airlines companies, which pressures their stock prices.

However low-cost or ultra-low-cost carriers may be able to weather an economic downturn somewhat better than established network airlines as these discount airlines operate under a lean cost structure.

In summary, an airline’s ability to prosper within this highly competitive industry depends on its productivity and cost competitiveness.

The Bottom Line on Airline Stocks

When evaluating airline stocks, in addition to looking at various fundamental metrics, I also pay attention to potential future changes and trends within a geography or society. As travel demand both in the U.S. and globally increases, well-managed airline stocks may deserve a place in a diversified portfolio.

As of this writing, Tezcan Gecgil did not hold a position in any of the aforementioned securities.

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