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Fear & Loathing in the Airline Sector: An Opportunity to Profit
By Vaughn Cordle, CFA / January 12, 2009
The constant stream of bad economic news will likely keep investors on the sidelines for airline shares in
the short term. Earnings will be ugly in the fourth and first quarters as the airlines report negative fuel
hedge benefits and large losses. Headline news about higher unemployment, falling home prices,
plunging stock markets, and lousy retail sales has resulted in record levels of cash remaining sidelined
and historic lows in 10-year government bonds.
However, history also provides strong evidence that the stock market always moves up well before actual
economic and employment data improve, and the massive sell-offs in airline shares last year caused
severe share price dislocations that have yet to correct, given where oil prices and jet fuel costs are today.
Eventually, investors will return to the investment game, and if their objective is to make money, then
airlines may be the best place to invest today—with the caveat that they are not fit for long-term investment.
Why? Bad fundamentals, which include a tendency for the industry to grow too fast for its own good
coupled with unionized labor that has a nasty habit of capturing the largest share of revenue generated by
the business. In fact, we must assume that any longer term relief in fuel costs will ultimately be offset by
increased labor costs. The exception to this rule will be the low-cost airlines that have young and lower
paid employees.
Certain airline shares are trading well below intrinsic values in view of their significantly improved cash
flow, which is being driven by the recent plunge in jet fuel costs. Fuel costs will be lower by $20 billion in
2009 for the top 10 airlines, and this more than offsets the rather severe $6 to $8 billion revenue hit we are
modeling currently because of the recession-driven contraction in air travel consumption. However, once
we net out the $3.5 billion or so in negative fuel hedge benefits and 2008's $4.3 billion or so in losses, the
industry should earn $4 billion plus in 2009. The group consumes 355 million barrels of jet fuel, so the
earnings estimate rests on a base-case oil price estimate of $60, but within a $50 to $70 range. In other
words, the industry essentially breaks even with $70 oil, but earns $7.5 billion with $50 oil.
With oil between $50 to $60 oil, the industry has the ability to earn profits during one of the weakest
economic periods since World War Two and will likely outperform all other sectors in terms of share price
performance. Airlines have demonstrated an extraordinary effort in terms reducing non-fuel costs and
excess capacity.
Note: Data do not include fuel hedge benefits/costs
Airline shares will remain exceptionally volatile as long as the stream of bad economic news continues
unabated. At some point, however—and most likely between now and the end of the first quarter—
earnings visibility will improve in terms of the upside potential in the airline sector. Moreover, to counteract
the massive losses in 2008, institutional investors must move farther out on the risk curve. High beta and
cyclical airline stocks are the perfect vehicles to provide high returns over the next year or two, or at least
until they are fully valued.
The key to making money in airlines is to remain two steps ahead of the crowd. The strategy should be to
buy (or sell) when shares are significantly below (or above) intrinsic value, and when uncertainty (volatility)
is the greatest. Today, fear is the dominant emotion as the heavily reported unemployment rate continues
to increase and (broader market) corporate earnings trend down in 2009. Airlines are uniquely positioned
to weather the recession because significant capacity cuts were made earlier last year when oil was
trading at more than $100 per barrel. Recall that oil peaked at $147 per barrel in the summer of 2008. We
expect the industry to continue capacity reductions as it right-sizes for a lower volume of consumer
consumption.
It's important to recognize that airline stocks will rebound well before employment numbers and actual
earnings improve. This insight will keep the smart investor ahead of the share price movements. Legacy
airlines will outperform the broader market as well as the low-cost airlines because they have been priced
as if they were going out of business. This is simply not the case when oil prices are below $70. If our
thesis is correct, then certain airline shares will soar—50% to 300% returns—as fear and uncertainty
recede and investors see the light at the end of the economic and earnings tunnel. Even in a very weak and
prolonged downturn, airline shares will rebound, but only if oil prices remain low and capacity discipline is
maintained.
Seventy percent of the industry's pilot contracts are amendable in 2009, and the airlines with the greatest
risk of job actions will likely be American and Continental. United's pilots lost their mojo and negotiating
leverage when the company secured an injunction against a militant and misguided pilot leadership. This
eliminates labor risk for a few years and allows the company a longer period of lower labor costs than
would have been the case otherwise.
Of course, wild swings in airline shares will continue as economic uncertainty remains high and balance
sheets remain over leveraged. However, as long as the risk of bankruptcy is low, beaten-down airline
stocks should provide significant returns over the next year or two. The industry's book equity, as a
percentage of total assets, has fallen from 29% in 2008 to 8% today, and several airlines have negative net
assets. The high leverage, combined with the exceptional volatility in oil prices, drives high betas and
share price volatility.
For every one-and-a-half steps forward, there will be one step backwards in airline share prices, as greed
eventually replaces fear during the transition from $4 billion in losses to perhaps $4 billion in profits. The
good news is that these steps will continue to head in the right direction as long as oil prices remain
below $60. Earnings comparisons will look significantly better once the bad [negative fuel hedge
impacted] 4Q08 and 1Q09 periods are history. The expected shift in market sentiment from negative to
positive represents the broad theme that should provide comfort to those who have the nerve to invest in
high beta airline shares. When market sentiment shifts many of the beaten down airline share prices
should gap up to a more appropriate equilibrium value that is appropriate for the expected cost of jet fuel.
Hate the airlines for their lousy service and wealth-destroying nature, but love the investment when price
dislocations provide a rare opportunity to profit in a downtrodden industry—on the cusp of a major
turnaround. If investors wait until the fog of [earnings] uncertainty dissipates, they will likely miss the larger
returns that typically come before better earnings materialize.
©Copyright 2009 AirlineForecasts, LLC All Rights Reserved
By Vaughn Cordle, CFA / January 12, 2009
The constant stream of bad economic news will likely keep investors on the sidelines for airline shares in
the short term. Earnings will be ugly in the fourth and first quarters as the airlines report negative fuel
hedge benefits and large losses. Headline news about higher unemployment, falling home prices,
plunging stock markets, and lousy retail sales has resulted in record levels of cash remaining sidelined
and historic lows in 10-year government bonds.
However, history also provides strong evidence that the stock market always moves up well before actual
economic and employment data improve, and the massive sell-offs in airline shares last year caused
severe share price dislocations that have yet to correct, given where oil prices and jet fuel costs are today.
Eventually, investors will return to the investment game, and if their objective is to make money, then
airlines may be the best place to invest today—with the caveat that they are not fit for long-term investment.
Why? Bad fundamentals, which include a tendency for the industry to grow too fast for its own good
coupled with unionized labor that has a nasty habit of capturing the largest share of revenue generated by
the business. In fact, we must assume that any longer term relief in fuel costs will ultimately be offset by
increased labor costs. The exception to this rule will be the low-cost airlines that have young and lower
paid employees.
Certain airline shares are trading well below intrinsic values in view of their significantly improved cash
flow, which is being driven by the recent plunge in jet fuel costs. Fuel costs will be lower by $20 billion in
2009 for the top 10 airlines, and this more than offsets the rather severe $6 to $8 billion revenue hit we are
modeling currently because of the recession-driven contraction in air travel consumption. However, once
we net out the $3.5 billion or so in negative fuel hedge benefits and 2008's $4.3 billion or so in losses, the
industry should earn $4 billion plus in 2009. The group consumes 355 million barrels of jet fuel, so the
earnings estimate rests on a base-case oil price estimate of $60, but within a $50 to $70 range. In other
words, the industry essentially breaks even with $70 oil, but earns $7.5 billion with $50 oil.
With oil between $50 to $60 oil, the industry has the ability to earn profits during one of the weakest
economic periods since World War Two and will likely outperform all other sectors in terms of share price
performance. Airlines have demonstrated an extraordinary effort in terms reducing non-fuel costs and
excess capacity.
Note: Data do not include fuel hedge benefits/costs
Airline shares will remain exceptionally volatile as long as the stream of bad economic news continues
unabated. At some point, however—and most likely between now and the end of the first quarter—
earnings visibility will improve in terms of the upside potential in the airline sector. Moreover, to counteract
the massive losses in 2008, institutional investors must move farther out on the risk curve. High beta and
cyclical airline stocks are the perfect vehicles to provide high returns over the next year or two, or at least
until they are fully valued.
The key to making money in airlines is to remain two steps ahead of the crowd. The strategy should be to
buy (or sell) when shares are significantly below (or above) intrinsic value, and when uncertainty (volatility)
is the greatest. Today, fear is the dominant emotion as the heavily reported unemployment rate continues
to increase and (broader market) corporate earnings trend down in 2009. Airlines are uniquely positioned
to weather the recession because significant capacity cuts were made earlier last year when oil was
trading at more than $100 per barrel. Recall that oil peaked at $147 per barrel in the summer of 2008. We
expect the industry to continue capacity reductions as it right-sizes for a lower volume of consumer
consumption.
It's important to recognize that airline stocks will rebound well before employment numbers and actual
earnings improve. This insight will keep the smart investor ahead of the share price movements. Legacy
airlines will outperform the broader market as well as the low-cost airlines because they have been priced
as if they were going out of business. This is simply not the case when oil prices are below $70. If our
thesis is correct, then certain airline shares will soar—50% to 300% returns—as fear and uncertainty
recede and investors see the light at the end of the economic and earnings tunnel. Even in a very weak and
prolonged downturn, airline shares will rebound, but only if oil prices remain low and capacity discipline is
maintained.
Seventy percent of the industry's pilot contracts are amendable in 2009, and the airlines with the greatest
risk of job actions will likely be American and Continental. United's pilots lost their mojo and negotiating
leverage when the company secured an injunction against a militant and misguided pilot leadership. This
eliminates labor risk for a few years and allows the company a longer period of lower labor costs than
would have been the case otherwise.
Of course, wild swings in airline shares will continue as economic uncertainty remains high and balance
sheets remain over leveraged. However, as long as the risk of bankruptcy is low, beaten-down airline
stocks should provide significant returns over the next year or two. The industry's book equity, as a
percentage of total assets, has fallen from 29% in 2008 to 8% today, and several airlines have negative net
assets. The high leverage, combined with the exceptional volatility in oil prices, drives high betas and
share price volatility.
For every one-and-a-half steps forward, there will be one step backwards in airline share prices, as greed
eventually replaces fear during the transition from $4 billion in losses to perhaps $4 billion in profits. The
good news is that these steps will continue to head in the right direction as long as oil prices remain
below $60. Earnings comparisons will look significantly better once the bad [negative fuel hedge
impacted] 4Q08 and 1Q09 periods are history. The expected shift in market sentiment from negative to
positive represents the broad theme that should provide comfort to those who have the nerve to invest in
high beta airline shares. When market sentiment shifts many of the beaten down airline share prices
should gap up to a more appropriate equilibrium value that is appropriate for the expected cost of jet fuel.
Hate the airlines for their lousy service and wealth-destroying nature, but love the investment when price
dislocations provide a rare opportunity to profit in a downtrodden industry—on the cusp of a major
turnaround. If investors wait until the fog of [earnings] uncertainty dissipates, they will likely miss the larger
returns that typically come before better earnings materialize.
©Copyright 2009 AirlineForecasts, LLC All Rights Reserved
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