Airlines: A Positive Story in the Works
by: Kristen Hendrickson and Jun Zhu
We think a positive supply/demand scenario may finally be playing out for this notoriously troubled industry group. Endless impediments over the past decade (recession, record-high oil prices and union labor issues just to name a few) have ultimately and painfully led to a massive industry transformation. While the storm is subsiding, an inordinate amount of obstacles may continue troubling the airline industry. Still, this doesn’t mean there isn’t potential for money to be made, as the Airlines group has managed to handily outperform the S&P 500 (total return) by nearly 7% YTD.
Subdued Capacity Supporting Higher Airfares
All of the industry drama has led to a seemingly helpful outcome—system capacity (defined here as U.S. carriers’ domestic + international flights) has been held in check for an extended period of time. This is due to a variety of factors, including managements’ reservations regarding increasing capacity in a slow-growing economy with volatile oil prices, along with bankruptcies and consolidations that have resulted in fewer competitors. This is clear in the chart below, as capacity lost during the recent recession (measured as year-over-year changes in total available seat miles) still has not been fully recovered. Even after some recovery from mid-2010 to mid-2011, capacity growth has slowed again with the 12-month moving average trending down to zero. Also noteworthy are the recent gradual increases to capacity compared to the sharp jumps seen in this reading in the early half of the last decade. It seems Airlines may finally be attempting different tactics and are exhibiting more discipline in this regard.
Capacity Utilization (Load Factor; revenue passenger miles-to-available seat miles) is one of the key ingredients in the airline profitability equation. Depicted below, the load factor has been trending upward over the past couple of decades, reaching historic levels as demand has outpaced capacity growth. Furthermore, looking at this measurement on a year-over-year basis (bars in lower graph), shows the system load factor trending upward since the beginning of 2011.
This constrained capacity ultimately contributed to U.S. carriers’ ability to charge higher airfares. As seen in the chart below, annual real airfares (shown in 1995 dollars) have been rising since 2009. Despite this recent rise of about 14%, prices remain below their real 1995-to-date median, as price wars among airlines have continually driven prices down. These relatively low prices lead us to conclude there may be room to further increase airfares, especially as demand continues growing despite the price hikes that have already taken place.
Increasing demand (more on this next) and rising airfares have resulted in growing revenues over the past few years. The chart below shows the annual changes in inflation-adjusted yields (measured in revenue cents per revenue passenger mile) from 1940 through Q2 2012. What is compelling is the 5-year moving average trending upward since the beginning of the last decade and breaking above the 0% threshold for only the second time over this 72 year timeframe. Perhaps we’ve entered a period where real yield can sustain its recent growth.
Travel Volume Rising Along With Travelers’ Enthusiasm
Sustained demand is important to maintain higher ticket prices. According to the Transportation Service Index (compiled by the Department of Transportation), the volume of transportation in the U.S. continues to rise. While the movement of goods has declined somewhat this year, passenger services continues its strong momentum (already reaching peak levels recorded in 2007).
Based on Conference Board’s survey (bottom chart below), consumers are ready to fly for leisure more than any time relative to the past couple of decades. The percentage of survey respondents who plan to travel by plane (chart below) is hovering around 22%, clearly an elevated level compared to the past.
Furthermore, according to the 2012 Business Travel Survey and American Express and CFO Re- search Services, 71% of U.S. financial executives expected to spend the same or more on business travel this year (which already appears to be reflected in the positive YTD data). This is good news as business travelers tend to be less price-sensitive and therefore more lucrative for airlines. The Business Travel Survey mentions significantly fewer firms are reporting negotiated deals/discounts with airlines. All of this bodes well for supporting airfares and, barring any significant events, we expect demand for air transportation to remain strong.
Can Airlines Hold On To Historically Low Labor Costs?
Compared to our positive perspective on airlines’ revenue growth, we are slightly less optimistic on the cost side of the equation. However, any upside surprises about the industry’s cost control would certainly be welcome news. As labor and fuel are the two major expenses in the industry’s cost structure, we focus the discussion here.
Over the past two decades, airlines have successfully slashed labor expenses through bankruptcy and negotiations with labor unions. The absolute
amount of labor expenses in the industry has been steadily rising, but as a percentage of revenue, it has declined from 30-35% earlier in the decade, to less than 25% as of now.
Going forward, further reduction in labor costs might be difficult to pull off. For example, airlines have kept pilots’ compensation so low they are now facing a pilot shortage. Low entry salaries make the hefty cost of professional training difficult to justify. Looking at labor productivity (lower chart above, approximated by total miles flown divided by total number of employees), it seems airlines have squeezed as much as they can out of the labor force. Nevertheless, as the slack in the overall labor market continues, airlines may be able to hold on to their historically low labor costs, which will bode well for them as air travel continues to pick up.
Tackling High Fuel Costs: Forecast Hazy
Aside from labor costs, the industry is increasingly making more efforts to tackle the other big ticket, volatile expense — jet fuel. The price of jet fuel has increased dramatically since 2000, and as a result, fuel expenses now account for more than 28% of revenue (compared to the 12% average during the 1990s, top section at right).
One common strategy is fuel hedging. But hedging only takes short term fluctuations out of the picture, and it can result in losses, leaving the industry unable to defend itself against the secular trend of higher energy prices (bottom section of chart above). At least lower labor costs are providing much needed relief to airlines, given all the uncertainties surrounding fuel prices.
Two factors influence jet fuel prices: crude oil prices (the input) and the crack spread (the manufacturing process). We certainly aren't energy experts capable of predicting prices, but we see the widely recognized domestic oil boom (demonstrated by the price differential of Brent and WTI) as a precursor to a stabilization of oil prices in the next few years.
Aside from the input cost, jet fuel prices are also impacted by the crack spread, which is the cost of making jet fuel from the crude, plus the refiner’s margin (if any). The crack spread has been rising steadily since crashing in early 2009. So does any potential solution exist for airlines’ bottom line being almost completely dependent on oil prices? Delta is attempting vertical integra- tion through the acquisition of a refining facility. Will this strategy work? Time will tell, but it is reassuring to see airlines brainstorming new money-makers whether they are buying refineries, pushing for more efficient aircraft or charging new and creative ancillary fees (the latter have transformed into a multi-billion dollar business).
Bottom Line: Industry P&L Looking Good
Higher revenue tailwinds, coupled with breathing room on the expense front, have left the industry’s P&L looking good. Beginning in Q2 2009, large U.S. airlines (including all airlines with revenue greater than $20 million) have experienced thirteen consecutive quarters of positive operating profit. Perhaps airlines are entering a period similar to the second half of the 1990s, when carriers touted sustained profits and rising stock prices.
CONCLUSION: The Airlines group currently sports an Attractive ranking along with impressive cash flow measurements. The group’s revenues are rising as decreased capacity, coupled with rising demand, allows airlines to raise airfares that are still below real median historical levels. Labor costs-to-revenue are also at historically low levels; and while oil is always a question mark, airlines are getting creative when it comes to combating this volatile expense. Finally, operating revenues have been promising of late, and we think it may be time to consider getting on board.
The Leuthold Group, LLC provides research to institutional investors. It is also a registered investment advisor that uses its own re- search, along with other data, in making investment decisions for its managed accounts. As a result, The Leuthold Group, LLC may have executed transactions for its managed accounts in securities mentioned prior to this publication.
The information contained in The Leuthold Group, LLC research is not, without additional data and analysis, sufficient to form the basis of an investment decision regarding any one security. The research reflects The Leuthold Group, LLC’s views as of the date of publication, which are subject to change without notice. The Leuthold Group, LLC does not undertake to give notice of any change in its views regarding a particular industry prior to publication of their next research report covering that industry in the normal course of business. The Leuthold Group, LLC may make investment decisions for its managed accounts that are inconsistent with, or contrary to, the views expressed in current Leuthold Group, LLC reports.
As with any investment, there can be no assurance that any of the funds’ investment objectives will be achieved or that an investor will not lose a portion or all of his or her investment in a fund. Limited Partnerships may offer limited liquidity, may engage in speculative investment practices, may offer limited valuation information to investors and will not be registered. A prospective investor should consult its own tax advisor regarding tax consequences of an investment in a fund.
This report does not constitute an offer or a solicitation of an offer to buy a security. Any offer of solicitation for Limited Partnerships must be made only by means of a delivery of a definitive private offering memorandum. The Partnership’s performance data have not been compiled, reviewed or audited by an independent accountant, and data for recent periods may be adjusted as a result of a subse- quent audit of the year of which those periods are a part.
Because the views expressed in Leuthold Group, LLC research relate to industry groups rather than individual securities, industry group ratings cannot be assumed to apply to each individual security within a group. Thus, if industry group “A” is ranked “Attractive,” The Leuthold Group, LLC may still decide to sell one or more of the component securities in group “A.”
Weeden Investors, L.P., Weeden & Co., L.P.'s parent company, owns 22% of Leuthold Group’s voting securities. An Executive Man- aging Director of Weeden & Co., L.P. is a member of The Leuthold Group, LLC board of directors.
Weeden & Co., L.P. Member FINRA, NASDAQ, and SIPC.