The State of the Airline Industry
Let's examine the state of the airline industry and our predictions for its outlook.
The domestic airline industry has been arguably one of the worst-performing industries in history, cumulatively losing money from its inception while bearing witness to more than 183 airline bankruptcies since 1978. This abysmal historical performance substantiates our claim that all industry participants lack an economic moat. In fact, Warren Buffett observed that the world airline industry has not made a dime for investors in a century of manned flight. Ironically, however, Buffett conceded this point after acknowledging his mistake in buying stock in US Airways (LCC), yet he managed to escape his investment profitably. Given recent developments, we will explore the economic climate that forced the domestic airline industry to change, the current challenges facing the industry, and our take on the industry's outlook.
Fundamental Shift in the Airline Industry
Due to minimal barriers to entry, the airline industry has always faced the threat of new competitors. However, we believe the entire airline industry changed dramatically after the 2001 recession, as low-cost carriers used the downturn to expand aggressively.
The chart below compares the yearly change in passenger traffic growth versus the yearly price changes in domestic airfares (as measured by the Bureau of Labor Statistics Consumer Price Index surveys) lagged by 12 months. When lagged, airfare pricing shows a positive correlation with traffic, especially leading into the 2001 downturn. Intuitively, this makes sense because an increase in demand (known as a change in the quantity demanded) results in higher prices, and vice versa. However, preceding the 2001 downturn the industry witnessed significant expansion of low-cost carriers such as Southwest (LUV) and Air Tran (AAI) and the emergence of startups like JetBlue (JBLU). Furthermore, regional carriers took flight ferrying passengers from small markets to major hubs. Consequently, airfares did not increase as rapidly when passenger travel returned beginning after January 2002. This downward pressure on airfares, combined with the enormous losses suffered from the 9/11 attacks, forced almost all of the legacy airline carriers to file for bankruptcy protection.
Surging Fuel Prices
Therefore, although falling ticket prices are a blessing for consumers, they are catastrophic for airlines if operating costs rise. Traditionally, airlines have had muted success increasing ticket prices to offset a rise in the price of oil. Because inventory is perishable, ticket prices never rise enough to cover higher costs and prices drop expeditiously once fuel prices subside. With this pricing dynamic in place, the entire airline industry soon encountered a near-death experience. Bankruptcy emergence plans forecasted profitability with oil at or around $80 a barrel, but management never dreamed of triple-digit prices. Historically, fuel costs have averaged between 10% and 15% of U.S. airline carriers' operating expenses. Although some firms such as Alaska Air Group (ALK) and Southwest have historically utilized long-term fuel-hedging strategies, legacy carriers use strategies for periods usually less than a year to mitigate the short-term volatility in fuel prices. The argument for hedging short term is that all costs are variable in the long run and these firms can redeploy their flexible fleets to accommodate any passenger-demand and fuel-price environment.
We decided to compare, using historical data, the price per gallon paid for the airlines we cover at Morningstar. The above table depicts the average price (excluding taxes) per gallon for the large airlines from 2006 until the third quarter of 2008. The average price paid per gallon by all U.S. airlines from 2005 to the third-quarter 2008 increased 119% according to Bureau of Transportation Statistics. Despite the industry's long-term hedging argument, it is apparent that Southwest's decision to hedge was prophetic. Southwest was still profitable during this span even though its average price per gallon increased 72%--mark-to-market losses ended the firm's 69th consecutive quarter of profitability in September 2008. Although the absolute change in the dollar per gallon appears trivial at $1.65, it has broad implications for the entire airline industry. According to the Air Transportation Association, the industry uses about 18.7 billion gallons per year, translating to an additional $187 million airlines must spend on annual fuel costs for every penny increase per gallon. As a result, fuel costs now account for roughly 30% to 40% of all airlines' operating costs and is the industry's largest operating expense.
Faced with falling ticket prices and surging oil costs, airline participants aggressively started cutting domestic capacity out of the system. As a result, the industry reduced total capacity by 10% during 2008, grounding 460 planes (the equivalent of eliminating an entire legacy carrier). Meanwhile, industry giants Northwest and Delta officially merged. While the legacy carriers cut capacity, the low-cost carriers also pared back their expansion plans. Furthermore, legacy carriers searched for ways to increase pricing power. Besides layering on fuel surcharges, the industry started to unbundle normal services and charge passengers extra for checking bags and in-flight food. This way, airlines could increase revenues without raising ticket prices. This unbundled package will ultimately benefit consumers because they will theoretically pay only for the service they receive, removing any subsidization among passengers. The most surprising fact of all these actions was that the average ticket price for Southwest increased 18% during the third quarter of 2008 versus the previous year. This increase in price from a low-cost producer indicates that prices have risen across the entire industry. Because airlines have been unable to recoup operating costs through revenues, this price development could be highly beneficial. Furthermore, it could indicate that industry participants are beginning to act rationally instead of competing for the marginal customer.
Now that oil prices have declined dramatically and price increases have thus far remained intact, one would assume airlines are poised to prosper. However, this assumption does not take into account the industry's out-of-the-money fuel hedges. With the exception of Alaska Air Group, most airlines implement costless collars as their hedging strategy. Effectively, this caps fuel prices at a maximum price, but it limits the downside protection. When oil prices fall below a floor price, airlines must make a cash payment equal to the difference between the market price and the floor price, which is similar to an insurance company paying out an accident claim. The reason the airlines employ collars is because they reduce the cash outflow; hence the name costless.
The table above displays the hedge book for the seven major airlines we cover at Morningstar. Based on Sept. 30 quarterly reports, we broke out the percentage of approximate fuel consumption hedged with ceiling (maximum price) and floor (amount where payment begins) prices on an estimated per barrel price of crude oil. For example, Delta had to pay the difference between the spot price per barrel of oil and $115 for 41% of its approximate fourth-quarter fuel consumption. We note that given the drastic capacity cuts, the percent hedged number might be understated. Although complicated hedge accounting often involves noncash charges, these are real cash outflows. Delta estimates it will post $1.1 billion in collateral as of Dec. 31 due to the severity of these losses. Given previous predictions for $200 per barrel oil, these floor prices appear prudent. However, the mathematical averaging does not illustrate how far some airlines went to protect against doomsday. According to its September quarterly report, Northwest hedged approximately 12% of its remaining 2008 fuel requirements with a floor and ceiling price of $161 and $200 per barrel, respectively. In our opinion, this indicates how cataclysmic the rapid rise and fall in oil prices was for Northwest and the industry in general.
As this recession continues, businesses will continue preserving margins by eliminating jobs and cutting unnecessary expenses, such as flying business class, which could affect the airline industry considerably.
The above chart compares the passenger traffic growth versus employment growth lagged by four months. Although the conclusions seem obvious, they suggest that passenger travel will likely fall as job losses continue. Especially around January 2007, falling employment looks like a leading indicator for passenger traffic growth. Besides cutting capacity, airlines have expanded aggressively overseas to stave off the fall in domestic air travel. For now, we expect the higher-yielding international flights will boost revenues, but as supply saturates the industry, we expect those yields to fall.
Once international yields fall, we believe that airlines will once again be stuck in their perpetual conundrum: lowering prices considerably to stimulate demand, or keeping prices elevated and hoping that the near-term barriers to entry of volatile oil prices and tight credit markets might stymie new startups, allowing the industry to survive. It is our contention that the airline industry will always suffer from poor characteristics. Despite this contention, we have increased our fair value estimates for the legacy carriers--Northwest, Delta (DAL), United (UAUA), US Airways, American Airlines (AMR), and Continental (CAL)--over the past half year and then watched some of these stocks nearly triple, be cut in half, and then double again, which begs the question: Should investors start adding domestic airline carriers to their portfolio? In essence, we deem that the airline fundamentals are so extreme that we cannot convincingly bound our fair value estimate with a reasonable range of potential outcomes. We reiterate to prospective investors that even though the greatest companies can be overvalued while the poorest ones can be undervalued, airlines have proved historically that bankruptcy has been a very likely long-term outcome.
Basili Alukos does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.