Fuel Prices - The Airline Industry's Toughest Headwind
Few factors take the wind out from under its wings like costly fuel.
The airline industry has made tremendous strides recently, after surging fuel prices, highly restrictive credit markets, and a debilitating recession pushed all carriers to the brink just three years ago. Subsequently, airlines smartly adopted an aggressive pricing scheme, and the reassuring upturn led the sector to impressive profitability during 2010. Current share prices indicate investors may now have a more constructive view toward both the industry's attractiveness, and the larger airlines' ability to compete more effectively going forward.
However, our view diverges somewhat from that rosy scenario. We suggest investors steer clear of many of these names. At their current market valuations, we think there's little margin of safety to make this an attractive entry point. In addition, while the industry has combated rising oil prices with fuel surcharge-like price increases, we don't believe that these pricing actions can offset recent cost increases. As a result, in early March, we lowered our fair value estimates for all of the legacy carriers, including: AMR (AMR), Delta (DAL), United-Continental Holdings (UAL), and US Airways (LCC).
Fuel Prices Dictate Airline Profitability.
The labor-intensive nature of the industry combined with high union participation has caused payroll-related expenses to remain the largest expense item for the airline industry. However, while labor costs have consistently fallen in nominal terms as the industry has removed pensions and seen its labor forces contract, fuel expenses have been extremely volatile due to geopolitical shocks. These include the 1970s oil embargo, and the current turmoil in the Middle East.
Although fuel expenses have only recently represented the largest line item for the airline industry, we believe oil prices have dictated airline profitability since the 1970s. In the chart below, we plotted the inflation-adjusted (using the commodities series from the Bureau of Labor Statistics' CPI index) price per gallon of fuel (in cents) for the airline industry compared to the Air Transportation Association's Airline Cost Index. This index is a basket of airline expenses that adjusts each line item for inflation based on the percentage weight of each expense--we prefer the ATA cost index to the overall CPI since the weightings are more appropriate. The chart clearly illustrates a strong positive correlation between the price of fuel and the overall cost index.
We reproduced the same Airline Cost Index in the bottom chart, but we included both the Bureau of Transportation Statistics' Air Travel Price Index, which measures the real price of airline tickets, and the pre-tax operating margins for the airline industry, to show the interrelationship between all three variables.
We draw two conclusions from this analysis. Our first chart above shows that changes in fuel prices dictate changes in airline operating costs. The second plot confirms that airline operating margins (orange bars) are clearly negatively correlated with airline costs (blue line). Thus, during the inflation spike in the late 1970s, airline profitability tumbled, while the collapse in airline costs during the 1990s led to substantial operating profitability for the industry. This relationship breaks down slightly between 2001 through 2004 during the aftermath of 9/11 and the financial burden it caused the industry.
Second, the airline industry has little pricing power in real terms, and there is often a substantial lag in ticket price increases when the industry attempts to recoup rising fuel costs. As recently as the middle of 2009, however, the airline industry raised ticket prices in lockstep with rising costs, and the substantial cost reductions the industry underwent, including two large-scale mergers (Delta-Northwest, and Continental-United) have helped reduce costs throughout the industry.
Despite the historical evidence that rising oil prices are responsible for the industry's losses, the airlines are loathe to enter into fuel hedges. Southwest (LUV) and Alaska Air Group (ALK) are the only major airlines with substantial hedges in place past 2011. The 2000s bankruptcy era forced the industry to reduce its hedging exposure, and the industry claims that it is not in the business of predicting fuel prices. Firms claim to be able to adjust flexible fleets to meet both the demand and the fuel-price environments. However, we think hedging should represent a greater portion of the industry's cost-mitigation strategy. Southwest is eloquent testimony to this notion, since its admirable profitability during the past decade has largely stemmed from its lucrative fuel hedges. In fact, based on our capacity growth projections for 2011, we estimate that each one-dollar increase in the price per barrel of crude oil results in between $415 million and $450 million in greater annualized operating expenses (or nearly 30 basis points of industry revenue) for the domestic passenger airline industry.
Will Pricing Power Prevail?
Airlines believe consolidation should improve pricing power, but passengers remain highly sensitive to price increases. During Delta's and Southwest's Analyst Days last December, both carriers commented on how fuel price increases necessitate raising prices. Delta hopes the industry can adopt a fuel-surcharges scheme similar to what UPS (UPS) and FedEx (FDX) currently employ to protect the passenger industry's fleeting profits. However, we do not expect the industry to emulate this success unless the airline industry can create barriers to entry. UPS and FedEx operate in a concentrated market, so customers have few substitutes. In the airline industry, however, passengers have a plethora of choices, between different airlines and different modes of transportation--cars, bus, or rail. So long as these factors remain, we don't believe the airline industry will demonstrate the requisite discipline to implement a successful fuel surcharge.
In years past, low-cost carriers like Southwest were responsible for pushing low fares, and we believe they were responsible for the industry's pricing problems during the past decade. During the first four months of 2011, however, Southwest has matched competitors' successive price increases, suggesting the perennial antagonist has changed its behavior, and perhaps indicating that the industry has gained pricing power. We think otherwise.
We anticipate that airlines could begin to experience some softening in pricing power within the next six months, and that the industry will lower prices to attract passengers. Anecdotally, we've already heard of passengers buying tickets close to the flying date at prices half off of the original fare, and more recently, some industry participants have resisted the latest round of price increases.
We see little long-run value at today's prices. That said, the three major mergers since 2008 (Delta-Northwest, United-Continental, and recently closed Southwest-AirTran) are substantial positives for the industry, as these three companies will account for nearly 65% of the domestic airline capacity, compared to around 40% heading into the recession. Moreover, the concerted reaction by all airlines to implement ancillary fees suggests some rationality is permeating the industry (although Southwest remains committed to its "Bags Fly Free" campaign).
While these actions augur well for the industry and our thoughts about competitive advantages in the space, we still think the industry's poor characteristics, including low barriers to entry and nonexistent customer switching costs, will prevail, and we're not ready to upgrade any airline moat or moat trend ratings. High fuel prices and restrictive credit spared the industry from any meaningful new startups or substantial expansion during the recession, but we view these impediments as transitory at best. Until we gain better confidence that the airline industry has evolved into a more rational market, we believe investors should view these companies as mere trading instruments, and not long-term value investments.
Basili Alukos does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.