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Market Update

Will Airline Stocks Fly in 2017?

Berkshire Hathaway's big investment in the large domestic carriers has revived interest in these volatile stocks.

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In mid-November, the world learned that Warren Buffett had bet on airlines. His company,  Berkshire Hathaway (BRK.B), invested $1 billion in  American Airlines (AAL),  Delta Air Lines (DAL), and United Continental Holdings (UAL), during the third quarter.

It was a curious move for the value investor, in part because he's been negative on these companies in the past, saying at a 2013 shareholder meeting: "The airline industry has a situation where it has a very low incremental cost per seat with enormous fixed costs. … I'm skeptical."

Why did Buffett buy into these businesses then? He hasn't said, of course. 

But when Berkshire purchased these airlines, they were going through a major rough patch. Greggory Warren, a senior analyst at Morningstar who covers Berkshire Hathaway, wrote shortly after the airline news broke: "On the surface, it looks to have been a good bet, as all three names got dragged down by the volatility created by the Brexit vote at the end of June only to increase in value more than 25% during the past four and a half months." In the fact, the airline sector was one of the worst industry performers during the second quarter of 2016, with the S&P 500 airline industry subindex falling by 30% between April 20 and June 27.

A Turbulent Year
Despite a less-than-stellar start to 2016, the airline industry has performed incredibly well the past five years. It's up 312% since the end of 2011 versus the S&P 500's gain of 80% during the same period. It used to be a mess of an industry, but consolidation, fewer price wars, improved capacity and better management overall have dramatically improved performance--and returns. Yet, airline stocks, in general, are still highly sensitive to specific market factors.

The sector struggled in 2016 because many international routes were not selling out, partly due to terrorism fears, says Chris Higgins, an equity analyst at Morningstar. Rising oil prices, which these companies are particularly sensitive to, negatively impacted operating margins, while worries over global GDP growth had an effect as well. All of this led to falling passenger revenue per available seat mile, which is the industry's main metric.

"PRASM had been decreasing, but there was a promise that it was going to reverse," Higgins says. "It didn't and then the market got really skittish."

While PRASM hasn't yet turned around--it fell, on average, by between 4.5% and 7.4% depending on the airline in the third quarter, according to company earnings reports--airline stocks have picked up. It's not hard to figure out why.

"A lot of it has to do with Buffett," says Higgins. "Everyone saw the Buffett stamp of approval, and it gave these stocks a nice pop."

Higgins is a little surprised that airline stocks have stayed as high as they have, considering that crude is up 13.7% since November as of this writing and that per seat revenues haven't yet turned positive yet--though he does note that per seat revenue declines are decelerating.

A Long-term Runway?
Buffett and his team generally invest for the long-term, so it's unlikely they'd buy into these businesses if they didn't think there were more gains to come, says Andrew Davis, an equity analyst at  T. Rowe Price Blue Chip Growth (TRBCX), which earns a Silver analyst rating from Morningstar and holds four airline stocks.

Davis thinks these companies have more runway ahead of them, especially after 2017. Revenues are starting to turn around, and the economy, which is highly correlated to airline company performance, is expected to accelerate over the next few years. If oil prices stabilize (Morningstar pegs 2017 West Texas Intermediate price at $60 per barrel and maintains a long-term assumption of $55/bbl WTI), then fuel costs won't be as big of a headwind after this year, either. Labor costs will also impact margins in 2017, as the four big airlines renegotiated pilot contracts in 2016, but that will be accounted for come 2018.

Airline companies are also generating billions of dollars on nonticket sales revenues. In 2015, these businesses made a collective $41 billion in extra fees and charges, such as checked bag and seat selection. That could rise as the big players start competing more with low cost carriers like Spirit (SAVE) and Frontier, says Davis. For instance, Delta now has a stripped down economy fair, where passengers have to pay for nearly everything, including checked baggage.

The airlines are also making billions from credit card partnerships with banks. In July, American Airlines signed a new deal with  American Express (AXP) that the company said will boost pre-tax income by $200 million in 2016, $550 million in 2017 and $800 million in 2018.

"All of this flows to bottom line cash flow," says Davis.

Finally, Davis thinks the sector looks relatively cheap, even though valuations have climbed since the summer. As of writing, the airlines were trading at about 11 to 13 times 2017 earnings, which is cheaper than other industrials, such as railways. If earnings estimates are revised higher, as Davis thinks they might be once PRASM gets back in the black, then these valuations could be considered attractive. Some airlines also pay a modest dividend.

"Compare them to other companies in the index and you can say they're relatively cheaper that the rest of the group," he says.

Take a Wait-and-See Approach
To Higgins, though, the major domestic airline stocks he covers look fairly valued; all are trading in 3-star territory as of this writing. These stocks aren't so overvalued that people should sell, but they're not screaming buys either, he says. He does say that if one thinks GDP will grow and oil prices will stabilize--or better yet, fall--then one could argue that these stocks should be trading higher than where they are today.

In any case, Higgins thinks we'll see a pullback in airline stocks this year, in part because they've risen faster than one would expect from looking at the fundamentals. It's when these stocks drop that investors can follow Buffett's lead and buy in.

"I'd wait for a more compelling entry point," he says.

As for opportunities, all the airlines may seem similar, but they have some nuanced differences.  Southwest Airlines (LUV) is one of the most overvalued airline stocks today, trading 11% above its fair value, but it's also the best managed, which means it could be a good choice if it gets cheaper, says Higgins. Southwest is still offering many goodies for free, which he says will continue, and he thinks customers like those freebies. It's also adding more routes.

"In terms of the business advantages and culture, Southwest is clearly the leader," he says.

While airlines may not see the massive outperformance they've experienced over the past five years, they could have more room to fly. Like Buffett, investors need to be patient, wait for the right price, and then get in.

"I'd be really surprised if Berkshire felt that this was a one- to two-year trade," says Davis. "They may be saying that the industry has finally figured things out."

Bryan Borzykowski is a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.com.

Bryan Borzykowski does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.