Tuesday, February 5, 2013

Airline Stocks

The Siren Song of the Airlines
I suppose every investment manager at some point in their career takes a look at airline stocks, and I am no exception.

The stocks almost always look cheap on most measures. The names of the companies are familiar to most. There is a huge amount of financial data available on the major and regional carriers, which makes analysis relatively straightforward.

Then there is the "hope" factor.  If the industry ran its business rationally, there should be profits aplenty.

But unfortunately the airline business has largely been a crummy one for investors.

Investing in airline stocks is really done successfully by only a very few traders, since the longer term return on the stocks in the group has been abysmal, to say the least. 

Here's an excerpt from a past article in the Guardian:

Former industry executives conclude that flying is a fundamentally bad business. 'For a variety of reasons, including very intense competition, which limits any one carrier's pricing power, the airline industry has consistently failed to earn adequate profits; cumulatively, the industry has lost money since its inception,' said Robert Crandall, former head of American Airlines, last week.


Even Warren Buffett - who held preferred shares in US Air for a short while in the late 1980's, escaping with a tiny profit - famously said of the airlines that "Investors have poured money into a bottomless pit, attracted by growth when they should have been repelled by it.".
The basic problem with the airline business is that it is a commodity product.  Most travelers focus on prices, and assume that one carrier is pretty much the same as another.

On the other hand, airline costs are volatile, especially fuel costs. Fuel costs for a typical carrier run 30% of revenue.  Higher oil prices can kill profitability.

Labor is the other major carrier expense.  In earlier decades the airline unions were a major thorn in the sides of the industry, but this has lessened somewhat in recent years. 

I went to go hear Glenn Engel yesterday.  Glenn is Merrill Lynch's airline analyst, and is one of the best in the group.

The story he told is unfortunately similar to his past presentations.  Yes, the stocks look cheap, and pricing appears to have firmed.  The industry seems to be more disciplined than they have in the past, and have continued to remove capacity by exiting unprofitable routes.

The largest airline that Glenn follows is Delta (ticker: DAL) which has a market cap of $12 billion.   DAL trades at less than 5x price/earnings, and 7x free cash flow. It also has no debt, and is expected to generate $2 billion of free cash in 2013.

(see what I mean about how cheap airline stocks are?)

But investing in DAL is not for the faint of heart.  Consider its trading history over the past couple of years:


As you can see, if you bought DAL two years ago, you quickly lost -40% over the next 6 months.

But then, around the middle of October, the stock soared, and recovered most of its losses in the next 5 months.

In 2012 you continued to have a wild.  After rising +6% in the first 4 months of last year, the stock lost -31% during the summer months.

And then recovered.

If you didn't know the history of the group, and looked at stocks solely on its valuation metrics, you would be sorely tempted to invest in the stocks.

But if history is any guide, this is a group that should be rented, not owned, and I am reluctantly going to stay on the sidelines.