Airline stocks have scared off many investors and for excellent reasons. Richard Branson jokes the easiest way to become a millionaire is to start as a billionaire and go into the airline business. Warren Buffett notes the cumulative profits of the airline industry, since inception, are about zero.
That said, there are times, often stretching to several years, when airlines and their investors do quite well, thank you. And we seem to be in one right now: The stocks of many of the major North American carriers have doubled, or even tripled, from recent lows.
If you’ve missed the takeoff, it’s clearly time to ask whether airline shares have already hit their cruising altitude or if they could rise even further from here. A number of analysts think it’s the latter.
“We’re not really big into saying, ‘It’s different this time,’” says Helane Becker, an analyst with the Cowen Group who has followed the U.S. aviation sector for 30 years. But, she says, things are different from some of the boom-and-bust cycles she’s seen.
“You really don’t have airlines willy-nilly expanding, buying lots of aircraft and battling for market share,” she says. “Airlines are very focused on making money and returning capital to shareholders.”
Walter Spracklin at RBC Dominion Securities, who follows the Canadian carriers, voices a similar cautious enthusiasm. “I used to be one of the naysayers who said airlines were very, very dubious investment vehicles.”
But, he says, “I believe investors will re-rate airlines given the substantial changes that are taking place in the U.S. and Canada. You’re seeing rampant consolidation in the U.S., and we’re already there in Canada. When you look at the fundamentals, you see a much more rational pricing environment. Investors are going to look differently at the airline sector in the U.S., and as a corollary, look differently at the airline sector in Canada.”
Consider this: Delta Air Lines Inc., the smallest of the big three U.S. carriers, has posted double-digit EBITDA margins — earnings before interest, taxes, depreciation and amortization — for three years in a row, the first time that’s happened since the late 1990s boom in business travel.
Analysts say Delta will produce its biggest earnings-per-share number this year since 2007. And their profit expectations for rival United Continental Holdings are their rosiest since 1999.
Much of the bottom line boost is the direct result of the merger wave that has swept through the industry and concentrated unprecedented power in the hands of a few players. Ms. Becker says the top 10 airlines controlled 90 per cent of U.S. capacity in the 1990s; now, with the merger of American Airlines and USAirways, just four airlines (including Southwest) control the same market share.
In the past when times got good for airlines, new entrants would rush in and disrupt the happy picture. But Ms. Becker points to Mr. Branson’s Virgin Airlines, which has burned through $700-million without being successful, as a warning to start-ups.
Ms. Becker has “buy” ratings on all four major U.S. carriers, with target prices of $35 (U.S.) for United Continental (versus current levels around $32); $21 for USAirways (versus roughly $16.50); $19 for Delta (versus roughly $16.50); and $14 for Southwest (versus roughly $13).
In 1998, she says, price-to-earnings multiples for Delta and United peaked at 14; since they’re at 6.5 and 8.5, respectively, “there’s room for these stocks to move higher.”
The new enthusiasm for airline stocks is crossing the border. Mr. Spracklin says Air Canada shares were trading at a “fear discount” because of labour issues and pension problems. But an arbitrated labour deal that allows for the formation of low-cost carrier Rouge, coupled with pension changes and positive investment returns that nearly halved the plan’s deficit, mean “the market is quickly readjusting its view on Air Canada to reflect the lower risk.” (He has an “outperform” rating on the stock.)
Air Canada’s plan to start a low-cost carrier might seem a risky move at first blush, but Mr. Spracklin notes, “There’s no changes in the way they operate, no new markets, no new aircraft types. They’re calling it a low-cost carrier, but it’s really just taking advantages of flexibilities that weren’t there before.” On smaller, price-sensitive routes on which it previously lost money, “they will now be able to either break even or make money.”
WestJet, Mr. Spracklin says, should “substantially increase” its average fares with the introduction of “premium economy” seating that will allow it to charge more for additional leg room. While its low-cost carrier effort “is a little bit of a departure” because it introduces a new type of aircraft into the WestJet system, Mr. Spracklin says, “The WestJet management team has time and again surprised me with how well they have run that company.”
He adds: “WestJet is no longer a sales-driven organization. It’s a return-on-invested-capital-driven organization. It’s in their targets, embedded in their DNA … and that’s very refreshing. It’s not very often you hear airlines talk that way, or have a dividend and share buyback as WestJet has had.”
Mr. Spracklin has an “outperform” rating on WestJet, but the shares have now matched his $25 (Cdn.) target price.
Some restraint is warranted. Morgan Stanley analyst John Godyn says he disagrees with some bulls’ argument that airlines are “the new rails” – a transportation sector on the verge of a significant and permanent expansion in profitability thanks to fundamental changes. “We’re bullish on the prospect for ‘stronger for longer mid-cycle margins,’ but disagree with the ‘it’s different this time’ rail-like call on the group.”
He has “overweight” ratings on Delta and United Continental and “equal weight” on USAirways and Southwest, but all four stocks have essentially met or slightly exceeded his target prices.
Meanwhile, analyst Ben Cherniavsky of Raymond James Ltd., who has “market perform” ratings on both Canadian airlines, worries about the resiliency of demand for air travel and says, “With WestJet’s stock at a new all-time high, we believe that now is a good time for investors to take some profits in this famously cyclical business.”
Not bad advice for those who’ve benefited from the great run so far. Bur RBC’s Mr. Spracklin has a thought for those who thought they’ve missed out on Air Canada, particularly: “People said six months ago, ‘The shares have doubled, I’m too late,’ and now they’ve doubled again.”