These Signs May Point to an Airline Industry Secular Bull Market

October 13, 2016

Many investors understandably assume that the airline industry is included in the consumer discretionary sector of the S&P 500 Index. It does seem as if it belongs there, along with travel, hospitality and leisure. But the industry actually qualifies as an industrial.

Regardless of which sector airlines belong in, the fleet has flown past both industrials and consumer discretionaries for the five-year period, as of April 1.

Not only that, but airlines were the best-performing industry in industrials for the one-year, three-year and five-year periods.

A misconception held among some investors is that airline stocks are outperforming right now only because fuel costs are down. Fuel, after all, accounted for about 30 percent of carriers’ operating costs in 2014. The implication, some believe, is that when oil prices begin to recover, airlines will be first to feel the pinch.

This isn’t necessarily the case. The industry is a much more rational business environment than it was a decade ago. Over the last five years, fundamental changes have taken place, including consolidation, new sources of revenue, better fuel efficiency and additional seats, that have helped airlines excel even when oil is $100 per barrel or more.

In fact, airline stocks for the four industry leaders—United Airlines, Delta Air Lines, American Airlines and Southwest Airlines—began their recent ascent even before oil prices began to plummet 50 to 60 percent starting last summer.

And because most airlines hedge their fuel, they’re still locked into $100-per-barrel oil prices and therefore haven’t yet felt the full benefits of lower fuel costs. American is one of the few that doesn’t hedge.

Airline research analyst Helane Becker of financial services firm Cowen Group writes:

American participates in 100 percent of the decline in jet fuel prices. The current per gallon price is $1.78, and American uses 4.4 billion gallons of jet fuel annually, so every $1 change in oil [saves the company] approximately $105 million per month.

Contributing to American’s diminishing operating costs is its purchase of dozens of new aircraft—99 delivered last year, 112 expected this year—that will replace older, less fuel efficient jets. This should help the company save millions not only in jet fuel but also maintenance fees for many years to come.

It should also be noted that new baggage-tracking technology has led to a dramatic decrease in lost and mishandled luggage, helping airlines all over the globe save billions and keep passengers happy. Even as the number of worldwide passengers has steadily increased year-over-year—exceeding a record three billion in 2013—there’s been a drop of 61 percent in missing bags since the peak in 2007. As a result, carriers save a collective $18 billion a year.

Free Cash Flow

Often it’s not enough to look just at a company’s revenue for any given timeframe to determine its strength. A more precise metric is free cash flow, which tells you how much cash the company has in the bank after taxes and all operating expenses have been paid. In other words, it’s what the company is “free” to spend.

The higher a company’s free cash flow yield, the better. When the yield is higher, the company is more likely to plow that extra cash back into its growth or declare a dividend. American, for instance, began paying a dividend in the summer of 2014; Alaska Airlines, the summer before last. Delta recently announced a stock buyback plan worth $5 billion and increased its dividend 50 percent, from 9 cents per share to 13 cents.

As you can see below, U.S. airlines’ free cash flow is expected to reach a record high this year and each subsequent year. Domestic carriers have never had this much cash potential on their hands—cash that can be used to grow and improve their business as well as reward shareholders.

If we look at individual companies’ free cash flow, three of them—Delta, Southwest and United Airlines—are expected to have yields above an impressive 10 percent in 2015.

According to a J.P. Morgan airline industry report:

We believe in the persistence of cash flows and the presence of a good structural model. The sector has begun to show us their success instead of repeating “trust me”… [T]he cash is real, the margins are real, the buybacks are real.

In light of this success, some analysts are concerned that airlines, flush with cash for the first time in recent memory, will increase capacity too quickly and outpace demand.

Two main arguments can be made here. For one, the industry is highly correlated to a nation’s gross domestic product, and carriers have historically avoided growing faster than the economy by too wide of a margin. The second argument has to do with what experts believe is an imminent pilot shortage in the U.S.

Pilot Shortage Ahead?

The Federal Aviation Administration (FAA) has recently mandated that all pilots must retire at age 65, which should help commercial airliner positions open up pretty regularly over the coming years. But because the starting salary with a regional carrier is around $20,000 per year, fewer and fewer would-be aviators can justify the typical $50,000-a-year flight training, not to mention the required 1,500 hours of flight time before they can even be considered for a position.

You might be wondering why carriers aren’t able to make up the difference by recruiting more pilots out of the Air Force. The reason is because a greater number of people are being trained now to fly drones than jets—and piloting a drone doesn’t count toward commercial flight hours.

This all might sound like troubling news, but it actually has the effect of encouraging discipline, reining in excessive spending and curbing carriers from growing too exuberantly. They can always increase seat capacity—to a certain extent, of course—but generally they’re not going to spend money needlessly on new aircraft if there are fewer people available to pilot them.

The S&P 500 Stock Index is a widely recognized capitalization-weighted index of 500 common stock prices in U.S. companies. The S&P 500 Industrials Index comprises those companies included in the S&P 500 that are classified as members of the GICS industrials sector. The S&P 500 Airlines Index is a capitalization-weighted index, comprised of the GICS Level 4 Sub-Industry Airline Group. The S&P 500 Consumer Discretionary Index is a capitalization- weighted index that tracks the companies in the consumer discretionary sector as a subset of the S&P 500. It is not possible to invest directly in an index.

Cash Flow is a measure of the amount of cash generated by a company’s normal business operations. Free cash flow yield is an overall return evaluation ratio of a stock, which standardizes the free cash flow per share a company is expected to earn against its market price per share. The ratio is calculated by taking the free cash flow per share divided by the share price.

Opinions expressed are subject to change at any time, are not guaranteed and should not be considered investment advice.