Are airline stocks finally investable?

Airline stocks have long been tagged by investors as one of the most uninvestable groups in the stock market. As a business, airlines are capital-intensive, labor-intensive, and fuel-intensive on the cost side, while facing commodity pricing on the revenue side. Barriers to entry are astonishingly low, as any individual with a few billion dollars can start an airline (and several have), while barriers to exit are surprisingly high — not exactly a model for success.

If a capitalist had been present at Kittyhawk back in the early 1900s, he should have shot Orville Wright.

—Warren Buffett, in a 2002 interview with The Telegraph

From bankruptcy to financial health: How today's airline industry swung to a profit

Yet after a nearly four-decades-long period of turmoil, labor strife, competition, and, ultimately consolidation, today's airline industry looks healthier than ever, making it a solid investment candidate once again, in our opinion. So what makes today's environment potentially different from the many failures of the past? We outline several reasons below:

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Unbundling the flying experience: fees have been a game changer for airlines

Unbundling the flying experience: fees have been a game changer for airlines

Chart shown is for comparison purpose only

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Market Share (seats)

Consolidation has boosted major carriers' market share

Chart shown is for comparison purpose only

  • Airlines have finally gotten their arms around their cost structures. Airlines have finally discovered what the American Airlines CEO, Doug Parker, seemed to discover years ago: He who has the lowest costs wins. Since airlines are forced to compete on price; they have to rely on low costs to make a profit. And low costs are not simply a function of payroll. For example, Southwest Airlines had the highest hourly rate for its pilots for years, yet maintained the lowest cost per seat mile flown (source: Wolfe Research). How did it pull off that nifty trick? By enacting work rules that paid pilots only when they flew, instead of the traditional legacy carrier method of paying pilots for a guaranteed minimum number of hours no matter how many they flew. As bankruptcies mounted and contracts were abrogated, labor lost much of its bargaining power. Eliminating in-flight meals is nothing compared to slight work-rule changes.
  • Airlines learned a new trick: Ancillary fees. Fees began as a way to offset internal costs, such as by charging to talk to an agent over the phone rather than booking online. But management teams eventually realized that these fees provided a way to raise revenues without actually raising ticket prices. Baggage fees, change fees, etc. have all become part of "unbundling" the product. Want a premium seat? That will cost you. Need to check a bag? There's another fee.

    These fees also are very high-margin, with some of them, including baggage and change fees, closing in on 80% incremental margin. In other words, airlines that would have otherwise been only marginally profitable on a stand-alone basis have become wildly so because of the ancillaries. It is estimated that American Airlines will generate $2 billion from baggage and change fees alone, which would be more than $1.5 billion of operating profit. Those two fees alone could represent 1/3 of the company's operating profits in 2014. (Data: Wolfe Research.)
  • Consolidation changed the playing field. Historically, there were too many players chasing market share within the airline industry. But that changed in the post-consolidation era. Before the recession of 2008-2009, the top four airlines represented 58% of all domestic seat miles. Only seven years later, the top four own 86% of those seat miles, and that number is rising. To put that figure in perspective, it would take 31 airlines in the European Union to generate that same 86% market share. (Source: Wolfe Research, Bureau of Labor Statistics.)
  • Fortunately, decades of bankruptcies may have finally paid off. Instead of fighting for market share, airline CEOs have realized that they control enough of the market that they simply don't need to gain incremental and minimally profitable, share. Instead, they are focused on industry strength in addition to that of their own carrier. Meanwhile, labor has been pacified with either equity or profit sharing. A decade ago, managements never would have discussed return on invested capital (ROIC) because they couldn't count on consistent returns. Now, ROIC and shareholder returns are top of the list. Two of the four large airlines pay dividends, and at least one of the remaining two is actively discussing it.

Investor implications

If airline managements continue to deliver on their promises, we believe investors could add 2-3 points of multiple expansion to the group, a bit below what the rails saw when they finally started to concentrate on returns. While airlines do have more upside potential on the earnings front, they are not as volatile as the rails, nor do they dominate individual markets with zero threat of competitive entry (that is, a rail company cannot simply pick up and move a train if a competitor's market is doing better).

Nevertheless, airlines are beginning to generate cash flow and return it to shareholders, first in the form of balance sheet repair, and later, with dividends and share repurchases. This means that the airlines shouldn't backslide when the economy turns down, but these managements have seen what happens in bankruptcy and aren't anxious to return to it. Furthermore, they own equity in their companies, as well. Personal enrichment, in addition to shareholder enrichment, is never viewed as a bad thing.

From our perspective as bottom-up (stock-by-stock) investors, we believe that a successful company will succeed on the strength of its management, the competitiveness of its productive asset base, the quality of its balance sheet, and the structure of its global market positioning. In general, sector or industry weighting is less important to us than the quality of the underlying companies we own. That said, we currently own two airline stocks within the global portfolio that share similar characteristics of focus on shareholder returns, cost savings, rising revenues through ancillary fees, robust market share, and strong management teams.


The views expressed represent the Manager's assessment of the market environment as of May 2014, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.

Carefully consider the Funds' investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses and their summary prospectuses, which may be obtained by visiting the fund literature page or calling 800 523-1918. Investors should read the prospectus and the summary prospectus carefully before investing.

IMPORTANT RISK CONSIDERATIONS

Investing involves risk, including the possible loss of principal.

Diversification may not protect against market risk.

Past performance does not guarantee future results.

International investments entail risks not ordinarily associated with U.S. investments including fluctuation in currency values, differences in accounting principles, or economic or political instability in other nations. Investing in emerging markets can be riskier than investing in established foreign markets due to increased volatility and lower trading volume.

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