Publications

- June 1, 2017: Vol. 4, Number 6

Airline Investors: Ignore the negative headlines, focus on the headroom

by Frank Holmes

T.S. Eliot famously wrote “April is the cruelest month,” and for the U.S. airline industry, Eliot’s words couldn’t be more true. By now, a significant swath of the world’s population has seen the April 9 video of a man, blood streaming from a busted lip, being violently dragged from a United Express flight. A day after the incident surfaced on social media, the 30-second clip had been viewed more than half a billion times in China alone.

Possibly even more egregious than the forced removal of the passenger, Dr. David Dao, was United’s clumsy handling of its PR. In a letter to employees, United CEO Oscar Munoz appeared to defend the decision, writing that it was “necessary to contact Chicago Aviation Security Officers to help.” Although he later reversed course and apologized, adding that “we are more determined than ever to put our customers at the center of everything we do,” the damage had been done. By April 11, the company’s market value had lost $250 million, like so much mishandled luggage.

Then, just when it seemed as if news networks were beginning to tire of the United story, another embarrassing blemish emerged on the face of the airline industry. An April 21 video, shared widely on social media, showed a heated altercation between a male passenger and an American Airlines employee that nearly came to blows. And the impetus for the encounter? A crying mother, also a passenger, claimed an American flight attendant had whacked her with her baby’s stroller, barely missing the baby in the process.

The cruelest month indeed.

FINDING THE SMOOTH RIDE WITH AIRLINE INVESTMENTS

Without minimizing passengers’ legitimate grievances, it’s important that airline investors not get air rage over these two isolated incidents, which have frustratingly been given a disproportionate amount of news coverage. A short-term selloff is expected, but a trend this is not. Despite all the recent noise, the NYSE Arca Airline Index still ended April up more than 1.6 percent. The index has been up, in fact, in nine of the past 10 months. As for United, the carrier reported first-quarter revenue of $8.4 billion, a 2.7 percent increase over the same time last year, and serviced 23.8 million passengers during the period, an increase of nearly 7 percent. It managed to do this despite the headwind created by President Donald Trump’s temporary travel ban, in effect between January 28 and February 4.

To help put things in perspective, consider this: Every day, almost 24,000 flights successfully take place in the United States, all of which carry a combined 2.24 million passengers, according to the Federal Aviation Administration (FAA). What this means is that for every United or American fiasco, there are literally hundreds of thousands of satisfied passengers who are pleased with the service they received and willing to fly again.

Don’t take my word for it, though I should add that as a frequent flyer, having spent untold hours in the air, I’ve rarely had a bad experience. Only once — last year, in fact — was I compelled to issue a formal complaint, for which I was rebated immediately.

Let’s look at what a recent study found. For nearly three decades, Embry-Riddle Aeronautical University and Wichita State University have jointly produced the annual and closely watched Airline Quality Rating (AQR) report, which assesses industry performance in four main areas, including on-time arrivals, mishandled baggage, involuntary denied boardings and consumer complaints. The most recent report, made available April 10, shows that the industry logged its highest score ever in the AQR’s 26-year history. Between 2015 and 2016, significant improvements were seen in all areas. Flights ran more efficiently; less luggage was lost or damaged; fewer complaints were filed; and fewer people were involuntarily denied boarding. As regrettable as David Dao’s removal was, statistics show that less than one passenger out of every 10,000 passengers is denied boarding, due to overbooking, failure to comply with the carrier’s dress code, being in possession of a weapon or some other reason.

And that’s not all. In May of last year, J.D. Power’s North America Airline Satisfaction Study showed that customer satisfaction reached a record high of 726 out of 1,000 in the study’s 10-year history.

“Airlines are making positive strides by adding value to its products and services with newer and cleaner planes, better in-flight services, improving on-time arrivals and bumping fewer passengers from their flights,” wrote Rick Garlick, J.D. Power’s global travel and hospitality practice lead.

RESILIENCE IS THE KEY

Proof of Garlick’s comments is United’s swift response to the Dao incident. The company officially ended its policy of allowing employees to take the seats of already-boarded passengers of oversold flights, and it also announced that it was raising the maximum incentive for passengers to skip such a flight to $10,000.

Also consider the industry’s solution to lost and mishandled luggage. Once a serious headache for flyers and carriers alike, costing companies millions of dollars each year, newly adopted technology has all but guaranteed that a bag will safely arrive at its destination. Small radio frequency identification devices (RFIDs), costing as little as $0.10 per passenger, are now embedded in luggage tags and emit radio waves that allow luggage to be scanned on conveyor belts. If a bag is headed in the wrong direction, ground crews will immediately be alerted. With a remarkable success rate of 99 percent, RFIDs support the International Air Transport Association’s (IATA) Resolution 753, which requires carriers to keep track of all baggage from start to finish. Since 2007, airlines around the globe have managed to halve the likelihood of a bag going MIA, saving them an estimated $22.4 billion in total, according to industry IT and telecommunication services company SITA’s Baggage Report 2016.

The U.S. airline industry has long enjoyed a reputation for being remarkably resilient, innovative and resourceful. Carriers have undergone much worse turbulence than April’s humiliating debacles, with most companies operating under bankruptcy protection only a few years ago. A wave of consolidation followed, bringing the number of major carriers down from 12 in 2005 to only four today. And the consolidation continues. When Alaska Airlines’ acquisition of Virgin America is complete, the Seattle-based carrier will become the fifth-largest in the United States and have dominant control of the West Coast market.

To survive, companies also learned to introduce new revenue streams. Think baggage fees, priority boarding, hotel booking commissions, a la carte services and more. Altogether, such ancillary revenue amounted to an estimated $67.4 billion globally in 2016, or nearly 10 percent of total sales, according to consultancy firm IdeaWorks.

As ancillary revenue continues to grow, so too has its share of many low-cost carriers’ gross sales. Among the carriers that rely the most on these new revenue streams are Spirit (43 percent of total revenue in 2015), Allegiant (38 percent) and Budapest-based Wizz Air (36 percent).

BUFFETT TURNS BULLISH

It’s for these reasons and more that legendary investor Warren Buffet changed his mind about the airline industry after deriding it for years. After allegedly losing money on his investment in the now-defunct US Airways in 1989, Buffett famously called the industry a capital “death trap” and even joked that investors would have been served well had Orville Wright’s plane been shot down at Kitty Hawk.

Today, however, he’s bullish on domestic airlines for the same reason he’s long been a fan of railroads — namely, the barriers to entry are extremely high, if not entirely impenetrable, to new competitors. This is the “moat” Buffett refers to when talking about rail, but the idea similarly applies to aviation, whether we’re talking about airlines, airports or aircraft manufacturers.

Carriers face a number of challenges that might detract new entrants to the field, including high capital requirements, fixed costs, regulations and the risk of rising oil prices. It’s next to impossible to build a new airport, with most construction upgrades reserved to parking lots or the terminals themselves. And as for aircraft manufacturing, Boeing and Airbus today collectively control 66 percent of the global market. By 2025, that figure is expected to climb to 76 percent, according to Aviation Week Network’s 2016 Commercial Aviation Fleet & MRO Forecast.

In its 2016 end-of-year report, Boeing announced it won a whopping $76 billion in net orders and currently sits on a massive order backlog that exceeds $473 billion. The company sees the commercial airplane market valued at $2.8 trillion by 2025, which it hopes to claim a significant share of.

But back to Buffett. Regulatory filings show that his holding company, Berkshire Hathaway, has generously loaded up on shares of the four major carriers — American, United, Delta and Southwest, which combined make up nearly 50 percent of our U.S. Global Jets ETF (JETS). The Omaha-based company is now the number one or number two holder of each of those four carriers. There’s even speculation that Buffett is considering buying a carrier outright, with Morgan Stanley analyst Rajeev Lalwani writing that Southwest makes the most sense because of its “domestic focus, robust and sustainable free cash flow, range of growth opportunities, defensible cost structure, and more tenured management team.” I should add that 2016 marked Southwest’s 44th consecutive year of profitability, and the company has consistently paid quarterly dividends since 1976.

While we’re on the topic, domestic airlines continue to seek to gain and retain equity investors by rewarding them handsomely. Last year hit a new record, with 10 carriers collectively returning more than $13 billion to shareholders in the form of stock buybacks ($12 billion) and dividends ($1.2 billion). This doesn’t include 2016 contributions made by Boeing, which amounted to $7 billion in buybacks and $2.8 billion in dividends.

We’ll find out soon enough whether Buffett has decided to hold or add to his airline position, but it’s worth mentioning that the industry continues to demonstrate attractive leadership within the transportation sector with regard to several financial factors favored by the Oracle of Omaha, including net income margin, return on equity and free cash flow per share. The group is also reasonably priced, with the Bloomberg U.S. Airlines Index trading at nine times earnings as of Dec. 31, 2016. Compare that to the Dow Jones Transportation Index (16 times earnings) and the S&P 500 Index (21 times earnings).

CONCLUSION

April brought a lot of negative attention to the airline industry, but this is nothing more than short-term noise. When you take the proverbial 30,000-foot view of the industry, you see that it’s poised for long-term, sustainable growth. As incomes rise and the middle class expands all over the world, an increasing number of people are able to afford airfare, which in turn boosts demand for greater airport capacity and more commercial aircraft. It’s a good time to take to the skies.
Frank Holmes is CEO and chief investment officer of U.S. Global Investors. The U.S. Global Jets ETF (JETS) provides investors access to the global airline industry, including airline operators and manufacturers from all over the world.

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