Published on June 26th, 2018 by Aristofanis Papadatos
Airline stocks used to be “death traps” for investors in the past. A recession or a downturn of the sector was sufficient to erase the profits of several years and drive some companies out of business. That’s why legendary value investor Warren Buffett had always advised investors to stay away from these stocks. However, thanks to a series of bankruptcies and mergers, the sector has greatly consolidated. Thus the four major U.S. airlines–American Airlines (AAL), Delta Air Lines (DAL), United Continental (UAL) and Southwest Airlines (LUV)–now have an 80% total market share and enjoy wide margins.
This helps explain why Buffett changed his stance and purchased significant stakes in the four major U.S. airlines two years ago. All four airlines are among Buffett’s top 20 stock holdings. You can see the entire list of Buffett’s biggest stock holdings here.
Airlines also benefit from a secular trend, namely the increasing tendency of people to travel more and more often. According to IATA, the U.S. and the global air traffic are expected to continue to grow by 2.8% and 3.7% per year, respectively, until 2035.
Due to their high debt levels and the high cyclicality of their business, airline stocks trade at markedly low, usually single-digit price-to-earnings ratios, which are less than half of the price-to-earnings ratio of the broad market. But this does not automatically make them good investments–investors should check the growth prospects and the risks of each individual airline and then decide whether it is a bargain.
In this article, we will compare the expected 5-year returns of the four major U.S. airlines found in the Sure Analysis Research Database, which ranks stocks based upon the combination of their dividend yield, earnings-per-share growth potential and valuation changes to compute total returns.
Best Airline Stock #4: United Continental
United Continental owns United Airlines and Continental Airlines and operates more than 4,500 daily flights to numerous domestic and international destinations.
In recent years, airlines have also greatly benefited from the depressed jet fuel price. This cost is one of the most important determinants of their earnings. However, the price of oil has strongly rebounded since last summer. In addition, as the supply glut has been eliminated and the oil market has become tight, the prices of oil and jet fuel are likely to remain elevated for the foreseeable future.
Despite a 26% increase in its fuel costs in Q1, the company grew its revenue and its earnings by 7.2% and 8.3%, respectively, thanks to its strong performance in its Atlantic and Latin America segments. In addition, the company reduced its share count by 9.4% and thus grew its EPS by 19%. Overall, United Continental has maintained its strong performance despite the headwinds facing its business.
Moreover, its management reiterated its positive long-term guidance in the last conference call. It expects to grow the earnings per share from approximately $7.73 this year to $11.00-$13.00 by 2020.
Source: Investor Presentation
Given the rising fuel costs and wages and the decreasing fares, this guidance is likely to prove somewhat optimistic. On the other hand, the company takes advantage of its cheap valuation and executes very efficient share repurchases. In the last three years, it has reduced its share count by 7% per year.
Thanks to the efficient buybacks, the airline is likely to grow its earnings per share by about 8.0% per year over the next five years. Nevertheless, the stock is now trading at a price-to-earnings ratio of 9.4, which is higher than its historical average of 8.0. If the stock reverts to its average valuation level within the next five years, it will incur a 3.2% annualized contraction of its price-to-earnings ratio. Therefore, as the stock does not offer a dividend, it is likely to offer a 4.8% average annual return over the next five years.
Best Airline Stock #3: Delta Air Lines
Delta Air Lines is one of the largest international airlines, serving 312 destinations in 55 countries.
Delta bought a refinery in 2012 in order to limit its risk of high jet fuel prices. However, a single refinery is not sufficient to eliminate this risk. In addition, the management of Delta has proved incapable of hedging the fuel cost of the airline. It was hedging the fuel cost before the downturn of the oil market began in 2014. Consequently, it incurred heavy losses from those hedges. Then, due to that traumatic experience, it stopped hedging the fuel cost. As a result, the company is now almost fully exposed to the rising fuel costs.
Delta posted record Q1 revenues but its adjusted fuel expense jumped 20% and resulted in a 16% decrease in its operating income. The bottom line benefited from a reduced tax rate and a 3% reduction in the share count and hence the company posted flat earnings per share. Due to the rising fuel costs, the airline recently lowered its guidance for the earnings per share of Q2 by 11%, from $1.90 to $1.70.
In the last four years, Delta has taken advantage of its cheap valuation and has efficiently repurchased its shares. In this period, it has reduced its share count at a 4% average annual rate.
Until recently, the management of Delta expected to grow the earnings per share by at least 15% per year over the next three years. This growth rate is not far from the 12% annual growth the company has reported in the last four years. However, due to the rising fuel costs and wages, most of the growth is likely to come from share buybacks. Overall, Delta can be reasonably expected to grow its earnings per share at a 5.0% average annual rate over the next five years.
The stock also offers a 2.3% dividend. On the other hand, it is trading at a price-to-earnings ratio of 9.0, which is higher than its historical average of 8.2. If the stock reverts to its average valuation level within the next five years, it will incur a 1.8% annualized contraction of its price-to-earnings ratio. Therefore, Delta is likely to offer a 5.5% average annual return until 2023.
Best Airline Stock #2: American Airlines
American Airlines is the world’s largest airline in revenue and fleet size, with about 950 aircraft and 6,600 daily flights to destinations within 54 countries. The company emerged from Chapter 11 bankruptcy in December 2013.
American Airlines has a volatile performance record, due to high fuel costs, as well as rising wages. Due to the high fuel costs and the rising wages, its growth is likely to come mostly from its share repurchases in the upcoming years. The company has taken advantage of the cheap valuation of its stock and has aggressively repurchased its shares in recent years. In the last four years, it has reduced its share count by 38%.
Source: Investor Presentation
Moreover, American Airlines currently has a $2 B buyback program, which is sufficient to reduce its share count by another 10% at the current stock price.
Overall, it is reasonable to expect the company to grow its earnings per share at a 5.0% average annual rate in the next five years. Moreover, the stock is now trading at a price-to-earnings ratio of 8.0, which is slightly lower than its historical average of 8.5. If the stock reverts to its average valuation level within the next five years, it will enjoy a 1.2% annualized gain thanks to the expansion of its price-to-earnings ratio. Therefore, given its 1.0% dividend, the stock is likely to offer a 7.2% average annual return over the next five years.
However, investors should note that the stock is highly risky due to its excessive debt load. Its debt-to-assets ratio has exceeded 100% lately while its net debt has climbed to $48.7 B, which is about 25 times its annual earnings. Moreover, its interest expense currently “eats” 23% of its operating income. As interest rates are on the rise, the debt pile will become even more burdensome in the upcoming years. It is also remarkable that the company has posted negative free cash flows in the last four years due to its high capital expenses. Moreover, it is fully exposed to the rising jet fuel price, as it does not hedge its fuel cost.
The excessive debt load renders American Airlines highly vulnerable to a downturn of the sector. Therefore, the stock will offer the above mentioned annual return only in the absence of a recession. If a recession shows up, the company will probably incur losses and its stock will plunge. As a recession has not shown up for nine consecutive years, investors should certainly keep this risk factor in mind.
Best Airline Stock #1: Southwest Airlines
Southwest Airlines is the second-largest U.S. carrier based on market capitalization and carries more than 120 million people annually.
Southwest stands out among its peers for its exceptional consistency. While its peers exhibit highly cyclical performance and tend to post losses during recessions, Southwest has remained profitable for 45 consecutive years.
Source: Investor Presentation
Southwest also stands out in its sector for two more reasons, namely its strong free cash flows and its low debt level. It has posted positive free cash flows for nine consecutive years and has by far the lowest debt-to-assets ratio. Its net debt is just $12.0 B, which is less than five times its annual earnings. Thanks to the strong balance sheet of the company, Moody’s upgraded its credit rating to A last year. Its superior balance sheet is of paramount importance, as it renders the company resilient during downturns. This helps explain its above mentioned consistency, which is unique in its sector.
The market obviously appreciates the unique consistency and the superior balance sheet of Southwest. That’s why it has assigned an average price-to-earnings ratio of 16.8 to the stock during the last decade whereas it has assigned single-digit ratios to its peers.
Southwest will pursue growth via new flight routes. This year, the company expects to begin to sell tickets for service to Hawaii through four main airports. Moreover, it has consistently repurchased its shares in recent years and is likely to continue to do so.
Southwest has grown its earnings per share by 28% per year in the last three years but it is likely to grow at a much slower pace in the upcoming years due to the above mentioned headwinds of the sector. Overall, it can be reasonably expected to grow its earnings per share by 8.0% per year over the next five years. In addition, its current price-to-earnings ratio is 12.1, which is much lower than its 10-year average of 16.8. If the stock reverts to a reasonable price-to-earnings ratio of 15.0 in the next five years, it will enjoy a 4.4% annualized expansion of its valuation level. Therefore, given also its 1.2% dividend, the stock is likely to offer a 13.6% average annual return over the next five years.
Investors should realize that airline stocks are leveraged proxies for the underlying U.S. and global economic growth. As long as the economy keeps growing, the airlines will continue to thrive. Thanks to their always cheap valuation levels, their buybacks will be very efficient and will thus greatly enhance shareholder value. On the other hand, whenever the next recession shows up, most of the airlines will incur losses and will thus see their stock prices plunge. As a recession has not shown up for nine consecutive years and interest rates are on the rise, investors should keep the high cyclicality of the sector in mind.
Southwest is likely to offer the highest annual return over the next five years. It is also the one that stands out in this group of stocks thanks to its unparalleled consistency, as it has posted a profit for 45 consecutive years whereas its peers have incurred heavy losses during recessions. It also has by far the strongest balance sheet in its group.
American Airlines offers the second-highest 5-year return. However, due to its excessive leverage, it is particularly vulnerable to a downturn of the sector. Given the rising interest rates and the absence of a recession for almost a decade, the risk of the stock outweighs its reward potential. Therefore, as the above mentioned return will materialize only in the absence of a recession, investors should probably avoid the stock.
United Continental is the only stock in this group that does not offer a dividend. On the contrary, Delta offers by far the highest dividend yield (2.3%). Moreover, it has a relatively reasonable amount of debt. Nevertheless, given the headwinds facing this sector, even Delta is risky for income-oriented investors. Those who definitely want to have exposure in the sector will be better served with Southwest, which offers the highest potential for total return, the greatest consistency and resilience during downturns.