United’s Passenger Debacle An Immaterial Investment Consideration
publication date: Apr 18, 2017
author/source: Brian Nelson, CFA
Image Source: Business Insider
The major airlines in the US have done a fantastic job capitalizing on the ongoing upswing in air travel demand, but their economically-sensitive business models remain the most operationally-leveraged out of any industry group in our coverage. This should be investors' biggest concern: A downturn in the global economy and competitive pricing pressures are far greater worries for investors than United’s recent passenger debacle. However, as with many news-oriented items (as opposed to materially-relevant, investment-related items), United's misstep is making headlines in a big way. Though the footage in this article is appalling, investors in airline stocks have much more important things to worry about, in our view.
By Brian Nelson, CFA
The airline industry has undergone meaningful changes since the beginning of the last decade. The painful restructuring of labor agreements and balance sheets by most of the legacy carriers via Chapter 11, the significant mega-mergers of Delta (DAL)/Northwest, UAL (UAL)/Continental, US Airways (LCC)/America West, Southwest (LUV)/AirTran, and most recently the new US Airways/AMR Corp, the introduction of ancillary revenue streams to combat rising fuel costs, and continued efforts to rightsize domestic capacity to slow the long downward trend in real yields are but a few. While unarguably these are steps in the right direction, airlines remain shackled to the poor structural characteristics of their industry. Absent implicit price collusion across every participant within the domestic landscape (a very unlikely event), airline stocks should solely be viewed as speculative bets or hedges on the trajectory of the economy (passenger travel) and the direction of crude oil prices, and not as long-term investments.
Due to the tremendous operating leverage inherent to airline business models non-pursuant to capacity purchase agreements (regional airlines operate on cost-plus arrangements), it becomes readily apparent that even minor changes in these key metrics can have large implications on profitability, cash flow and ultimately the fair value of an airline's equity. And while operating leverage may spell opportunity should these metrics move in favorable directions (as they have been doing during this economic upswing), the wide range of potential outcomes in forecasting these metrics suggests that most airline stocks should be viewed as no more than boom-or-bust, speculative vehicles.
As many airline executives may attest, both unit revenue and unit cost are largely out of their control. For one, air travel service is largely commodified and suffers from substantial and intense fare competition driven by severe price transparency and the unavoidable concept of perishable inventory -- when a flight takes off, empty seats cannot be filled. Such a combination is the weight that keeps real pricing (yield) growth from being sufficient to meaningfully alter the long-term economics of the industry. To do this day, network airlines are still forced to match fares offered by low-cost carriers or suffer even greater revenue declines. Fare increases can only be sustained if they are matched permanently by low-cost peers (like Southwest or JetBlue (JBLU), for example).
Further, with barriers to entry primarily limited to capital costs (any US carrier deemed fit by the Department of Transportation can operate passenger service in the US), it's safe to assume that we haven't seen the last domestic start-up, even after the most recent failure of upstart Skybus. The mere existence of interested, economically-tied parties (like Boeing, for example) seem to suggest that new entrants will always pose a threat to dump unwanted capacity on otherwise healthy routes. Perhaps unsurprisingly, one can even tap Boeing's expertise in launching an airline: Starting an Airline. The poor performance of systemwide--domestic and international--real yields (pricing) across US airlines is very unlikely to change anytime soon.
A version of this article has appeared on our website in the past.