Passenger airlines have been pretty hot news items lately all across the supply chain, both in globally and in Canada in terms of operational developments and corporate finance activity.
The biggest news story was United’s public relations fiasco where a passenger was forcibly removed – equity research analysts said that airlines were essentially an oligopoly and that the bad press wouldn’t affect the stock price because customers had no real buyer power.
Shares of United Continental Holdings (UAL) reacted anyway and research analysts quickly backtracked, citing a changing market due to social media. After more instances where a giant rabbit died and the airline resold a baby’s seat, share prices recovered because airlines are essentially an oligopoly.
This Bloomberg article sheds light on how the airline industry in China, which has historically been quite clunky compared to smooth running high-speed passenger rail due to legacy inefficiencies and much of the airspace being reserved for military aircraft, is becoming more competitive.
In addition to the rise of semi-private enterprises like Hainan Airlines (which is in the middle of a neat marketing campaign at the moment), China Eastern and China Southern are now taking multiple slots at the new Beijing airport, meaning that incumbents can no longer lean on their regional hub.
Airports themselves are pretty cool (top quality ones such as HKG and Changi), and as infrastructure assets that are natural monopolies, they are large bond issuers and have quarterly financial reporting. Airports are, to the surprise of some, not all owned by governments but rather operated as non-profits with government mandate. We may write an airport primer some time.
As discussed in our airline primer, airlines are at the bottom of the value chain and constantly deal with price wars and overcapacity issues – so if flights are still so expensive, some company is reaping the profits – which leads to…
First year economics introduces students to game theory and the Prisoner’s Dilemma, which has Boeing and Airbus as the perpetual duopoly where both players commit to an option which results in suboptimal returns for both. In reality, Boeing has always had outsized returns on capital.
With China’s new commercial aircraft, a third player may join the mix, shaking up the status quo. The aircraft is constructed using the same components as BA and EADS planes with a lot of General Electric and Pratt & Whitney parts.
Air Canada has faced bankruptcy and has historically been a troubled stock. Since their last restructuring, the stock has gone on a tear.
Cash flows have been growing and with some intelligent corporate finance activity, they have rejigged their capital structure to take advantage of low interest rates and boost shareholder value.
As such, it is a good time to highlight some trends in the industrials subsector of transportation where we have two robust primers in airlines and railroads (and crude-by-rail is back now that Canadian oil differentials have widened enough to make shipping by boxcar profitable).
Fuel Trends and Correlation
Kerosene and jet fuel prices (and before that crude oil prices) are a major component of air carrier costs. As such, many air carriers hedge out fuel costs to smooth out earnings volatility. The recent oil price weakness has been great for Air Canada, but Westjet took a tumble because their customer base is ironically concentrated in a place that depends on the oil price for the strength of their economy.
Remember Harmony Airlines? We see the prevalence of discount carriers, known in the industry as Low Cost Carriers (LCC) – a business model started by Southwest Airlines, upon whose business model WestJet’s is based.
These carriers are heavily involved in intracontinental traffic and domestic fares, often looking at keeping prices affordable and being nimble. Southwest does not have a hub network (operations are heavily based out of a certain city), but rather works on a point-to-point framework across various airports.
These LCCs have been joined by ULCCs (ultra-low cost carriers) such as Spirit and Hawaiian – who will charge for very basic items on the flight. Free of issues that burden legacy carriers (unions, in particular), these companies have been achieving exceptionally high returns on invested capital (above 30%). In Canada, WestJet Encore and Air Canada Rouge fight over a high volume business as air travel penetration increases.
Investor Appetite Creeping Back
Although investing in airlines has been a surefire way to lose money in the past (with the exception of Southwest and WestJet) and investors continue to be wary of airline cost discipline and lack of buyer or supplier power by assigning airlines cheap valuations – there is an increasing acceptance of airline investing as more consolidation takes hold (most recently Alaska and Virgin America) and economies of scale are realized, boosting a new thesis that airlines are becoming stable and will soon resemble rail – a financially reliable transportation provider. Airline stocks have been rising and Berkshire Hathaway and other value investors are picking up both well run UCCs and legacy carriers who have seen rising ROIC.
Mergers and consolidations are logical due to obvious cost synergies, but are complicated by foreign ownership restrictions and possible antitrust. Do not expect an Air Canada-WestJet merger.
Advances in Technology – IoT and In-Flight WiFi
Technology is no less important in the airline industry. Data science helps to optimize flight paths and maximize revenues through efficient management of customers. New technology offerings in-flight (Wi-Fi is getting cheaper and cheaper) allow for more ancillary business opportunities while competition tightens.
Every time you sit in an aircraft there will be something new: a tablet, an app, etc. Airlines will realize superior price discrimination techniques to boost incremental revenue through loyalty programs (frequent fliers and gold status equivalents).
On the flip side, new technology is also a threat, as sites help customers look for the cheapest option in getting from destination A to destination B while taking a cut (Expedia). Some sites help customers take advantage of pricing optimization models and help customers cheat on pricing by skipping layovers (Skiplagged).
The risk of industry obsolescence is low, as commercial passenger aviation is not likely to have a substitute anytime soon (barring rapid advances in hyperloop technology… or a stargate). More likely is the continued decarbonisation of society and the development of flexible, clean energy planes.
Related Reading for Airlines