The industry may have started to scent an upturn but investors will not be impressed if airlines let loose on capacity, warns Chris Tarry of Commerzbank.
The phrase "getting back to normal" has started to be banded about in the last few months. Not only does this raise some real concerns over whether business is back to normal, other than in crude volume terms, but also a fundamental question over whether normal is good enough. From the point of view of investors the answer is that it is not, at least not unless the mainline carriers are happy to be seen only as short- term investment opportunities.
It is true that the airline sector from the point of view of the stock market is a good trading sector and for the most part it is characterised by investors who have a shorter time horizon. That said there are those who are prepared to take the longer view - but to do this they must be certain that the performance of the airline that they invest in will produce better returns than from an investment made elsewhere.
Stock markets are seen as expectational - they look forward rather than back - and as a result the real issue is how the near-to-medium-term future should be evaluated. On that score, the Commerzbank perspective was positive on most of the sector from late September but has become generally neutral/negative as 2002 has progressed and capacity has come back. That is in contrast to many analysts who have buy recommendations on much of the sector.
A clear message from investors is that they are interested in growth companies and in the airline sector this tended to be provided only by the lower-cost new entrants - although admittedly Southwest has now been established for over 30 years. For evidence one need look no further than the JetBlue share issue. While in Europe the "no-frills" sector seems to have been similarly well received it is important to guard against so called "bandwagon effects" - not all of these businesses are the same.
In terms of market capitalisation, Southwest is greater than that of the rest of the US airline sector put together. In Europe, although Lufthansa is still top, Ryanair's market capitalisation is greater than that of Air France and British Airways, while easyJet is coming up fast.
So what will make the mainline airlines attractive to investors over the medium term? For that it is necessary to take a look at both the broad industry outlook and the actions that the airlines are actually likely to take - which is not necessarily the same as what they have announced.
At heart, air transport is a very straightforward business - it is about getting the costs and capacity right and ensuring that the returns can be sustained above the weighted average cost of capital. Notwithstanding this, the great concern is that, despite the intentions in the immediate aftermath of 11 September, what is now being seen is a reversion to type with the inevitable fixation on market share. In some quarters of the industry there is a real concern that as traffic recovers (in some markets massively stimulated by fare reductions), so the plans for cost and capacity reduction are being scaled back.
The issue then becomes one of distilling hopes and expectations from reality. A number of commentators have got excited about rising load factors, yet that is not difficult to achieve - economics dictate that aircraft are likely to get fuller if fares are cut and capacity is decreased. There is also a mathematical certainty that if you cut fares you also place upward pressure on the breakeven load factor, which is, by definition, a key determinant in profitability. Anybody who doubts this should take a look at the first quarter figures from the US majors. The old warnings still apply about placing too much faith in traffic alone. That is particularly true against the background of widespread concern over the rate and extent of a recovery in business traffic as well as general worries over prevailing fare levels.
A large percentage of airline costs are also externally determined and once again fuel is at the forefront. The lower fuel price environment of the past months has provided a tailwind for the industry, but since February the average price of jet kerosene has increased by over 30%.
The background in respect of traffic and capacity is quite different than during the last period.. When fuel rose rapidly in 2000, the still strong economies and the control of capacity that was evident meant that airlines were generally able to raise fares to recover the increased cost. That is unlikely this time.
So what of the prevailing circumstances now? It is true that economies are beginning to recover and that capacity has been cut, but on the other side of the equation there remain a number of concerns. The fundamental question is whether the airline industry is a good investment opportunity and on that score the answer is not straightforward. It depends upon which airline, when and what the investor wants out of the investment.
Source: Airline Business
