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Time to Invest in Airlines?

29 January 2016

A380-2 copy

A Great Way to Buy? SIA’s A380. Pic/Shukor Yusof

With oil prices showing little signs of rebounding, is now the time for investors to buy into airline stocks? Are airlines entering into a period of sustained profitability? The sage of Omaha Warren Buffett eschews airlines, while Richard Branson once said the way to become a millionaire is to be a billionaire and then buy an airline.

Generally speaking the airline industry is marked by weak characteristics, whichever way one looks at it. What are the risks to the airline industry?

  • Capital intensive
  • Labour intensive
  • Cyclical / seasonal
  • Susceptible to fuel price volatility
  • External threats (epidemics, natural disasters, terrorism)
  • Aircraft and fuel denominated in USD, creating forex mismatches
  • Low barriers to entry, high barriers to exit
  • Dependence on government – ATC, airports

On the other hand, the industry’s strengths are:

  • Airlines provide critical services to most countries
  • Aircraft are sought after assets and easily financed
  • Other modes of transportation not as effective
  • Correlated to economic growth (growing population stimulate long-term growth)
  • Governments aid to help fund infrastructure

Fuel makes up at least a third of an airline’s operating costs. With the recent sharp falls in oil prices, many airlines are starting to show profits – some solid, some not so. Beware: it can be quite deceptive, especially when hedges and forex factors are taken into account.

Our assessment of an airline’s profitability considers profit margins and return on investment. Airlines define operating margin as operating income after depreciation expense, divided by revenues. Thus, to be fair, the best way to compare is by applying lease-adjusted operating margins before depreciation.

Return on capital of a typical airline is generally low, due to modest profitability and heavy investment in assets. Investors see airlines that have consistently made money, such as Singapore Airlines (SIA) and Cathay Pacific Airways, as “safe bets”.

One of the areas that investors need to look into before pumping cash into any airline is studying the carrier’s route network and market position, two factors that help determine revenue potential.

Market positioning is pivotal as it generates revenue. Therefore an airline’s: (a) route network, (b) position within the markets it serves and (c) passenger preference, are absolutely key to its success.

For example, SIA is unique, as it has no domestic market. It only flies internationally and relies on the effectiveness of Changi Airport as a hub to provide traffic flows. Cathay is in a similar position, too, although it has a greater geographical advantage by being next door to mainland China.

So should you buy airline shares?

The short answer to that is, no.

Five years ago, about the same time current CEO Goh Choon Phong took over as chief, SIA shares were hovering around SGD12.50. Today the stock is just under SGD11. It’s fair to say SIA’s share price has been “neither here nor there”. If you’ve been a shareholder of SIA for the past five years, let’s just say your return was pretty much dismal. And it will be for a while.

While SIA remains one of the world’s top carriers, it’s share price, in our view, is over-valued. It has a market cap of SGD12.7 billion and a P/E ratio of 23.3. That said Cathay Pacific has fared even worse. Over a five-year period it fell from around HKD18 in 1H11 to about HKD12. Cathay Pacific’s P/E ratio is 9.9 with a market cap of HKD47.3 billion.

What about the low-cost carriers? AirAsia had been fairly consistent from early 2011 up until a GMT Research report in 3Q15 threw a spanner in the works, questioning the airline’s accounting methods. The airline was further hit by a fatal crash in December 2014 in Indonesia. It now trades around MYR1.35, compared to MYR3.40 or thereabouts for much of 2011.

One of the better valued LCCs in Asia as far as share price is concerned, is Philippine-based Cebu Pacific, the discount carrier owned by Cebu Air, a subsidiary of the well-run conglomerate JG Summit Holdings. It has a P/E ratio of 19.9 and the share price has, since 2H14, been mostly on the uptrend. It is currently trading in the high PHP70s. The carrier expects to carry over 19 million passengers in 2016, up from more than 18 million last year, according to its president Lance Gokongwei.

CEB balance sheet copy

Cebu Pacific’s balance sheet

Source: Bloomberg

Among the worst are Garuda Indonesia and Thai Airways International. Garuda shares are worth under IDR400 today, from a high of about IDR750 in mid-2012. It would appear the carrier was better run when it was in the hands of Emirsyah Satar, a former Citi banker.

Thai Airways is without doubt the worst performing among ASEAN’s listed full service carriers, having gone from around THB40 in 1Q11 to below THB9 today. Years of political instability since the ouster of Thaksin Shinawatra in September 2006 and poorly managed by mediocre managers placed by the military, the stock has further downside, in our view.

THAI 5Y stock

Thai Airways 5-year stock performance

Source: Bloomberg

Is there anything worth investing in the aviation industry?

Yes – aircraft leasing companies. This is the new asset class investors (especially high net worth), are focusing on, where annual returns can be as high as 15%. Currently about 35% of all the world’s aircraft are on lease, and this figure will rise to 50% within the next decade.

There are many benefits when linked to aircraft leasing namely it is more liquid compared to property and the best part is that an aircraft can move across borders easily. Aircraft leasing funds present a steady stream of income, according to this Financial Times article.

In Asia, BOC Aviation, the Singapore-based lessor wholly owned by Bank of China, is planning an IPO in the second quarter of this year. It should be big hit. Not because its parent company has hired Goldman Sachs and BOC International (see here) as joint sponsors for the projected USD3 billion listing in Hong Kong, but because BOC Aviation is a real success story.

Less than two years ago another China-linked lessor went public. China Aircraft Leasing Company (1848 HK) made its debut on 11 July 2014. It has a P/E of 10.38 and is currently trading around HKD6. Shenzhen-based lessor CDB Leasing, a unit of China Development Bank, is also eyeing a listing in Hong Kong this year and expects to raise USD1 billion. CDB Leasing has over 200 aircraft on order.

Bottom line…

All things considered, and the aircraft leasing business aside, there are more negative fundamentals than positive ones, to invest in the airline business. Just wait till oil prices start climbing up again, and we’ll once again witness volatile results and meagre profits, if at all. For the past 20 years the industry’s financial track record has been mediocre, marked by massive losses in the 1980s, 1990s and especially post-September 11.

 

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