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Investing in airline stocks? Caveat Emptor!

vietjet-aircraft-on-the-runway-at-tan-son-nhat-international-airport

vietjet A320s at tan son nhat airport. pic/vietjet

Why are investors buying airline stocks? Is it because Warren Buffett, the Sage of Omaha, has gone into it or because there really is value in airline shares?

Buffett once described the airline industry as a “death trap”, so what changed his mind?

Vietnamese low cost carrier VietJet Aviation Joint Stock Company saw its shares surpassed the 20% daily limit (from the listing price of VND90,000 to VND108,000 or USD4.74) when it made its debut on the Ho Chi Minh Stock Exchange on February 28.

In 2016 VietJet posted net profits of around USD105 million, on revenues of USD1.2 billion. That puts the carrier ahead of many listed flag carriers in the region, in terms of return on invested capital, or ROIC.

At the closing price on its first trading day, the LCC was valued at around VND32.4 trillion, or USD1.4 billion. The IPO raised almost USD170 million and was the 3rd largest listing for a Vietnamese company.

Among the foreign investors that stood out was Singapore’s GIC, the island’s state wealth fund, which is now the second largest shareholder after VietJet’s CEO and founder Nguyen Thi Phuong Thao. She has direct and indirect stakes that amount to 60%.

So if reputed and savvy investors like Buffett and GIC have bought into airlines, surely it’s a good time for retail and institutional investors to go into other carriers, too, right?

Not so quick… Buffett has purchased select US carriers – Southwest (the world’s first LCC), American, Delta and United Continental – those airlines were among the best performers in 2015-16.

This is largely due to a revival in North America attributed to low fuel prices, consolidation, capacity management, and smart new ways of making money via the ancillary business.

Indeed, there are a lot of positives for airlines today – especially with crude at current levels. As long as oil stays below USD70/bbl there’s a very good chance carriers will see profits.

Airline valuations appear attractive, too, particularly the discount carriers, such as Cebu Pacific and AirAsia. P/E multiples are below historical average for many airlines. AirAsia’s P/E ratio is 3.7 while Cebu’s is 7, according to figures from Bloomberg.

What’s clear is that both airlines have managed to improve their revenues while reducing expenses – something full service airlines find so tough to achieve. We think Cebu is really cool (its profits grew very significantly over the past few years – well over 100%).

aa-320-jhb

Alone in its class. An AirAsia A320 at JHB. Pic/Shukor Yusof

Malaysia’s AirAsia remains ahead of the pack though, with its expansive network, growing A320 fleet and slick advertising. The airline shares are likely to outperform in the next 2-3 quarters. At under MYR3 (67 US cents), the share is inexpensive.

AirAsia has the first mover advantage in Southeast Asia and the airline is forecasting a 10% revenue growth in 2017. Its rivals – Malaysia Airlines and Malindo Air – aren’t really hurting AirAsia – so it’s worth considering…

Shares of established airlines such as Singapore Airlines and Cathay Pacific should be given a wide berth. Both have performed poorly in the past two years at least and are unlikely to provide solid returns like those from VietJet and other listed discount airlines.

It would seem flag carriers’ shares are certain to stay stagnant or worsen. The Indian government is considering selling Air India’s stake to a strategic partner after a billion dollar bailout failed. Air India has debts of around USD7 billion.

Likewise, Alitalia – Italy’s national airline – is teetering on the brink of bankruptcy (again). We think Etihad made a big mistake investing in that airline. But then, anyone foolish enough to inject billions into an ill run airline deserves to lose money. That reminds us of one flag carrier in the region…

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