Airlines: the ‘bubble’ an investor actually wants

2020 has been a difficult year for the global airline industry in the wake of the COVID-19 outbreak. The MSCI World Airlines USD Index is down 47.4% year-to-date versus -2.3% for the MSCI World Index (USD), and in historical terms the Index is near the post September 2001 and September 2008 Financial Crisis levels.

However, we think that investment opportunities may exist for the prudent investor. The first signal of recovery will be the success of emerging international “air bubbles” or air corridors, air bridges.

It is commonly known that the airline industry is a tough business. Even pre-COVID, according to the International Air Transport Association (IATA), with 298 member airlines, for the period 2015-2018 (considered to be better industry years with cumulative revenues of almost US$3 trillion), the industry could only generate US$135 billion in net earnings or, on average, only US$8.52 net profit per passenger flown. The same figure would be even less, at US$4.65, if we extend back to the mid-2000s and allow for the 2008 Global Financial Crisis.

So why then consider airlines for investment? Firstly, the industry has survived shock events before and, secondly, some airlines are simply better than others. For example, of the 25 largest listed airlines by revenue for 2014-2018 (roughly 60% of industry revenues), only 15% both significantly outperformed industry net margins and did so with minimal leverage. It is these airlines, with above-average margins and better liquidity that we think are best positioned to recover and adjust to a post-COVID environment.

This, of course, is premised on assuming industry recovery from COVID. Conceptually, we like airlines with larger domestic businesses, because domestic COVID restrictions will be eased more quickly and domestic tends to be a higher ‘through-the-cycle’ margin business than international. We think the first test will be domestic travel recovery in major domestic markets like China, Japan and Australasia. For example, New Zealand this week reduced their COVID alert to Level 1, allowing the resumption of domestic travel. In China, we are seeing domestic passenger recovery, with June month-to-date volumes down 44% year-on-year versus -65% in May and -90% in February 2020.

The bigger test will be the success of air “travel bubbles” or quarantine-free travel. For example, Australia/New Zealand are discussing a Trans-Tasman corridor starting in July 2020. Singapore and China have reached agreement to start a “fast lane” for business travellers, with strict criteria including traveller applications, compulsory COVID testing at both ends (with cost borne by the passenger), no public transport travel (private car only) and, for now, flights limited to six Chinese cities.

We also think it’s important to consider several other investment factors. Airlines with aging fleets, undesirable models and high capital expenditures may face liquidity concerns and operational inflexibility. Fleets with significant cargo freighter exposure (as opposed to passenger belly) will benefit currently from favourable market conditions and generate much needed cash revenue. On government support, we have a mixed view. We like, for example, Japan’s US$15 billion “Go To Campaign” to stimulate Japanese citizen domestic travel but are cautious on government credit lines and/or equity to airlines. Like with future capital expenditure, we think the interest burden or direct government equity participation could limit shareholder returns post-COVID. Low jet kerosene prices are helpful, but the benefit varies enormously depending on hedging and surcharge rules and, on a cautionary note, historically-cheap fuel led to increased, irrational competition.

The airline industry is, arguably, facing its greatest challenge in modern times. We believe though that the industry could selectively offer investment opportunities to the prudent investor. The first test will be the success of forthcoming “air bubbles”.

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