Last year, airlines survived what seemed to be a near-death experience.
In February, the WHO declared Covid a global pandemic. The world went into lockdown and air travel came to a complete standstill. Nine out of 10 planes were grounded. And most airports became like the Costco parking lot for aircraft.
Airlines began bleeding billions of dollars. At one point, Delta was burning $60 million every single day. Afraid airlines would go bust before they could recover, investors fled the industry. Even diehard value investors like Warren Buffet swore off airlines on the lows.
In a matter of a month, airline stocks crashed ~70%. But then, Uncle Sam went “Peekaboo!” and began America’s biggest bailout program:
- Trump signed the then-unprecedented $1.9 trillion stimulus package, $60 billion of which went straight to America’s biggest airlines in loans and grants
- The Fed slashed rates to zero and “assured” it would buy out all junk in case things went wrong. Investors threw caution to the wind and bought hundreds of billions of dollars’ worth of junk bonds from airlines.
The result is that American airlines borrowed and shored up their balance sheets with baggage carts full of money. Federal aid soothed up investors. The crippling panic turned into faith. And the faith turned into greed to make an easy buck off the recession.
And there we are.
The lofty valuations and the #1 thing airlines have to do to justify them
Airlines are up to their wings in debt. They are still burning cash like hell. And yet, their stock prices have nearly bounced back as if nothing happened, as you can see here:
Meanwhile, thousands of jets are stowed away in airports. Half of domestic flights are still grounded and international travel is down 80% from pre-Covid levels. And the lag apparently shows up in airlines’ earnings:
So to justify their prices and keep up with the market, airline stocks have to a) get out of the hole and bring back earnings to where they were, or b) in some way investors have to make peace with much higher valuations.
Will they? Let’s look at the bearish and bullish cases.
1) The most lucrative customers won’t come back soon, if at all
Everyone is itching to get out. And you don’t need a complex quant model to predict swarms of travelers taking to the airports this summer. The real question is: will they be enough to bring airlines back to life?
See, leisure travelers fill nine out of 10 seats on a plane, but it’s business travelers who are the real moneymakers here. While just a fraction of airline customers fly business, they bring in 40% of an airline’s revenue (UBS data). And on some flights, they even generate up to 75% of sales.
Problem is, corporate customers will be slow to come back for two reasons. Covid has taught big enterprises to do more business online. And second, a lot of corporate travel is a pain in the butt, and reps themselves won’t be dying to return to the friendly skies.
In other words, business travel could suffer for years to come and may not ever fully recover.
The decline of this segment will punch a hole in airlines’ earnings and create ripple effects. For example, it could weigh down so-called “opportunistic” personal travel—when business travelers go on business to a new place and take time off to explore it.
2) Airlines will spend the next 5 years paying down a mountain of debt
As you know by now, airlines have taken up piles of debt. Take America’s biggest carriers. Since the onset of Covid, Delta Airlines grew its long-term debt 3X from $8 billion to $26 billion. Meanwhile, American Airlines added an extra $16 billion.
These billions of dollars are not grants. The money doesn’t come free. Airlines have to pay it back with fat interest on top. And the cost of that debt is starting to show up in airlines’ reports.
For example, Delta Airlines’ interest payments grew 3-4X to 361 million in the past year. That’s a lot. For perspective, this amount would have eaten 25% of Delta’s profits in 2019’s most profitable quarter.
Zooming out, this debt is going to be a big drag for airlines. Even when air travel recovers, it will weigh down airline profits for years. Hunter Keay of Wolfe Research—#1-ranked airline analyst among institutional investors—estimates that airlines’ profitability won’t come back to pre-Covid levels for 4-5 years.
1) Pent-up wanderlust will boost leisure travel and fares
During the pandemic, holed-up Americans saved up $3+ trillion. And savings accounts keep plumping. Fun fact: people are hoarding money so much that bank deposits are growing twice as fast as loans.
The #1 bullish argument for reopening sectors, including airlines, is that people are simply fed up with couch potatoing in front of TV, eating out of plastic containers, and ordering in stuff. They are dying to go places. And when the world opens up, they’ll squander their savings to make up for lost time.
This pent-up wanderlust means that people will fly more than usual. Demand will outstrip supply. There won’t be an empty middle seat on any flight. Fares will rise. Margins will rise. And airlines will earn more.
2) Covid will knock out competition for American airlines
At the end of last year, Jamie Baker, senior airlines analyst at JPMorgan
You see, after 9/11, airlines were in the red for more than six years. During that time, a number of smaller carriers went bust or merged with bigger airlines. And while the crisis dealt a heavy blow to everyone in the short run, in the end big airlines came out stronger.
Baker thinks America’s big airlines may follow a similar script after Covid. The difference is that it will unfold on an international scale. (While airline bankruptcies are not yet through the roof thanks to government handouts, they’ll likely spill over in the coming years when the coddling ends.)
So the argument here is that Covid will blow over and international travel will recover. American airlines will face less competition overseas and international markets will drive more profits than they did before Covid.
3) Speculative, “bulk investing” will hold airlines’ valuations higher
The last bullish argument has nothing to do with recovery in earnings. It’s about the “inertia” of recovery stocks driven by investors’ appetite for risk, which is off the charts.
Take margin debt, which is money investors borrow from brokers to invest in stocks. Today American investors are trading on $800+ billion of debt, according to Finra. That’s an all-time record and 30% more than before Covid.
At the same time, investors are investing in a less selective way. They are shoving record amounts of money into ETF funds. For some hard facts, in the first four months of this year, ETFs raked in more money than they did in all of 2020. And this tide lifts all boats, good and bad.
So unless something happens and investors change their behavior, the record “bulk investing” may keep propping up airlines despite lagging earnings.
Airlines with the biggest potential this year
One corner you could explore in particular is airlines that live off domestic and leisure travel. When the travel boom takes off, they’ll be the first to recover. They have less debt. And they don’t give a damn about the dying business class.
In this niche, you could look into Alaska Airlines
As for my take
Now, if you asked me, I’m more a bear than a bull here. I’m not saying that the industry will crash and big airlines will go bust. They won’t. Big players have hoarded up lots of cash. Air travel is recovering. And if things go south, Uncle Sam will step in again.
But there are better ways to play this recovery. And gains from mainstream airlines probably won’t outweigh the opportunity cost of sinking the money into an industry that’s run up so far ahead of itself.
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