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Air Transport Industry Overview
The Air Transport Industry primarily contains domestic air carriers that focus on passenger service. Its constituents range from major international airlines with annual revenue run rates of over $10 billion, down to smaller intra-domestic carriers with revenue bases as low as $575 million. Large, traditional (legacy) carriers operate through a hub-and-spoke system, whereby many flights go through one of their main hubs dispersed throughout the U.S. Smaller players may utilize a point-to-point system, serving leisure destinations from smaller airports.
Included in the industry, too, are the large package shippers, FedEx Corp. (FDX) and United Parcel Service (UPS). These firms’ financial prospects are similar to the passenger airlines in that profitability is largely a byproduct of the broader economic situation. However, their earnings are significantly more consistent, and thus should not be perceived as being airlines. There are also several specialist companies in the industry, including cargo and personnel transporters.
Delta Air Lines (DAL) is the biggest passenger carrier in terms of revenues, following its October, 2008 merger with Northwest Airlines. More recently, in 2010, UAL Corp. (UAUA) and Continental Airlines (CAL) agreed to merge, and form a carrier that would rival Delta as the nation’s largest. Consolidation activity has been spurred by rising competition, particularly on intra-U.S. routes, from smaller, more cost-efficient carriers. Furthermore, the desire for horizontal integration increases when conditions sour. Other majors affected by this trend include AMR Corp.’s (AMR) American Airlines and US Airways (LCC).
In fact, the domestic airline industry is already relatively concentrated, due to the large capital investment necessary to launch a new company. But, it is also increasingly characterized by point-to-point carriers that are able to undercut the average airfare. These include JetBlue Airways (JBLU), Southwest Airlines (LUV), and AirTran Holdings (AAI). Additionally, on foreign routes, competition from local carriers can constrain revenue yields (revenues-per-available-seat-mile).
In the airlines’ favor, though, over the past decade an increasingly globalized economy has boosted the need for international air travel, providing new avenues for growth. Carriers have bulked up their overseas presences. That said, in March, 2008, the U.S./EU open skies agreement became effective, allowing carriers to operate between any two points in the two regions. This deregulation has facilitated the expansion by airlines into foreign markets and enhanced competition on transatlantic routes.
Ascending competition and the growing need by travelers to reach multiple destinations has encouraged the formation of global alliances, of which currently three sizable ones exist. These groupings allow carriers to retain their market shares by offering access to markets not served directly.
Generally, revenues from ticket sales rise and fall with air traffic (revenue passenger miles). Airfares fluctuate according to the seating supply/demand balance and are generally matched by competitors. The average fare is also affected by the mix of business to leisure passengers. Along those lines, excess seating capacity (measured in available-seat-miles) can force airlines to discount ticket prices. Load factors (occupancy), indicate a carrier’s efficiency in altering capacity to meet demand.
The airlines also derive a small portion of revenue, 3%-4% of the total, from cargo transport, and another modest amount from other items such as bag checking and flight change fees. Carriers can aggressively increase these ancillary charges as a means of offsetting the impact of elevated fuel costs and other negative trends. Margins are hard to predict and depend on the carrier’s cost structure.
Oil prices are another important factor, as fuel is currently the airlines’ biggest cost. When oil prices and the operating environment are favorable, profits can be sizable, however during an economic slump, or when oil prices skyrocket, carriers are apt to record net losses.
After fuel, labor is the largest cost outlay. Strong unions often set wage rates and scheduling rules that may be incongruent with the current operating climate. In response, carriers can take cost-cutting and revenue-boosting steps, such as tacking fuel surcharges onto fares, hedging fuel prices and furloughing employees to some extent.
Those considering Air Transport stocks should be wary of significant risks that accompany them. Foremost, their earnings profiles are volatile and usually highly unpredictable. As such, we recommend examining an airline’s Earnings Predictability score as well as its Safety rank. Given that they often also have sizable capital spending requirements, cash levels may decline precipitously, especially during the seasonably slow December and March quarters. Accordingly, most airlines often issue new shares, carry a sizable debt balance, and may be at risk of credit defaults if conditions worsen severely. For that reason, we advise reviewing each carrier’s long-term debt-to-capital ratio.
Air Transport stocks’ performances generally mirror the broader market, but can also move sharply on oil price changes. They typically trade at low P/E ratios, and, depending on the airline, stock prices may rise more than the market average when operating conditions improve or oil prices drop.