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Why Are Airline Shares Soaring While Their Unit Revenues Continue To Sag?

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This article is more than 7 years old.

U.S. airlines are continuing to suffer significant year-over-year unit revenue declines for the second year in a row, crude oil prices are up 9 percent from their five year low just six months ago, and economic weakness, political instability and increased low fare competition in their critically important international markets are serious concerns.

Yet investors are scrambling over one another to bid up the stock prices of the six largest U.S. carriers by 26% to 40%.

Are investors betting heavily on the post-election Trump Bump on Wall Street blossoming quickly into an actual Trump Boom across the U.S. industry?

Do they know something rest of us don’t?

Or have they simply lost their minds and gotten caught up in an indefensible wave of exuberance?

Please see: Delta's Small Unit Revenue Improvement Won't Offset Rising Costs Through First Half

A half decent argument could be advanced for each of those propositions. But it’s clear that there’s been a fundamental change in both U.S. carriers’ operating formula and the way they are being analyzed as investment vehicles. And the results are striking.

In the past three months – since Nov. 11, coincidently also since Donald Trump’s election as our next President – the Dow Jones Industrial Average has risen a quite handsome 9%.  But in that same time frame:

  • United Continental Holdings, the parent of United Airlines, has seen its share price rise more than 40%
  • Alaska Air Group, parent of Alaska Airlines and, as of Dec. 14, Virgin America, is up more than 36%.
  • Delta Airlines’ shares are have jumped more than 30%
  • Southwest Airlines’ stock price has grown just under 30%
  • American Airlines shares have gained more than 27%
  • JetBlue’s stock price has risen about 26.5%

Yet, in the vernacular, their unit revenue performance sucks. Yes, according to their most recent statements and guidance issued to analysts, it recently has sucked a slight bit less than it was sucking previously, and a little less than it has continuously sucked for at least the last 18 months.  But the truth remains: U.S. airlines continued in the fourth quarter to take in alarmingly less money per unit of capacity – one seat mile flown one mile – than they did in the same period the previous year.

To put that in perspective, think of what would happen at your company, or to your business, if it got 3% to 5% less money per widget, or per service delivered than it did in the same month last year, and did so for 18 or months in a row.

Despite a basketfull of positive comments and/or recommendations published in the last few days/weeks by actual Wall Street analysts, and by investors who publish their views via vehicles such as Seeking Alpha U.S. airline almost certainly will take in less money per unit of capacity this month - and likely for some additional months - than they did in their year-ago periods.

Yes, one Wall Streeter, Helane Becker at Cowen Research, issued a report last week in which she forecast a whopping 0.7% increase in 2017 airline unit revenue, vs. the 4.6% drop in unit revenue that the industry experienced over all of 2016. As measly as it is, her forecasted gain in unit revenue, for now at least, continues to be very much a minority opinion.

And even if Becker is proven correct, it would leave U.S. airline unit revenue down about 4% from 2015 and down more than 5% from 2014. And even in 2014 - the group’s peak year in nominal unit revenue at 12.02s cent per available seat mile – on an inflation-adjusted bases U.S. airlines collected less revenue per available seat mile, 8 cents, than they did in 1995, when they took in 8.56 cents per available seat mile, per U.S. Department of Transportation data.

The weakness in U.S. airline unit revenues is not by now a new phenomenon. I first wrote about it in this space in August 2015, meaning that the negative trend in unit revenue production began earlier that year. In addition to my writing in this space on that same subject seven more times – now eight – since then, other, often far more influential industry watchers have written or spoken publicly about the problem, too.

Indeed, airline executives have become publicly exasperated at times by the concerns raised about the industry’s problem with weak unit revenues.  Some, led by American CEO Doug Parker, passionately have advanced the idea that thanks to consolidations, bankruptcies, global alliances and the unprecedented discipline shown by the industry not to throw back into the skies all the capacity that was taken out of traumatic geopolitical and economic events in the 2000s the U.S. airline industry has been changed fundamentally and irrevocably.

Yet beginning late last summer, most U.S. carriers began applying the brakes to their capacity growth plans. Those plans, for the most part, were not super aggressive to begin with. Even Southwest, the most aggressive of U.S. carriers that have been in business more than 25 years, was only planning to add 5-7% more capacity (vs. its double-digit growth rates in the ‘90s and ‘00s). But five of the six biggest U.S. airlines now have announced less aggressive growth plans since summer, and most have cancelled or deferred orders for new jets that had been due to join their fleets in 2017 and 2018. Only Alaska Air Group has not completely sorted out its growth plans, which have been complicated by its December acquisition of Virgin America. But Alaska always has been managed more conservatively than the other big U.S. airlines, so it’s not likely to break ranks and launch a rapid growth plan while trying to figure out how to assimilate the Virgin America operation.

So why then, are airline stocks streaking?

Occam’s Razor is the widely-used – though certainly imperfect - reasoning principle that says that if there are two or more possible explanations for an occurrence, the simpler one is usually best, or right. And the simplest explanation for why airline stocks are up so much is that investors have, in fact, lost their minds. There’s a reason why it has long been said that the best way to make a small fortune in the airline business is to start with a large fortune. Historically, airline shares have been viewed by most savvy investors as highly cyclical trading instruments that you try to make money on in six- to nine-month buy/sell cycles.  Those who have bought and held airline shares for long periods more often than not have gotten burned over the last 75 years.

But a case can be made – and indeed is being made by industry leaders and some investors, including the undisputed king of the buy-and-hold approach, billionaire Warren Buffett – that the airline industry has undergone a fundamental change and is no longer subject to the old boom-and-bust cyclicality that made it such a risky and volatile segment in which to invest. In effect, they’re telling us that what we always thought was true about how to value airlines and their shares no longer is; that things have changed to make airlines more conventional and less cyclical enterprises whose shares should be more highly valued as a result.

Part of that argument is built on the dramatic change in operating fundamentals. U.S. carriers no longer try to make money by throwing 40% more capacity into specific travel market than they can reasonably fill with passengers who pay above-break-even fare prices. Rather, nowadays, and really for almost a decade now, they have focused on discounting fares enough to fill 82% to 86% of their seats at average fares that are profitable. The result has been fares that are near historical inflation-adjusted lows, but record profits (of course, low fuel prices and, arguably, reduced competition, have played major roles in that, too).

Still, the now-prolonged period of weak unit revenues is troubling.

Historically, unit revenue declines in the airline industry were seen as a leading indicator of an economic downturn (though the opposite was never true of a strongly positive uptick in unit revenues). Clearly, with the Dow industrial average up nearly 10% in three months and nipping at the 20,000 point barrier, that historical relationship has been broken, perhaps irrevocably. Either that or investors are in for a very painful surprise sometime later this year.

So, what’s causing the change? Clearly the restructuring of the airline industry over the last decade through bankruptcies, layoffs, mergers and the like has had an important impact. Today U.S. airline capacity more closely aligns with actual demand for air travel. And airline operating costs are more under control, vis-à-vis revenues than they have been at any time since the early 1960s (but that's about to change).

Yet low fare competition continues to be a growing problem in the domestic market, where the big airlines at least try to break even. And it’s now becoming a problem in international markets, which is where U.S. airlines really have made hay over the last 20 years. That explains why most of them have slowed, deferred or cancelled the delivery of more than 100 big wide body jets, the kind of planes used on international routes.  And it explains a big portion of the unit revenue declines U.S. carriers have been experiencing since at least mid 2015.

Analysts agree that higher fuel prices of late, which are expected to persist through 2017, will shave the top off what had been record or near-record airline profits in recent years. But they still expect most U.S. carriers to report net margins in the mid- to high-single digit range. That still would rank as good financial performance in light of the industry’s dismal history in that regard.

The question remains, however, do that reduced-but-still-okay profitability, the industry’s continuing unit revenue weakness, and costs that are set to explode thanks to rich new labor deals negotiated during a time of record profits really support the kind of 25% to 40% share price increases we've seen over the past 90 days?

I’m no stock analyst, but there’s a reason that people have been relying Occam’s Razor as an analytical tool for nearly 700 years.