Should You Invest in Airline Stocks?

Flying today is a different experience than it was just nine months ago. For one, you now have to stand 6 feet — or “one surfboard,” if you’re in San Diego — apart in the security line, and the only time you can take your mask off while in line is for the security agent to check whether your chin matches your ID.

Perhaps even stranger is how empty the airports and airplanes might seem. That coveted row all to yourself in flight may be a lot less rare. With planes only two-thirds full, no one has to worry about getting stuck in the middle seat. While all this is good news for travelers, it bodes less well for the airlines themselves.

“The coronavirus pandemic has caused an unprecedented crisis for the airline industry,” says Matthew Moulis, portfolio manager of the Fidelity Select Air Transportation Portfolio (ticker: FSAIX). “Demand for air travel is depressed. Management teams and labor groups are intensely focused on cutting costs, reducing cash consumption and preserving jobs.”

While there’s been some government aid, it’s varied internationally, with some governments offering a life preserver and others letting the airlines sink toward bankruptcy. True salvation for the airlines will only come by ending the pandemic and returning countries to economic growth, Moulis says.

“At this point, it seems a vaccine is required to achieve both outcomes,” he says. But when that will be is anybody’s guess. And between now and then, airlines are hemorrhaging revenue like fuel from a ruptured hull.

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Why Now Is a Bad Time to Buy Airline Stocks

Jim Boothe, chief investment officer at Brentview Investment Management, cautions investors against adding airline stocks to their portfolios.

“Global passenger traffic in June fell 86.5% from last year, which was a slight recovery from the 91% decline in May,” he says. “While we believe people will still travel for business and leisure, the volumes will take time to recover, with the International Air Transport Association projecting that global passenger traffic will not reach pre-pandemic levels until 2024.”

In May, Morningstar’s health care equity research team predicted a vaccine would be available by the end of 2020 and widely distributed by mid-2021. Using this prediction, Burkett Huey, an equity analyst at Morningstar who covers commercial aerospace, defense and airlines, foresees a robust recovery in domestic passenger traffic alongside a slower recovery in business and international leisure travel.

In the meantime, companies will likely substitute business travel with Zoom and virtual meetings, further depressing customer demand for airline travel. And then who’s to say virtual meetings don’t become the norm even after a vaccine is in place? Remote meetings are not only safer for employees during a pandemic, Boothe says, but also cheaper and more efficient for employers.

What is not cheap is running an airline. “From a balance-sheet perspective, airline companies are capital-intensive, highly leveraged and have high operating costs overall,” Boothe says. “For these reasons, we believe any investment in an airline stock would not be a productive allocation of assets as better ideas exist elsewhere with much lower risk.”

The negative free cash flow many airlines will incur in 2020 and 2021 will offset positive cash flows from 2022, 2023 and 2024, according to Huey’s analysis. Anyone considering investment should be thinking long term because the near term is a scary place for airline companies.

“The most pressing near-term challenges center on the survival of each airline and include reducing cash consumption rates, raising capital to weather the storm and appealing to governments for financial assistance,” Moulis says. “Each of these near-term efforts have long-term implications.”

When reducing costs, he says airline managers need to “avoid cutting ‘muscle’ and impairing growth potential.” As they raise capital through debt or equity, they’re increasing their annual interest expense and diluting existing shareholder equity. And by seeking government aid, they raise the possibility for greater future regulatory oversight.

“But the adage that a crisis can create opportunities is also relevant,” Moulis says.”For example, some low-cost airlines may be poised to gain share from higher-cost peers. And some management teams may be successful in structurally reducing what had previously been viewed as fixed costs.”

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Why Now Is a Good Time to Buy Airline Stocks

There is no denying that airline companies are in a crisis. They’re “burning cash (and) have raised debt and equity to fund unprofitable operations,” Huey says. “The question is how much can they ultimately make , and what’s the proper price for it today?”

He says there are three things driving the valuation of airline stocks right now: First, the depth of the pandemic and how long it’ll last; second, what the recovery process will look like; and third, the underlying profit margins airlines can produce — all of which he notes are incredibly uncertain right now.

Using Morningstar’s assumptions about the 2020 arrival and 2021 distribution of a vaccine and research from its health team, Huey came to the following fair value estimates as of this article’s publication:

— Delta Air Lines (DAL): $42.50/share

— Southwest Airlines Co. (LUV): $44/share

— American Airlines Group (AAL): $14.50/share

— United Airlines Holdings (UAL): $40.50/share

He adds a caveat: Given the high level of inherent uncertainty right now, investors should have a wide margin of safety when investing. If the market price is too close to your fair value estimate, it may not be enough of a discount to make a compelling investment.

“But say, hypothetically, if the stock were priced at half or a quarter of what you think it’s worth, maybe then it’d be a worthwhile investment,” he says.

[See: Best Growth Stocks to Buy]

The Best U.S. Airline Stocks to Buy Right Now

“If an investor was determined to buy airline stocks, companies with the greatest efficiency, such as Southwest Airlines, will likely be best for the long run,” Boothe says. “Also of note, recently JetBlue ( JBLU) and American Airlines announced a strategic partnership to improve operating efficiencies for their collective traveler networks.”

He tells investors to pay particular attention to companies’ cost structures and how much debt they have. Both of these will be “important for a company’s staying power until a better business environment arrives,” Boothe says.

Huey also highlights Southwest Airlines as a more attractive option right now, along with Delta, noting that both airlines have a fairly strong frequent flyer program.

Airline co-branded credit cards are a major driver for the airline business model,” Huey says. People may not be flying, but they can still be encouraged to consolidate their spending on a co-branded credit card.

Airlines with such cards can net “a good chunk of almost pure profit” off their cards, Huey says, so while “it’s a small part of the company’s revenue, (it can be) a much higher portion of their operating income simply because they don’t have very many expenses on selling a currency for which they’re the only supplier.”

He points out Delta in particular has succeeded in capitalizing on the credit card market with its strong relationship with American Express. Southwest also has a “pretty strong credit card portfolio,” he says.

He considers Southwest to be the best-positioned airline over the near term thanks to its largely domestic and leisure business, both of which are expected to recover faster than international and business travel.

Editor’s note: The writer owns Delta and Southwest stock.

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Should You Invest in Airline Stocks? originally appeared on usnews.com

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