 | Horacio Coutino, multi-asset strategist |
While the airline industry may be viewed by some as a little boring as it is known for prioritising stringent safety standards, this year has already proven to be anything but dull. Investors in the airline sub-sector are navigating an exceptionally dynamic and challenging landscape due to several noteworthy events.
The year thus far has already seen a major US airline find itself grappling with a prominent activist investor seeking the removal of its CEO; while significant product quality concerns have emerged from the leading US aircraft manufacturer, causing the grounding of hundreds of planes. In addition, a legacy US carrier is entangled in a dispute with two tech giants, including Microsoft, over allegations that a faulty software update resulted in a staggering $500 million loss and the cancellation of over 5,000 mainline flights over a five-day period. And finally, strategic initiatives from ultra-low-cost carriers are blurring the lines between their model and that of legacy carriers.
All these developments have unfolded within the first eight months of 2024, underscoring the unprecedented volatility and complexity within the airline industry. Although Covid hit the industry hard, life after Covid is proving to be challenging in its own way.
Have airlines fully recovered their capacity and pricing power since the pandemic?
US airlines' capacity, measured in Available Seat Miles (ASM), has now exceeded levels observed in the fourth quarter of 2019. The degree of recovery varies among carriers, with Southwest Airlines demonstrating the most significant increase, surpassing its Q4 2019 capacity by 15.6% to reach 46,250 million ASM. Delta Air Lines followed closely with a 14.0% increase, reaching 74,656 million ASM. JetBlue and American Airlines have surpassed their Q4 2019 capacity by the lowest factors, at 5.0% and 7.1%, respectively.
When comparing the current Passenger Revenue per Available Seat Mile (PRASM) of US carriers to the fourth quarter of 2019, the recovery is even more pronounced. All major US airlines have leveraged the resurgence in air travel demand to surpass their Q4 2019 PRASM levels. Delta Air Lines has demonstrated the most substantial increase, with PRASM exceeding its Q4 2019 level by 21.0%, followed closely by United Airlines at 20.0%. In contrast, Southwest Airlines has experienced a more modest PRASM increase of 4.7%, which can be attributed to a relatively low load factor (80.3% as of Q2 2024) compared to its peers, as the airline continued to expand its ASM.
How did US carriers performance fare over the summer?
US carriers experienced significant growth in both domestic and transatlantic markets during the summer of 2024. Schedule data from aviation analytics firm Cirium reveals a substantial increase in capacity compared to the previous year.
Major US airlines scheduled approximately 6% more domestic capacity this past July, with the notable exception of JetBlue, which reduced its capacity by 9.2% due to staffing constraints and network congestion on the East Coast. Southwest Airlines also scaled back its plans due to Boeing 737 MAX aircraft availability, resulting in a modest 1.4% increase in seats.
American Airlines led with over 20.5 million scheduled seats, closely followed by Southwest Airlines. Capacity plans varied significantly across different carrier types, with ultra-low-cost carriers offering substantially fewer seats than the Big Four (American, Delta, Southwest, and United).
Transatlantic carriers, including European operators, also expanded their capacity, with a 7.8% increase in seats flown from the US to Europe compared to July 2023. United and Delta continued to capitalise on revenue premium opportunities, while European carriers like Air France increased their scheduled seats by 15%, possibly anticipating heightened demand due to the Paris Olympics.
Interestingly, the domestic city-pair with the highest number of seats flown in July 2024 was Seattle to Anchorage, with around 146,000 seats. Alaska Air operated nearly 80% of these flights.
On a global scale, the International Air Transport Association, IATA, reported an 8.0% increase in passenger demand in July. Total demand, measured in revenue passenger kilometres (RPK), and total capacity, measured in available seat kilometres (ASK), were up 8.0% and 7.4%, respectively, compared to July 2023. The July load factor was 86.0%, a 0.5 percentage point increase from the previous year. Despite the CrowdStrike IT outage on 19th July, which affected global computers including those at airports and airlines, there was no noticeable negative impact on the industry.
US domestic demand grew by 4.8% compared to July 2023, with a 2.8% increase in capacity. The domestic load factor improved to 86.1%, a 1.7 percentage point increase from the previous year. All regions experienced growth rates exceeding 5%, although a gradual deceleration has been observed since April 2021. Consequently, it may take longer to see a return to pre-2020 figures.
International demand saw a 10.1% rise compared to July 2023, while capacity increased by 10.5%. The load factor for international flights slightly decreased to 85.9%. The Asia Pacific region demonstrated the most substantial growth at 19.1%, however, the disparity with other regions is diminishing. Latin America and Europe followed suit in terms of growth. July 2024 witnessed record-high RPK volumes for all regions with the exception of Asia Pacific and Africa. As of July, North America represents 24.2% of total demand, measured in RPK, while Europe stands at 27.1%.
How might potential constraints on aircraft availability influence the US airline industry landscape?
Aircraft deliveries in 2022 and 2023 fell significantly short of initial projections, with 25% and 12% fewer deliveries than planned, respectively. While the 2023 shortfall indicates some improvement compared to 2022, it is important to recognize that 2023 delivery plans were likely more conservative due to carriers adjusting their order books in anticipation of production challenges. The slower-than-anticipated delivery pace has inadvertently helped to balance pilot supply and demand, as a smaller fleet necessitates fewer pilots. However, this has essentially exchanged one growth constraint for another, shifting the primary limitation on capacity expansion from pilot availability to aircraft supply.
Given persistent supply chain disruptions, we anticipate continued downside risk to airline delivery forecasts. This potential risk is likely to be further compounded by Pratt & Whitney's geared-turbofan (GTF) engine issue, which is projected to result in an average of 350 aircraft being grounded from 2024 to 2026. In response to this, Airbus has indicated that a higher proportion of 2024 A320neo Family aircraft will be delivered with CFM LEAP engines rather than GTFs, enabling Pratt & Whitney to better manage the GTF spare fleet. This adjustment likely implies downside risk compared to original plans for airlines expecting deliveries of GTF-powered A320neo Family aircraft in 2024. Moreover, the GTF issues could also potentially impact 2024 A220 deliveries, although Airbus has not yet commented on this.
Turning to Boeing, the FAA has capped 737 MAX aircraft production following the MAX 9 grounding in January, and Boeing has also withdrawn its request to expedite approval for the MAX 7. Neither the MAX 7 nor the MAX 10 has been certified yet, and no airlines in our coverage currently anticipate deliveries of either variant in 2024. However, fleet plans beyond 2024 still include MAX 7 and MAX 10s for airlines with these aircraft on order.
Of the eleven US airlines with 2024 order books, seven have 100% exposure to either GTF-powered or MAX aircraft. Notably, United Airlines is the only carrier with order book exposure to both MAX and GTF-powered aircraft, which together constitute 92% of its order book. Hawaiian Airlines stands alone with no exposure to either GTF-powered or MAX aircraft, as the company exclusively plans to take delivery of 787-9s this year.
The challenging delivery environment is underscored by United and Southwest already revising their FY 2024 delivery outlooks downward by 18% and 42%, respectively, compared to their original plans announced in January. United attributed the change to revised MAX delivery assumptions, while Southwest removed the MAX 7 from its 2024 delivery plan and reduced its MAX 8 deliveries. Based on its updated outlook, Southwest now expects to cut FY 2024 capacity by at least 1 to 1.5 points compared to its prior guidance of +6% y/o/y growth. While United has not provided formal 2024 capacity guidance, the company has already reduced its June quarter scheduled capacity. Should there be further downside risk to aircraft deliveries, it would likely lead to additional downward revisions in industry capacity plans.
However, it is important for investors to note that lower-than-expected capacity growth should, all else being equal, support the revenue environment. 1Q 2024 revenue trends exceeded expectations, likely bolstered by cuts made in the fall of 2023, and capacity growth plans have moderated.
Further complicating the delivery landscape, Boeing is currently facing an ongoing strike that began on 13th September. This work stoppage, resulting from a labour contract dispute, has halted production of most of the company's aircraft, including the popular 737 Max. This development adds another layer of uncertainty to the already challenging delivery environment.
Delays in aircraft deliveries present a complex scenario for airlines, impacting their network and financial performance in potentially contrasting ways.
Constraints on aircraft availability can impede airlines from fully capitalising on projected revenue growth. With fewer seats available for sale, airlines may find themselves unable to accommodate the full extent of passenger demand, especially during peak travel seasons.
Conversely, delays in aircraft deliveries could inadvertently bolster profitability under certain circumstances. A reduced fleet size may lead to higher load factors on existing flights, potentially driving up yields as airlines can command premium fares for scarce seats. This scenario, where demand outstrips supply, could improve the revenue landscape despite the limitations on overall capacity growth.
Jet fuel prices: a potential tailwind in Q4?
A significant potential tailwind for airlines is the decrease in jet fuel prices, driven by both lower Brent crude prices and narrower crack spreads, the overall pricing difference between a barrel of crude oil and the petroleum products refined from it. According to IATA's Jet Fuel price monitor, the S&P Global Platts' Jet Fuel Price Index has experienced a 7.1% decline from 252.2 in the week ending 23rd August to 233.0 in the week ending 20th September. Concurrently, the average crack spread per barrel has contracted by 16.3%, from $11.93 to $9.98.
The price of Jet Fuel Kerosene (type US Gulf Coast) and its associated crack spread exhibit a similar trend. The current implied crack spread per barrel of $7.16 is notably lower than its 3-year and 1-year averages of $23.98 and $21.97, respectively. Moreover, while Brent Crude prices have decreased by 4.1% year-to-date, Jet Fuel Kerosene prices have declined by a more substantial 18.4%.
This development is particularly noteworthy given that fuel constitutes a major operational expense for airlines, ranging from 18.8% (Delta) to 38.9% (Ryanair) of total revenue as of Q2 2024. Consequently, the potential decline in jet fuel prices could provide a boost to airline profitability.
What is the investment profile of a portfolio dedicated to the airline sector, specifically targeting US and European carriers?
Despite the lingering effects of the Covid-19 pandemic, the airline sub-industry is demonstrating robust and sustained demand for air travel, signalling a potential turning point. In light of these positive trends, a strategically constructed portfolio comprising 11 major US and European airlines has been assembled. This portfolio includes Delta, United Airlines, American Airlines, Southwest, Alaska Air, JetBlue, Lufthansa, Air France-KLM, International Consolidated Airlines Group, Ryanair, and easyJet.
This diversified group of companies, strategically spanning two continents, is designed to capitalise on the cyclical nature of the airline industry while also benefiting from individual company dynamics that could enhance the overall risk-reward profile. Moving forward, we will refer to this portfolio as the FLY portfolio.
Source: Facset
As of 23td September, the total market capitalization of FLY was $130.14 billion, equivalent to 0.3% of the total market value of the S&P 500 Index.
How have they performed this year?
The FLY portfolio has exhibited a lacklustre performance year-to-date, yielding a return of 3.1%. However, there is significant divergence in the performance of its individual components. International Consolidated Airlines Group leads with a 31.9% return, followed by United Airlines at 26.7% and Delta at 17.4%. Conversely, Air France-KLM has experienced a substantial decline of 40.0%, while American Airlines and Lufthansa have also underperformed, with losses of 20.3% and 19.6%, respectively.
Source: Facset
Still runway to go amidst an uneven recovery
While the FLY portfolio's EBITDA margin has demonstrated a recovery from pandemic-induced losses, the pace of this recovery has decelerated, with margins contracting each quarter since Q2 2023. This can be partially ascribed to the adverse impact of elevated interest rates on net margins, which typically affect airlines' financing costs with a lag. The full ramifications of tighter monetary policy are likely to persist throughout 2024. Furthermore, delays in aircraft deliveries have escalated operating lease prices to unprecedented levels, potentially further impacting profitability this year.
Looking ahead, however, with the initiation of monetary easing cycles by both the Fed and the ECB, the prospect of reduced financing costs could provide a tailwind for margin expansion in the future.
Source: Facset
Within the FLY portfolio, the disparity in recovery trajectories among the constituent airlines is striking. Ryanair, the European ultra-low-cost carrier, stands out as the sole airline in the group to surpass its 2019 EBITDA margin, achieving a 3.8 percentage point improvement to reach 24.0%. In stark contrast, Southwest Airlines exhibits the lowest EBITDA margin within the FLY portfolio at 6.2%, also representing the most significant negative differential compared to its 2019 margin, a substantial 12.9 percentage points.
Among the European airlines, International Consolidated Airlines Group boasts the second-highest EBITDA margin at 18.8%, albeit 0.9 percentage points below its 2019 level. In the US, United Airlines leads with an EBITDA margin of 14.8%, trailing its 2019 level by 0.6% percentage points. Delta Air Lines follows closely with an EBITDA margin of 14.7%, marking a 4 percentage point decrease from its 2019 performance.
Source: Facset
The FLY portfolio's Q2 2024 LTM net margin of 3.09% is notably lower than both the S&P 500's 10.86% and the STOXX Europe 600's 8.79%. However, reflecting the trend observed in EBITDA margins, there exists a considerable divergence in the net margins of the individual constituents within the FLY portfolio.
Regarding EPS expansion since 2019, only Ryanair, Delta, and United have achieved growth, with increases of 70.5%, 37.3%, and 5.2%, respectively. In contrast, the remaining airlines within the portfolio exhibit substantial declines in their EPS compared to 2019 levels. Southwest's EPS currently stands at a level 85.6% lower than its 2019 figure, followed by American Airlines at 80.3% and Lufthansa at 64.0%.
Source: Facset
Attractive valuation and a strategy that enhances diversification in a cyclical environment
With an EV/EBITDA multiple of 6.37x, the FLY portfolio's valuation is currently at a 56.5% discount compared to the S&P 500's 14.67x. This discount is consistent with the 1-year and 2-year average differentials of 56.0% and 57.9%, respectively. However, the current EV/EBITDA multiple of FLY is 8% higher than its 1-year average (5.90x) and 15% higher than its 2-year average (5.52x).
As the potential for margin expansion and increased revenues materialises, we could anticipate a narrowing of the EV/EBITDA multiple differential between FLY and the S&P 500. This phenomenon was observed in early 2022 as post-pandemic travel patterns began to normalise.
Source: Facset and Exante research.
Furthermore, the FLY portfolio's 1-year correlation with both the S&P 500 and STOXX Europe 600 stands at 0.44 and 0.41, respectively. This moderate level of correlation suggests that incorporating the FLY strategy into a traditional equity portfolio benchmarked against either or both of these indices could enhance diversification benefits. Moreover, the current correlation between FLY and both equity indices is notably lower than their respective 1-year and 3-year averages, further highlighting the potential for reduced portfolio volatility and risk mitigation through the inclusion of this strategy.
This relatively low correlation can be attributed to the unique set of factors driving the performance of the airline industry, which diverge from the broader macroeconomic trends influencing the broader equity market. As such, the FLY portfolio may offer investors an opportunity to access a distinct source of returns that is not perfectly aligned with the movements of traditional equity benchmarks.
Source: Facset and Exante research.
Potential risks: upside and downside
Key risks encompass macroeconomic factors that could potentially dampen demand for premium products, and any future disruptions to the Boeing or Airbus order books that impact aircraft deliveries.
In addition to previous challenges related to labour ramp-up, concerns regarding raw material sourcing and inflationary pressures are also contributing factors. The ongoing conflict in Ukraine has prompted a reassessment of critical raw material supply chains, particularly for titanium, given the prior reliance on Russia (VSMPO-AVISMA accounted for approximately 50% of total aerospace-grade titanium supply before the conflict). As a result, the re-shoring of production has gained prominence, and aerospace suppliers are actively mitigating their exposure in an increasingly volatile geopolitical landscape.
Since 1970, air traffic has consistently outpaced global GDP growth by more than 1.5 times, fueling demand for both new aircraft and maintenance services. For instance, the average person in the US takes nearly two trips per year, while in China and India, this figure is just 0.5 and 0.1 trips, respectively. However, this may change in the future as the residents of these countries see their incomes rise. Continued growth in global fleet capacity can be expected, primarily driven by the expanding global middle class and their increased propensity to travel as incomes rise.
Another potential upside risk includes a faster-than-anticipated recovery in corporate and international travel, which could further accelerate demand and growth within the industry. As workers return to their offices, business flyers are likely to continue to return to their corporate events and meetings.
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