(By Basili Alukos, CPA, CFA) The airline industry has made tremendous strides recently, after surging fuel prices, highly restrictive credit markets, and a debilitating recession pushed all carriers to the brink just three years ago. Subsequently, airlines smartly adopted an aggressive pricing scheme, and the reassuring upturn led the sector to impressive profitability during 2010. Current share prices indicate investors may now have a more constructive view toward both the industry's attractiveness, and the larger airlines' ability to compete more effectively going forward.
However, our view diverges somewhat from that rosy scenario. We suggest investors steer clear of many of these names. At their current market valuations, we think there's little margin of safety to make this an attractive entry point. In addition, while the industry has combated rising oil prices with fuel surcharge-like price increases, we don't believe that these pricing actions can offset recent cost increases. As a result, in early March, we lowered our fair value estimates for all of the legacy carriers, including: AMR (AMR), Delta (DAL), United-Continental Holdings (UAL), and US Airways (LCC).
Fuel Prices Dictate Airline Profitability
The labor-intensive nature of the industry combined with high union participation has caused payroll-related expenses to remain the largest expense item for the airline industry. However, while labor costs have consistently fallen in nominal terms as the industry has removed pensions and seen its labor forces contract, fuel expenses have been extremely volatile due to geopolitical shocks. These include the 1970s oil embargo, and the current turmoil in the Middle East.
Although fuel expenses have only recently represented the largest line item for the airline industry, we believe oil prices have dictated airline profitability since the 1970s. In the chart below, we plotted the inflation-adjusted (using the commodities series from the Bureau of Labor Statistics' CPI index) price per gallon of fuel (in cents) for the airline industry compared to the Air Transportation Association's Airline Cost Index. This index is a basket of airline expenses that adjusts each line item for inflation based on the percentage weight of each expense--we prefer the ATA cost index to the overall CPI since the weightings are more appropriate.