Flying High On Airline Stocks Air Canada Appeals To Momentum Investors, US Global Jets ETF For Industry Exposure

My wealthy friend Jim is gloating again these days, this time over his investment in Air Canada (AC/TSX). During a pause between games of pool in the billiard room of his palatial home, Jim showed me a well-worn logbook —he doesn’t bother with computers — and thumbed backward to an entry he’d made in 2012. The entry showed an initial purchase of 5,000 shares of Air Canada for $9,050 plus a $10 commission. For him, that was a relatively small wager in a company whose shares had not traded above $2 in the previous four years. Today that stake is worth $119,500, with the shares gaining 80% since May alone.

“Warren Buffett must have been watching me,” Jim said. “He sure changed his mind on airline stocks.”

Buffett, chairman of Berkshire Hathaway Inc. and arguably the world’s most successful investor, hated airline investments for years. In an interview with the London-based Telegraph newspaper in 2002, he said he regretted a 1989 airline investment that Berkshire had made, even though it eventually resulted in a gain.

“If a capitalist had been present at Kitty Hawk back in the early 1900s, he should have shot Orville Wright. He would have saved his progeny money,” said Buffett. “But seriously, the airline business has been extraordinary. It has eaten up capital over the past century like almost no other business because people seem to keep coming back to it and putting fresh money in. You've got huge fixed costs, you've got strong labour unions, and you've got commodity pricing. That is not a great recipe for success. I have an 800 (free call) number now that I call if I get the urge to buy an airline stock. I call at two in the morning, and I say: ‘My name is Warren and I’m an aeroholic.’ And then they talk me down.”

As late as 2013, Buffett still shunned airlines, referring to them as a “death trap for investors” at Berkshire’s annual meeting that year.

Since then, however, Buffett has reversed his stance, and Berkshire has taken huge stakes in the four biggest U.S. airlines: American Airlines, Delta Air Lines, United Continental Holdings and Southwest Airlines. Berkshire added to its airline holdings last year.

In an interview on CNBC’s Squawk Box show in February 2017, Buffett said "It's true that the airlines had a bad 20th century. They're like the Chicago Cubs. And they got that bad century out of the way, I hope. The hope is they will keep orders in reasonable relationship to potential demand."

Today, airline investments are suited only for momentum investors who hope to buy high and sell higher, since their share prices reflect optimism. Air Canada appears a good choice for such investors, while the US Global Jets (JETS) Exchange Traded Fund (ETF) provides exposure to airlines in the rest of the world.

Keeping investors happy has been an elusive goal for airlines, whose managers must deal with aircraft purchase or lease payments, fuel costs, salaries for pilots, cabin stewards and maintenance staff, airport docking fees and a variety of other expenses that don’t change unless they reduce the number of flights. Competition from low- and ultra-low-cost carriers (LCCs and ULCCs), combined with passengers’ instant ability to find the cheapest flights on the Internet, means airlines cannot raise fares to solve the problem.

“A major airline tends to match the lowest airfare by a competitor, even if that carrier is losing money at those fares,” CFRA analyst Jim Corridore says in a November 25 report on United Continental.

For decades, airlines would order new planes to accommodate passengers during boom periods, only to have to file for protection from creditors during busts, often re-emerging from bankruptcy to begin the cycle again. Over the past few years, a variety of factors have combined to help airlines break the cycle and stay profitable. Mergers (such as United and Continental in 2010 and US Airways and American Airlines in 2013) have allowed airlines to reduce overlapping routes, cut staff and negotiate more favourable contracts, jet fuel costs have fallen along with the oil price, and the ability to charge for premium seat selection and baggage has increased revenue.

Air Canada

The huge run-up in Air Canada’s share price has coincided with the company’s successful efforts to cut costs, turning the 2008 and 2009 losses the airline recorded into operating margins of 10.8% in 2015 and 9.2% in 2016, said Chris Higgins, senior equity analyst at Morningstar.

“Lower fuel costs, combined with a solid management team, will enable the carrier to remain profitable through a full cycle; this has not occurred in the past, and it points to a fundamentally different company emerging,” Mr. Higgins wrote in a November 3 report.

At a recent price of $24.25, shares of Air Canada appear fully-valued, yet the airline’s record Q3 results show the stock has appeal, at least for short-term momentum investors.

In late October, Air Canada reported strong results in revenue, margins and free cash flow and continued to reduce its debt.

The airline’s third-quarter passenger traffic was up 8.8%, while revenue rose 9.1%, including strong gains in its business-class cabin. Operating income was $1.004-billion, up from the third quarter of 2016, which itself had been a record $896-million. Net income for the quarter was a record $1.786-billion or $6.44 per diluted share on revenue of $4.88-billion, compared to net income of $768 million or $2.74 per diluted share on revenue of $4.45-billion in the previous year’s quarter.

Earnings before interest, taxes, depreciation, amortization, impairment and aircraft rent (EBITDAR) is an important measure in the airline industry as each airline finances its assets differently. EBITDAR makes it easier for investors to compare one airline to another.

Air Canada’s third-quarter EBITDAR was a record $1.388-billion up $140-million over the same quarter a year ago. This year the airline recorded a record third quarter EBITDAR margin of 28.4%.

Based on its latest quarterly results, Air Canada’s shares trade at only 3.6 times earnings of $6.90 per share. The www.GlobeInvestorGold.com site shows that analysts expect earnings to come in at $4.12 per share for 2018, based on estimates from seven analysts, giving the stock a forward P/E ratio of about six times.

WestJet

WestJet Airlines Ltd. (WJA/TSX), launched in 1996, has grown quickly but is still less than half the size of rival Air Canada. WestJet’s market capitalization (shares times share price) of just $3.1-billion looks modest when compared with Air Canada’s $6.74-billion, and employee head count at WestJet is 11,000, vs. Air Canada’s gigantic 27,700 employees.

WestJet has not served investors nearly as well as Air Canada, despite paying a dividend that yields 2.1%. A $10,000 investment made five years ago is worth just $14,000 today, no better than the performance of the TSX Composite index itself, whose diversification makes it much less risky than any single stock.

Like Air Canada, WestJet reported record results in its third quarter. Diluted earnings per share jumped 21.6% over the third quarter over Q3 2016, while Return on Invested Capital (ROIC) climbed to 10.2%. Net earnings climbed to $138.4-million or $1.18 per diluted share on revenue of $1.2-billion, up from $116-million ($0.97). The airline’s load factor climbed to a record high 85.7% in the quarter.

WestJet’s shares trade at 10.8 times earnings of $2.49 per share. The www.GlobeInvestorGold.com site shows that a survey of seven analysts expect earnings to come in at a consensus average of $2.77 per share, giving the stock a forward P/E ratio of about 9.6 times.

US Global Jets ETF

Investors who feel buying into any single carrier can buy units in the US Global Jets ETF (JETS/NYSE). The fund, launched in April 2015, has US$107-million in assets and carries an expense ratio of 0.6%.

Almost half of the fund is invested in the four largest U.S. airlines, with roughly 12% of its net assets in each of Delta Air Lines Inc. (DAL/NYSE), American Airlines Group Inc. (AAL/NYSE), United Continental Holdings Inc. (UAL/NYSE) and Southwest Airlines Co. (LUV/NYSE). The fund has about 4% in each of JetBlue Airways Corp. (JBLU/NASDAQ), Allegiant Travel Cp. (ALGT/NASDAQ), Hawaiian Holdings Inc. (HA/NYSE) and Alaska Air Group Inc. (ALK/NYSE) and smaller stakes in manufacturers of aircraft components. Air Canada represents just 0.85% of the fund.

As of September 30, 2017, the fund was up 29.5% over the previous year and 7.6% since inception. The fund is one of only two managed by U.S. Global, the other being a tiny gold and precious metal fund.

Conclusion

Airlines are still vulnerable to economic downturns, a spike in fuel prices (if they have not hedged against that eventuality) and weather-related factors such as volcanic eruptions, blizzards and hurricanes, not to mention bad publicity when passengers are forcibly removed from overbooked flights. In my opinion, airline stocks are best suited to vigilant investors prepared to sell at the first sign of trouble. Air Canada appears a good choice for such investors, while the US Global Jets ETF is less risky as it provides diversification.

Correction

In my last column on railway stocks, I erroneously said Canadian National Railway Co. (CNR/TSX) had a dividend reinvestment plan. It does not. Investors who want to reinvest CNR dividends will have to do so manually. Given that CNR pays $1.65 a share in annual dividends, you should be able to buy 1.65 more CNR shares for each 100 that you own.

Richard Morrison, CIM, is a former editor and investment columnist at the Financial Post. richarddmorrison@yahoo.ca