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Investing in an airline company? Here's what to look out for
PERHAPS it's the thrill of voyaging to a far-flung place. Maybe it's the teasing prospect of a seat or, indeed, earnings upgrade. Whatever our reasons, we remain seduced and frustrated by the airline industry.
In a 2007 letter to shareholders, Warren Buffett observed that the worst sort of business is one that grows fast, requires significant capital for growth, then earns little or no money - think airlines.
Here, a durable competitive advantage has proven elusive ever since the days of the Wright brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favour by shooting Orville down.
In the beginning, airlines were a must-have sovereign accessory, an essential strategic asset with monopoly powers that conferred national pride and international prestige. That said, packing a soft-power punch wasn't cheap, and the industry was stuffed with loss-making state-owned firms.
To the relief of investors (and taxpayers), economic sanity eventually prevailed and privatisation, together with the introduction of low-cost carriers (LCCs), have helped forge a more sensible trading environment.
Old habits die hard though, and aspects of a state-owned past haunt the industry. Inter-governmental deals dictate which airlines can fly and where they can land. Despite cheaper alternatives, national airlines still locate their hubs on home turf.
Industry pricing is also quixotic: a flight with two stopovers may be 40 per cent cheaper than a shorter, more fuel-efficient, direct journey.
Today's industry is fiercely competitive, with LCCs and ambitious ultra-LCCs challenging the market share of traditional full-service carriers (FSCs). Airlines are also vulnerable to "events", including disease outbreaks (SARs, bird flu), acts of terror and fluctuations in the price of oil.
It is also worth mentioning that FSCs are overly sensitive to changes in the economic cycle, as downturns affect the demand for premium-class seating. These long-established operators also have a proportionately higher number of unionised employees, prepared to take disruptive industrial action.
Furthermore, airlines companies have little or no bargaining power with the upstream manufacturers, Boeing and Airbus, who operate as a duopoly.
Sit back and relax
More positively, the Asia-Pacific is the world's most promising growth engine, dominated by young and affluent customers with a taste for travel. Also, flying has become an affordable mode of transport with declining fares supported by low oil prices, better technology and competitive LCCs.
The non-discretionary nature of demand, predominantly from the business sector, helps prevent a hard landing during periods of rough weather.
Despite all recent advancements, the industry is still far from operating at its optimal best. Some of the crucial stumbling blocks it can look to address to garner better efficiencies include:
* How to work more efficiently with intermediaries such as online travel agencies, to reduce costs and provide a customised experience;
* Ways through which technology can eliminate the need for intermediaries;
* The simplification of airline/customer interactions, which are still cumbersome when compared with Amazon or Uber, for example.
Your investment routes
If you plan to invest in an airline company, there are several factors worth considering before you make a final decision. In this section, we have extracted some important lines of enquiry from our sector-analysis framework that will help to move your analysis forward. The complete question bank is available at www.arx.cfa.
Leading companies usually offer several airline brands that are split into three groups. There are the traditional FSC carriers; the so-called hybrids, which have low-cost business strategies but offer their customers some full-service features; and lastly, the "pure" LCCs that get you from A to B with little else in between. For this framework, we will classify the hybrids and the LCCs as the same.
To begin with, it is worth noting a company's route profile: Is this dominated by low-cost brands or full-service operations, and how does it decide where to deploy each business model?
Having established the business model of a company, it's helpful to look inside its aeroplanes to see how seat demand reacts to changes in price. At a broad level, it may be worth analysing if this differs according to passenger profile - leisure/business.
If you would like to delve deeper, observe if price sensitivity varies with route type - short-haul versus medium- or long-haul; domestic against international - and at different times of the year.
Unless the company is a niche, single-country player, it will most likely offer a mixture of domestic and international routes. What are these and who travels on these routes - for business or pleasure? Does the airline plan to expand its route network or are there routes earmarked for closure?
Networks and fleet management
If you board a flight that is always quiet or continually operates at full capacity, then the company may have capacity-related issues. Therefore, scrutinise which routes experience the most significant mismatch between supply and demand. What add-on services or promotions does it offer to increase the load factor, and do these have an impact on cost?
Not so long ago, the time spent at the airport was a reasonably enjoyable part of the flying experience. Now it often feels like an endurance test. But we still need airports, so how does a company decide which ones to use?
Lastly, look at time slots and even gate numbers - this information can be quite revealing.
Old aeroplanes make passengers nervous, investors too. Study the makeup of a company's fleet and determine its average age. Does it align with the operator's route profile?
Key routes, such as Singapore/Hong Kong, used to be the preserve of a select few FSC carriers. But this incestuous arrangement has been disrupted by the LCCs, which have introduced competition and sensible fare structures. Therefore, take time to look at the number of carriers on a company's key routes and determine how the market will evolve and the impact it can have on demand and pricing?
Among the key quantitative metrics to track, you should suss out the company's capacity growth expectations, measured in available seat kilometres (ASKs). Simultaneously, assess per-unit revenue expectations, or revenue passenger kilometres (RPKs).
Earlier, we mentioned the statist mindset prevalent among airlines companies, which can influence attitudes towards technology. Consider how well an operator is embracing change: for example, does it offer web/mobile check-in, then follow through with automated bag-drop facilities? Does it use of robots in the baggage handling, cargo, supplies, cleaning and refurbishment divisions?
The environment and climate change
Up to now, the airline industry has avoided intense environmental scrutiny, but that doesn't mean we shouldn't examine a company's plans to reduce emissions and become more fuel-efficient. Find out if it monitors the cabin air quality of its passenger flights. Another line of enquiry could relate to the regulations governing noise produced by the company's aircraft during take-off and landing.
Finally, remember Warren Buffett and his gloomy view of the airline industry? Well, in 2016, he spent more than US$1.3 billion on stocks across four major US airlines: American Airlines, Delta, Southwest Airlines and United Continental.
Mr Buffet's actions serve to highlight the undulating dynamics of the airline business model: one minute it's a complete disaster, and the next, a heaven-sent opportunity. It is why analysis so enjoyable - you never know what you're going to find.
- Alan Lok, CFA, is the director of Society Advocacy Engagement of the CFA Institute.
- Eunice Chu is an ACCA-qualified finance professional and now heads the policy function of ACCA Hong Kong.
- Guruprasad Jambunathan, FRM, is a director for Financial Research at CRISIL, a global analytical company.
This column is an excerpt from the joint research by CFA Institute, Association of Chartered Certified Accountants (ACCA) and CRISIL, entitled "Sector Analysis: An Investors Framework". The excerpt is printed here with permission from the three organisations. A full version of the research will be published on CFA Institute Asia-Pacific Research Exchange at www.ARX.cfa