Taking Flight: 3 Favorite Airline Stocks

09/10/2014 10:00 am EST

Focus: STOCKS

In the latest issue of Kiplinger’s Personal Finance Magazine, Tom Petruno highlights the improved prospects of the historically poor performing airline sector; he also discusses three favorite airline stocks.

Steven Halpern:  Our guest today is Tom Petruno of Kiplinger’s Personal Finance Magazine.  How are you doing today, Tom?

Tom Petruno:  Very well, thanks.  

Steven Halpern:  Our topic is the airlines, a sector that historically has not been very good for investors, but you note that things have changed.  Could you expand on that?

Tom Petruno:  Sure.  There’s an old Wall Street joke about how do you end up with a million worth of airline stocks?  You start with ten million.  I mean, this is an industry that has been horrendous over the last 30 years.  

Once the regulations started, many airlines just simply could not compete and so what you’ve had is, basically, a very cyclical industry anyway and many, many names of course have disappeared into bankruptcy or mergers.  

I think virtually every one of the major airlines, maybe, except for a couple, have been in bankruptcy at least once in the last couple of decades.  What’s happened here is we’ve consolidated this industry so much through mergers and bankruptcies that—just to give you an example—you’ve got the big four today, which are American, Delta, Southwest, and United Continental.  They control about 80% of the US market.  

In 2000, nine airlines controlled about 80% of the US market, so we’re down to just four airlines having incredible market share—the vast majority of market share in the US market—and what that leads to, of course, is it’s giving them a greater opportunity to essentially dictate fares, which I think a lot of people can relate to, and you have a situation where all these annoying fees they’ve slapped on, of course, for baggage and so forth, great for shareholders, not great for passengers.  To sum it up, really, the industry is much more in control of its own destiny.

Steven Halpern:  You highlight in your recent article that the industries in proven fortunes were evident in the second quarter results.  Could you tell us about that quarter and whether or not you think those positive trends will continue?

Tom Petruno:  Sure.  The numbers—almost across the board—were really dramatic.  You had for example Southwest’s earnings were up 108% from a year earlier as revenue was up 8%.  

United’s earnings were up 68% year-over-year in the second quarter on a 3% rise in revenue, so really dramatic jumps and what’s happening is they are able to raise fares because they’re able to keep more and more seats filled on the planes and the benefit just flows directly to the bottom line at that point.  

Can it continue?  I think so—and I think a lot of analysts on Wall Street think so—mainly because, again, you’ve got just a handful of airlines really controlling the majority of the market, you’ve got a situation where there is weakness overseas.  Delta highlighted that in August.  

There is weakness in Europe, of course.  There’s been some weakness on flights for example to and from Russia, but the US market is still pretty strong and so I haven’t seen any indication that Wall Street is really beginning to lower earnings estimates for the rest of this year or 2015.

Steven Halpern:  As in all investing, there are obviously some risks.  Can you highlight what investors—in particular in the airline sector—should be concerned about?

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Tom Petruno:  Sure.  Number one, this is still a cyclical business.  It always will be.  If a recession hits, we know that business trips decline, vacation trips decline, and fewer and fewer people can afford or want to take them, so it’s a cyclical business.  If the economy goes down, the airlines will go down.  

Second thing is fuel prices.  Fuel costs generally make up about 38% of the industry’s total cost.  If oil were to skyrocket again, that would be an instant hit for a lot of the airlines.  They do hedge some of them in terms of fuel, but for the most part, rising oil prices are going to be bad for the airlines.  

Even if they can raise fares, they may not be able to raise them fast enough to cover the rising fuel prices, so those are two things, and then, of course, you’ve got the ever present threat of a terrorist attack.  

We know what happened on 9/11.  This is still an industry that is very vulnerable to any kind of terrorist attack, or even if it’s not involving an airline, just the thought of, let’s say something goes wrong in Europe, there’s a terrorist attack in Europe, obviously, that’s going to change a lot of people’s minds perhaps about flying to Europe, so it’s always going to be a very cyclical industry.  

Those are the major risks.  But, what you’ve got is a situation where Wall Street understands that.  What they’re looking for—and I think what they’re believing in more now—is that the real busts that were typical for this industry when things went wrong, either cyclically or just bad management on the part of airlines, that those busts are in the past and airlines maybe can just continue.

Although they’ll be cyclical, the bad parts, the downturns won’t be as severe, and so if Wall Street gets more of a sense that the earnings are becoming perhaps a little less cyclical, what that should do is raise the price people are willing pay on the stock relative to earnings.

Steven Halpern:  Let’s turn to the trio of stocks that you highlighted as the most attractive in this sector.  Could you tell us about Delta Air Lines (DAL)?

Tom Petruno:  Delta is a situation where it’s been considered by Wall Street to always have been very well-run.  Many consider it maybe the best way to play in the overall industry improvement.  Delta’s situation is interesting too because they are doing an incredible job of reducing their debt load.  

Their debt was 17 billion in 2009.  They’ve got it down to eight billion now and their target is to reduce it to five billion in 2016, so paying down that debt is a huge help, obviously, in terms of their long-term planning.  You lower the debt, you lower the amount of interest cost that goes out and the benefit flows are the bottom line.  

Delta’s considered very well-run, very well-regarded by passengers, and at this point, the stock sells for about 10 times estimated 2015 earnings.  Again, airline price earnings ratios are always pretty low relative to the market but at 10 times earnings there are a lot of analysts who don’t believe there is significant risk in Delta buying at these levels.

Steven Halpern:  Southwest Airlines (LUV) has also received favorable commentary. What’s the story there?

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Tom Petruno: Southwest is the survivor.  Southwest has survived all the industry turmoil over the last 20, 30 years.  Southwest has made a lot of money.  Southwest has a great reputation with passengers.  

They are considered to be just very well-run, in a very good situation domestically and now they’ve actually begun to expand overseas, very tentatively.  They started flying to the Caribbean, for example.  Those are its first international flights.  

Southwest is just considered also a real play on the US economy and just on a management team that seems to really know what it’s doing.  One note of caution with Southwest is they are likely to face some very tough contract talks with their unions coming up, but, overall, this is still a stock that looks reasonably cheap at about 16 times 2015 earnings estimates.  

Steven Halpern:  Finally, you cite the outlook for Alaska Air Group (ALK).  Could you tell us a little about that?

Tom Petruno:  Alaska is another one that is very well-run.  Their hub is out of Seattle.  They’ve sort of owned the flight to Alaska market and they’re up and down the west coast.  Very well-run airline, and, like Southwest, they also have a relatively clean balance sheet.  They’re not burdened by huge debt.  

The key with Alaska is retaining the strength they have out of their Seattle hub, and what’s happening now is Delta is trying to fight them for market share in that Seattle hub.  Alaska has faced competition in the past.  

They have a very good relationship with their passengers and a very good reputation and so I think the idea here is when you’re buying Alaska you’re betting that they will continue to dominate their particular market, add to flights as they see opportunities.  

The key with all the airlines is the idea that what they have to avoid is the urge to over-expand and put so much new capacity into the system that suddenly fares crash.  If that would happen, of course, it would be great for you and me as the traveler, it would be horrible for the airlines once again and for their shareholders, so we’ll see if all of them keep this discipline now.  

One interesting point I failed to mention earlier, a lot of the airlines have now talked about returning more capital to shareholders, either via stock buybacks or raising their dividends further, and that’s very important because once you start to commit to returning more capital to shareholders, it may impose much more discipline in terms of thinking about, “Are we going to expand, is it really worth expanding routes, or are we just going to end up producing so much capacity that we drag ourselves down and the entire industry?” So, that’s a real key here too to watch is this new discipline they’re showing with their own capital.

Steven Halpern:  Well, you have shared some fascinating ideas with us. Thank you so much for taking the time.

Tom Petruno:  Thank you.

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