Airlines were hammered in the coronavirus market downturn, which caught the attention of contrarians and deep-value investors. Many people felt like geniuses for buying on the dip ahead of a May rally, but the plot has since thickened with much of those gains being erased. Shares of Delta Air Lines are down 55% year-to-date, while American Airlines dropped 60%, United Airlines has fallen 64%, and Southwest has managed to relatively shine at a mere 38% decline. Long-term investors should consider the evolving industry fundamentals and compare these to historical figures. What results do the airlines need to report to demonstrate true recovery?
Air travel nearly came to a complete halt in April, and the resulting revenue shock fueled worries that large carriers would be unable to meet their monthly debt and lease obligations. Bankruptcy threats are usually enough to rattle cages in the stock market, and that certainly held true in this case. The JETS ETF (NYSEMKT: JETS) dropped from $32 in February to $12 in March, far outpacing major indices. The ETF was volatile for several weeks following the low, before a rally pushed shares as high as $22 in May. That joy was short-lived, as JETS has since dipped to $16.
The Extent of Disruption is Staggering
Preliminary data from the Bureau of Transportation Statistics indicates that airline passenger volume fell 96% year-over-year for the month of April, following a 51% drop in March. Major airlines carried three million passengers in April, the lowest monthly total in the 45 years of industrywide data tracking.
This has obvious implications for top-lines across the industry. Major US airlines generate roughly 75% of revenues from passenger fares, while baggage fees, upgrade and itinerary change fees, and cargo represent the remainder of revenue.
This Shock is Especially Challenging for Airlines
No business can casually absorb multiple months of lost revenues, but airlines are especially vulnerable in this scenario. These companies have significant fixed expenses and cash outflows due to their business model and capital structure.
Airlines generally maintain narrow margins. Industry average operating margins were around 7% in 2019, with net profit margins around 4-5%, so a 10% decline in revenue could wipe out profits entirely.
Some major expenses for airlines will decline with lower volumes, such as fuel costs, which represented about 20% of total operating expenses in 2019. Nonetheless, labor costs make up 35% of total expenses, and it's difficult to quickly downsize with heavily unionized employees. Fixed cash outflows are also supported by aircraft and facilities leases, capital expenditures for aircraft, facilities and maintenance, and debt service obligations. Airlines tend to carry debt-heavy capital structures, meaning short-term debt and interest are more meaningful than in most other industries.
Major airlines clearly have little room for error in their business model. When revenues contract sharply, the companies quickly become unprofitable, and it becomes difficult to meet their cash flow obligations. That's exactly why the chatter about bankruptcy and bailouts was so dire when this recession first began, and the threat continues for many carriers.
How Airlines Reacted
Domestic passenger revenues fell roughly 20% in the first quarter, and Q2 figures promise to be far worse. Competitors in this industry were still deeply impacted on the bottom line in Q1. American, for example, reported net cash outflows from operations exceeding $160 million, with an additional $925 million paid on long-term debt and lease obligations.
Carriers slashed capacity more than 80% by eliminating flights and using smaller aircraft. American announced that its current employee count was 20,000 too high for Q4 projected volumes, though no layoffs could be made in the current period due to terms of the Payroll Protection Program loan. It won't be shocking to see 15-20% of airline employees laid off or furloughed in September or October. United, for example, warned 36,000 employees that they could be laid off in October if air traffic doesn't increase.
Several airlines have been able to retain liquidity through various provisions in the CARES Act. American, Spirit, Hawaiian, Frontier, and SkyWest were able to hash out loan deals in early July, and other carriers may follow that lead. Several companies have tapped private capital markets to increase cash on hand too.
What Does Recovery Look Like?
Major airlines still have a long way to go to justify pre-COVID valuations. Even if we suppose that lower fuel prices and the current cost-cutting initiatives lead to a sharp increase in margins, systemwide monthly volume would have to climb to 60 million passengers, at a minimum. That assumes steady pricing despite likely lower demand, and higher margins despite lost economies of scale. The additional debt assumed by carriers will also lead to higher cash outflows. It is hard to envision a turnaround of this magnitude occurring in 2020.
It would appear that true recovery is far from realized today. This may still be an attractive entry point for value investors looking for high-quality stocks with upside, but it would need to be a long-term position.
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