Understanding the Investment Fundamentals of Airlines. A part of the series "Sector Analysis: A Framework for Investors"

Joseph Wong    Alan Lok, CFA, Eunice Chu, ACCA, Guruprasad Jambunathan
15 Apr 2019
Categories: Industry/Sector Analysis, General Market Analysis, Fundamental Analysis, Investment Management, Investor Education

Country or region: Asia Pacific (Overall)

Summary:
INTRODUCTION TO AIRLINE SECTOR ANALYSIS: A FRAMEWORK FOR INVESTORS

The key to a company’s success depends on how well it executes its business model. This calls for optimising the allocation of limited resources to generate sustainable cash flows, for investing in new products, technologies, and services in responding to the wider competitive landscape or societal changes and mega trends, as well as for devising appropriate responses in the face of an evolving macroeconomic, regulatory, and political environment.  

Different industries often require very different business models; and even within the same industry, the model that does add value to the business may vary somewhat from company to company.  

To help investors undertake proper due diligence on a company, we have generated a framework of analysis designed to tease out the following: (1) whether the pertinent factors favour the firm in question; and (2) whether management is effective in executing its business model or value-generating strategies, while responding appropriately to its external environment.

This framework is customised to specific sectors and incorporates interviews with professionals within those sectors. 

AIRLINE INDUSTRY

Perhaps it’s the thrill of voyaging to a far-flung, unfamiliar place. Maybe it’s the teasing prospect of a seat or—even better—an 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 rapidly, requires significant capital to engender the 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 favor 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 replete with loss-making state-owned companies.
To the relief of investors (and taxpayers), economic sanity eventually prevailed and privatisation, together with the introduction of low-cost carriers (LCCs), helped to forge a
more sensible trading environment.

Old habits die hard, though, and aspects of a state-owned past haunt the airline industry. Intergovernmental deals dictate which airlines can fly and where they can land, and despite cheaper alternatives, national airlines still locate their hubs on their home turf. Industry pricing is also quixotic: a flight with two stopovers may be 40% cheaper than a shorter, more fuel-efficient, direct journey.
 
To read more, download the full sector analysis for the airline industry with accompanying question bank below.

This publication qualifies for 1.0 CE credits under the guidelines of the CFA Institute Continuing Education Program.
We encourage CFA Institute members to login to the CE tracking tool to self-document these credits.  


Abstract

MAPPING YOUR INVESTMENT ROUTES

In this section, we extract some important lines of enquiry from our sector analysis framework that will help to move your analysis forward. If you plan to invest in an airline company, consider these several factors before you make a final decision.

Leading airline operators usually offer several airline brands, which can be split into three groups: the traditional FSC carriers; the so-called hybrids, which have low-cost business strategies but still offer some full-service features; and the “pure” LCCs, which get passengers from A to B but provide little else. For this framework, we will classify the hybrids and the LCCs together. 

To begin with, it is worth noting a company’s route profile. Is the route profile dominated by low-cost brands or fullservice operations? How does the company decide where to deploy each business model?

Having established the company’s business model, figuratively look inside its aeroplanes and understand how seat demand reacts to changes in price. At a broad level, analyse if this differs according to passenger profile – leisure/business. If you would like to dig deeper, observe if price sensitivity varies with route type (e.g., short-haul versus medium or long haul; domestic versus international) and with the time of year. 

Unless the company is a niche, single-country player, it will most likely offer a mixture of domestic and international routes. Study what these are and the number of passengers who travel for business compared with those who journey at their leisure. Does the airline plan to expand its route network or has it earmarked routes for closure? 


NETWORKS AND FLEET MANAGEMENT

If your flights are always quiet or, conversely, constantly operating at full capacity, it may indicate that the company has capacity-related issues. Scrutinise which routes experience the most significant mismatch between supply and demand. What add-on services or promotions does the airline offer to increase the load factor, and do these have an impact on cost?

Not long ago, time spent at an airport was a reasonably enjoyable part of the flying experience. Now that time often feels like an endurance test. Airlines still need airports, however, so how do they decide which ones to use? Identify whether the airports an airline company is using are centrally located or situated many kilometres from the actual destination. Lastly, look at time slots and, where possible, gate numbers – this information can be quite revealing. 

Old aeroplanes make passengers—and investors—nervous. Study the makeup of a company’s fleet and determine its average age. Does it align with the operator’s route profile (e.g., larger aircraft for long-haul routes; smaller planes for shorter trips)? 


COMPETITION

Key routes, such as Singapore/Hong Kong, used to be the preserve of a select few FSC carriers. Fortunately, this arrangement has been disrupted by the LCCs, who introduced competition and sensible fare structures. 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 that evolution may have on demand and pricing.

Among the key quantitative metrics to track, ascertain the company’s capacity growth expectations, measured in available seat kilometres (ASKs). Simultaneously, assess per-unit revenue expectations, also known as revenue passenger kilometres (RPKs). 


TECHNOLOGY, EFFICIENCY, AND COST CUTTING 

Earlier, we mentioned the statist mindset prevalent among airlines companies, which can influence attitudes toward technology. Consider how well an operator is embracing change. For example, does the airline offer web/mobile check-in, then follow through with automated bag-drop facilities? What about the 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 you shouldn’t examine a company’s plans to reduce emissions and become more fuel-efficient. Find out if the company 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 takeoff and landing.


PREPARE FOR LANDING

And finally, remember Warren Buffett and his gloomy view of the airline industry? Well in 2016, he spent more than USD1.3 billion accumulating stocks across four major US airlines: American Airlines, Delta, Southwest Airlines, and United Continental.

Changes of heart are, of course, free, but 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 also underscores why analysis is so enjoyable – you never know what you are going to discover.

 



Date of original publication:

09/01/2018


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Reader Comments

Hardik Shah
Oct 25 2018
Very thorough guide and framework to analyzing an airline in any geography.

Thanks!


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