JBLU - JETS: Airline Stocks Are High Risk With Potential

2023-10-19 10:20:38 ET

Summary

• Airline stocks have historically been volatile and have underperformed the market over the long term.
• The U.S. Global Jets ETF includes a mix of US and international airlines, as well as other travel-related stocks.
• Labor costs and rising oil prices are putting pressure on airline stocks and profitability.
• Airline stocks alternate outperformance with strong underperformance.

Airline stocks are notorious for their volatility and for me that has been a major reason to not make them a core holding in my portfolio. While at times airlines have the ability to outperform, we do see that over the longer term, airline stocks fail to generate consistent value and even underperform the markets. In this report, I will be discussing what is holding airline stocks down not just in recent months but over a broader timeframe and I will highlight the fact that there is indeed value in the industry.

What Holdings Are In The Jets ETF?

You might wonder why the IATA outlook is relevant for the US Global Jets ETF (JETS) since the IATA outlook is a global outlook. The reason is quite simple, the IATA outlook includes split outs by regions so we can assess the expected performance by region, and it also shows how regions recover relative to one another. Furthermore, the IATA forecast is based on airline surveys, so it is a good representation of the expected industry performance.

The top airline holdings in the U.S. Global Jets ETF are:

1. Southwest Airlines (LUV) with 9.75%
2. Delta Air Lines (DAL) with 9.63%
3. American Airlines (AAL) with 9.63%
4. United Airlines (UAL) with 9.08%
5. Sun Country Airlines (SNCY) with 3.44%
6. SkyWest (SKYW) with 3.15%
7. Allegiant Travel (ALGT) with 3.03%
8. Alaska Air Group (ALK) with 2.94%
9. Air Canada (ACDVF) with 2.76%
10. JetBlue (JBLU) with 2.75%.

Furthermore, while over 55% of the ETF consists of holdings in the top US airlines, the remaining 45% consists of airlines in other regions as well as airport stocks, OEMs, and other travel-related stocks. So, the US Global Jets ETF is not a pure play on US Airlines.

US Global Jets ETF Structurally Underperforms With Glimpses Of Outperformance

While airline stocks are under significant pressure now, what holds is that its underperformance almost seems structural in nature. Since inception, it has shown a -36% performance compared to the market doubling. Obviously, the pandemic hit the airline and related industries which are also reflected in the ETF harder than any other industry, but even when we consider pre-pandemic times the industry had a difficult time showing outperforming returns.

I wouldn't want to say that airline stocks or the representative ETF do not provide any value or any outperformance for that matter, because that would not fetch the truth. From July 2016, until somewhere in Q3 2019, the JETS ETF actually outperformed the broader markets. However, making the investment worthwhile or more worthwhile is all about riding the cycles. While the markets went up in a relatively constant fashion, the cyclical nature was clear with roughly 4 cycles over the course of three years. Timing is always key but it seems to hold even more so for airline stocks.

Airline Stocks Underperformed Since The Boeing 737 MAX Crisis

I have quite often described the airline industry as self-destructive as they grow in capacity to gain market share and thereby have more than once eroded pricing strength. That, however, does not tell the full story as there sometimes are external factors as well. The crisis with the Boeing 737 MAX is an example of that. The crisis led to fewer planes being delivered than initially anticipated forcing airlines to cut their schedules and we are not talking about an insignificant number of airplanes not being brought to the market. Those numbers are in the range of 600 airplanes and the margins in the industry might seem juicy at times but they are not. On average, in 2019, the airline profits per passenger were $6. Doing a quick calculation shows that it means that airlines depending on utilization lost $1.5 billion in profits due to the MAX crisis and there certainly are airlines that would lose even more. In 2021, Boeing (BA) reached a settlement that included $1.77 billion in compensation for airline customers. So, the quick back-of-the-envelope calculation fetches reasonably well with part of the compensation Boeing rendered.

Labor Costs Provide A Permanent Profit Pressure

Following the easing of travel restrictions, the industry was met with a new challenge. During the pandemic, many employees in the airline industry left either to work in a different industry or retired altogether, leaving the industry too small to efficiently capitalize on demand from customers who had been able to save up money for the better part of two years, and even if the crews would be there to fly the planes, it also became clear that the supply chain for commercial airplanes had weakened such that building the production capacity which had been dialed back during the pandemic was going to be a major challenge. It was what would provide the strong fundament for high unit revenues coupled with high disposable income from travelers as we have seen for well over a year now.

However, the airline industry wouldn't be the airline industry if there were another issue that would derail its prospects. The war in Ukraine did not have huge direct implications other than services to Ukraine and Russia being halted and more fuel-consuming flight routes to avoid Russian airspace. The bigger issue is the global energy crisis it caused sending inflation to levels I have never seen before. In many industries, there was a huge call for increasing pay and airline crews stood even stronger to demand a higher pay since there also was a significant shortage of staff.

The impact of labor has become clear in the most recent earnings of the big airlines. Delta Air Lines measured by capacity is a 16% bigger company compared to a year ago, but its labor costs rose 23.2% for the quarter and for the nine months ended the labor costs have been higher by roughly that same percentage and even a third higher when considering the one-off expenses related to the ratified pilot agreement.

United Airlines saw similar cost dynamics. The company has grown by 15.7% year-over-year, but labor costs grew 37.7% during the quarter and 29.3% for the nine months ended.

Generally, labor costs are around 15 to 20 percent of the operating costs for an airline with fuel accounting for 30 to 40 percent. Those dynamics have completely changed by now. Delta Air Lines sees labor costs at 27 to 28 percent of all costs while United Airlines sees costs being 30 to 31 percent.

American Airlines ( AAL ) has yet to report Q3 earnings, but it is most certain that labor costs will jump as the ratified agreement with pilots announced in July will include a 21% increase in pay that will grow over time to more than 40% while there will be a one-time provision of $750 million recorded in the third quarter results.

What About Demand Strength?

Airlines weren't particularly quick in increasing pay, but that should not come as a surprise. The reality is that the demand strength is driven by a shortage of airplanes and a shortage of crews. Indeed, if there is a scarcity of labor, the value of said labor increases, but the big question has been whether the value of said labor also remains as strong when the topline generated using that labor declines and that is the difficult situation that airlines face today. Airline staff is needed to generate value, but the demand for higher pay largely has been made on the back of shortages and significant demand strength, in other words the consumer has been paying for it and that is where cracks are showing now.

Delta Air Lines saw its passenger revenues increase by 14.4% for the quarter and 25% to date, but it happened on 16% capacity growth in Q3 and 17% for 9M 2023. The 9-month ended figures provide little reason to worry pointing at 5% higher unit revenues but the Q3 figures show that unit revenues declined by 2.5%. Yields declined 2% for the quarter and were up 4% for the nine months ended.

United Airlines saw revenues up 14.6% and 27% in the passenger segment on capacity expansions of 15.7% and 18.5% respectively pointing at unit revenues being down 1% in Q3 versus up 7.1% for the nine months ended. Yield was stable year-over-year and was up 5% for the nine months ended.

What it tells us is that while labor costs have been structurally inflated by now beyond levels seen before relative to the cost basis, the unit revenues and yield are being pressured. Strictly speaking, the value generated by the labor that is being paid higher for today than a year ago is declining and that is while we are still in a strong unit revenue environment but one can wonder when the softening in unit revenues and stagnant yield will trigger a cost rationalization. Data from the Bureau of Statistics show that Q2 fares dropped 5.1% year-over-year on the domestic market and the reality is that for many airlines possibly without exception operating expenses have risen.

Oil and Turmoil Always Hit Airlines

The elephant in the room that has not been addressed so far is oil. Normally, oil as a factor for swings in cost structures would be on top of the list as it normally is the biggest cost component. Not anymore, the recent figures from Delta and United show that fuel which is considered an uncontrollable and highly dynamic cost component is a smaller cost component than the labor-controllable cost component. Perhaps that also shows how much the entire cost structure of airlines has changed over the course of a year or two.

The reason why airline stocks have lost value since July is simple, oil prices started climbing. Oil prices are headed higher as supply is getting tighter while demand is strengthening. Oil prices tanked during the banking crisis earlier this year and while liquidity went in the direction of gold, the money flow ignored strengthening demand for oil and factored in lower demand for oil this year. While airline stocks did not climb in response to the fall in oil prices as there was a significant fear for demand to weaken which we also saw for two weeks in bookings of some airlines, the market has surely started discounting airline stocks as oil prices strengthened realizing that the fall in oil price was a welcome gift to airlines through July but not so much driven by reduced demand and if you add tightened supply you get a spring-loaded price reaction.

War or looming wars have never been good for airlines. On one side, wars and terrorist attacks have the potential to dampen demand for air travel. The other side of the story is the impact on oil prices. Especially with conflict in the Middle East as we are seeing now, the reaction in oil prices can be quite severe and the effect of the attacks in Israel has been clear on airlines as well as oil. Oil prices increased by more than 8%, and airline stocks tumbled by almost 8%.

Putting It Together Creates A High-Risk Cocktail For Airlines

If you put labor, oil and demand together, you get a cocktail that at present is not quite in favor of airline stocks. Labor costs are currently permanently inflated while we are seeing yields being somewhat under pressure. Airline unit revenues and yield still stand strong but we are seeing that the same labor that is being paid for better today is not adding more value, in other words, the airline is paying for it rather than the consumer which means that airlines to make the higher labor costs worth capacity additions are required. Currently, the ability to add capacity is still limited due to airplane shortages and with pressure on unit revenues adding capacity will almost certainly lead to further unit revenue pressure. So, it is hard to see a sustained path forward on the current cost structure and airline investors are becoming more and more aware of that as the discount on oil prices has quickly slipped in the past three months.

The Big Mac Merger With Spirit Airlines and JetBlue

In 2019, IATA calculated that the entire airline industry would on average generate $6 in profit per passenger which at the time could buy you a Big Mac in Switzerland. It goes to show the cost intensity of the airline industry as well as the industry's inability to prudently add capacity. Airlines have been competing for market share in a race to the bottom destructing yields. Competition is also good, but in the case of the airline industry, we are also seeing signs that the airline industry is too fragmented to be strongly profitable. Airlines are getting more complex and the costs and complexity to keep an airline operating are rising. Southwest Airlines found this out the hard way as its network grew to complexity levels that would not allow an efficient rescheduling in case of disruptions and we have been seeing problems with IT across the industry, which also gives the impression that for airlines to be able to grow efficiently in a more complex environment a round of consolidation is needed.

Spirit Airlines and JetBlue are attempting to team up to grow stronger together and perhaps there is a good reason for it if you consider how slim the profits per passenger are. The $6 Big Mac in 2019, now costs $7.37 and JetBlue is generating $12.30 per passenger in profits calculated from its most recent earnings. Yes, you can almost buy two burgers from it but it is still not huge. A company such as Spirit Airlines generated $2.88 in profit per passenger. Lawmakers are heavily opposing the merger, but the profit generation at Spirit Airlines leaves to be desired at this stage. One can wonder whether consumer protection against higher prices is not turning too much into an anti-consolidation sentiment that simply denies the reality that competition could force one or both parties out of business leaving consumers with less choice at higher prices. Following the announcement from Air France-KLM (AFRAF) taking a stake in troubled SAS A/B (SASDQ) tighter regulations around airline mergers have once again surfaced. Indeed, the consumer needs to be protected but if you look at the state of the industry the post-pandemic consolidation round was bound to happen and that is currently further amplified by rising costs. So, the need for consolidation which in my view is clear could drive airline stocks higher but the anti-consolidation stance observed amongst lawmakers also provides a clear pressure.

There Still Is Value in Airline Stocks

As I have discussed in this report, there is a flurry of reasons for airline stocks to be highly volatile, but one should also keep in mind that at times rationale is lost on the markets. Indeed, there is proper reason to be cautious about investing in airlines at the moment, due to rising dynamic cost components such as oil prices, inflated cost components as well as static cost components being semi-permanently elevated. However, the reality is that from the bottom for airline stocks in March 2020 until today the JETS ETF has only shown a 27% return while the industry as a whole has seen its profits rise and its balance sheets deleveraged which I think is worth way more than a 27% return. In fact, some airlines are paying a dividend and given the outperforming nature of the airline industry in 2021 the current prices do not quite make sense.

It also tells you that instead of looking at the airline industry as a whole, it might be more worthwhile to handpick certain airline names. Names such as United and Delta have shown total returns of 60 to 90 percent and while this is well short of the market return, it is significantly better than the performance seen among the basket of airlines as it includes companies such as JetBlue and Southwest Airlines losing 14 to 45 percent of value. Perhaps Spirit Airlines has been the strongest performer with a 107% return but that has been driven by the takeover battle and somewhat surprisingly it is not part of the JETS ETF.

Conclusion: US Jets Hold If You Don't Want To Cherry Pick

I am not a huge fan of the US Global Jets ETF for the simple reason that I believe that there are too many weak performers in the basket of stocks and one would likely be better off picking several airline names to invest in as well as several aerospace and defense companies, which would likely already show better returns than the ETF. The pity state of the airline industry is that labor costs have risen above the levels that we typically see and it begs the question of how sustainable the current cost structure is as we are also seeing yields lacking growth and even turning negative in some cases. So, it does seem that while oil prices are heading higher which could also further reduce disposable income and spending on airline tickets, airlines are also hit with permanent elevation in labor costs and at this point, we have to wait for costs to rationalize because if there is one thing that seems to be clear is that if tomorrow the aircraft production constraints ease, all parties will be adding capacity to the market while we are already seeing pressure now. So, the continued strength is not a certainty and profits already have been under pressure making airline investment high risk, potentially with high returns as well in case a pragmatic approach is taken and costs are rationalized.

One thing is certain and that is while the airline industry at times outperforms, its phases of underperformance make investment less desired, and hand-picking the gems in the airline industry yields better results. Even then, it should be noted that the dynamic nature of the industry as well as the rather slim margins make the industry highly susceptible to changes in costs and fare strength.

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