Airlines are terrible investments – but it could be time to buy

published 27 September 2013

13-09-27-airline-stocks2 — Airline profits could take off

Airlines are notoriously bad investments.

They are ultra-sensitive to things they have no control over, such as bumps in the economy, or the direction of oil prices. They can be inflexible keeping flights and routes open, even when they are losing money.

And life has been particularly tough recently. Competition has driven down prices, rising fuel costs have eaten into margins, and the global recession has hit passenger demand.

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However, things may be turning around. Prices and passenger numbers on one of the most lucrative routes in the world transatlantic flights are bouncing back.

And two European airlines are particularly well-placed to profit

The transatlantic turnaround

As the economy picks up, so airline passenger numbers are recovering too. The good news for the established airlines is that this comes after a series of mergers and code-sharing' deals (where groups of companies get permission to fix prices) have reduced capacity on various routes.

As a result, the remaining planes are filling up more quickly. Transatlantic passenger yields (the key measure of capacity) have increased by 4.5%. This has allowed airlines to stop cutting prices and start charging more per seat. The latest figures suggest that prices in economy are now rising by over 6% a year (in sterling terms).

Experts think this is unlikely to change in the near future. Airlines seem to have learned their lesson (for now, at least) that oversupply will reduce prices and leave them vulnerable to shocks.

Even if they wanted to, airlines would find it hard to increase capacity in the short term. Rupert Fleming, of the Smith & Williamson Enterprise Fund, points out that there is a shortage of new planes, and a backlog of orders. It would take at least six months for carriers to increase the number of planes from current levels. Fleming remains confident that this shortage will continue.

Another potential positive is oil prices. While both Brent and WTI prices remain in triple-digit territory, it is hard to see them rising much higher on a sustainable basis. Indeed, there is a good chance they could decline.

Oil produced from fracking' in the US has driven production to levels not seen since the start of the 1990s. Of course, just because this oil is plentiful, doesn't make it cheap it costs around $70 a barrel to get out of the ground. But that's still a good way below the current price. And the extra capacity will make it harder for oil cartel Opec to rig the market.

Another factor that could push prices down is the possibility of a US deal with Iran. In return for Iran pledging' to stop its nuclear programme, the US could ease sanctions, which have hit oil output. While it is hard to see Tehran sticking to any promises, the deal is likely to reduce crude prices in the short term.

Cheaper oil would cut the cost of aircraft fuel. While some of this may be passed onto the consumer, it'll also be used to boost profit margins.

Who's best-placed to profit?

As we've repeatedly pointed out, the only way to solve the euro crisis, without politically damaging bailouts, is for Brussels to turn on the printing presses. (If you're not already a subscriber, subscribe to MoneyWeek magazine.)

As well as boosting European demand, it will have two main benefits. Firstly, it will also reduce the value of the euro relative to the dollar. This will give European firms a cost advantage over their American rivals, especially in terms of labour costs. A weaker euro will also increase the purchasing power of American tourists, making a holiday on the continent more attractive.

The German airline Lufthansa (FRANKFURT: LHA) should do well. At the moment it gets over half its revenue from flights to and from the US, with passenger numbers growing at a healthy rate. It is also seeking to expand into other fast-growing markets, such as flights to the Middle East and Asia. Despite these strengths, the airline looks reasonable value on 8.4 times 2014 earnings.

Transatlantic revenues from British Airways should also help boost International Consolidated Airlines Group (LSE: IAG). In the longer term, the decision to buy fast-growing Spanish carrier Vueling should help the group (formed by the merger of BA and Iberia) grow at a fast rate. Irish broker Goodbody thinks revenue is set to grow by 5.7% in the next year, bringing the price/earnings ratio down to 8.2 in 2014.

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Matthew graduated from the University of Durham in 2004; he then gained an MSc, followed by a PhD at the London School of Economics.

He has previously written for a wide range of publications, including the Guardian and the Economist, and also helped to run a newsletter on terrorism. He has spent time at Lehman Brothers, Citigroup and the consultancy Lombard Street Research.

Matthew is the author of Superinvestors: Lessons from the greatest investors in history, published by Harriman House, which has been translated into several languages. His second book, Investing Explained: The Accessible Guide to Building an Investment Portfolio, is published by Kogan Page.

As senior writer, he writes the shares and politics & economics pages, as well as weekly Blowing It and Great Frauds in History columns He also writes a fortnightly reviews page and trading tips, as well as regular cover stories and multi-page investment focus features.

Follow Matthew on Twitter: @DrMatthewPartri