What investors can do as global airlines remain grounded

The airline sector’s equities have nosedived due to Covid-19. Brave investors take note, says Chris Carter.

Airlines have taken a battering this year. The ARCA Global Airline index plunged by almost 60% between late February and early March – and has been in a holding pattern after a small subsequent uptick. It remains 46% below February’s level. And it may be some time before the index takes off again. 

Due to travel restrictions aimed at containing the spread of Covid-19, the number of air passengers worldwide in 2020 is expected to be around 2.8 billion lower than usual, according to the International Civil Aviation Organisation (ICAO). It reckons air passenger traffic, including both international and domestic, will be 57% to 61% smaller in 2020 compared with last year. That translates into a 54.7% decline from 2019 in revenue passenger kilometres (RPK: an industry yardstick arrived at by multiplying the number of passengers by the number of kilometres travelled). 

Fewer passengers and fewer kilometres travelled spells disaster for airlines. Judging by how fast they were burning through their cash reserves as stated in the second quarter of 2020 (during the height of the pandemic), the International Air Transport Association (IATA) calculates that the average airline can hold out for just over six months before it effectively goes bust. That’s assuming the rate of cash burn experienced in the months from March to June persists. 

That dismal prospect can hardly be ruled out. While nowhere near the levels seen early on in the crisis, new infections are still increasing globally at a weekly rate of around 7%, according to the World Health Organisation (WHO). So truly open borders are unlikely anytime soon, especially as we head into winter. The IATA doesn’t expect RPK will return to pre-Covid-19 levels before 2024 at the earliest. 

Covid-19 crimps crucial transatlantic market

That US borders remain effectively closed is dire. “The transatlantic market between the UK and US is vitally important for the aviation sector, as over 22 million passengers used direct air services between the two countries in 2019, which represented 8.7% of international air travel from the UK,” states a new report for trade body Airlines UK. That also spells bad news for the lucrative business-class market and the airlines that depend on it: “business travel is a vitally important component of these routes and as a proportion of the overall total, the US is more business-orientated than other long-haul markets”. Airlines, especially long-haul carriers, will need to adapt to this tough new environment.

Adapting to a new environment

The upshot? “The economics of air travel are fundamentally changing – airlines that relied on business class for a large proportion of their profits will need to rethink their strategies and cabins will need to be reconfigured,” says Stuart Middleton, chief commercial officer at air-fare aggregator Skyscanner. “Remote working and private flying are making all the headlines right now, but ultimately innovation – whether in ticketing, pricing or the overall experience – will be key to re-attracting business travellers.” 

Some airlines will find it much easier to adapt than others. The no-frills carriers, for instance, won’t mourn the loss of the business-class market as it was never part of their business model anyway. “Low-cost carriers’ low margins, agile and point-to-point approach” bode well, says Skyscanner. They are also well-positioned because “short-haul, domestic and regional travel [are] driving [a] recovery”. What’s more, low-cost carriers “have been very adept in understanding the price points that stimulate demand among different types of travellers”.

Short flights are the new normal

Whether the trend towards greater short haul, domestic and regional travel will endure in a post-Covid-19 world remains to be seen. But the odds are that it will. After all, budgets are squeezed. In the Bank of England’s latest NMG survey of household finances in Britain, carried out in April, well over half (57%) of households were cutting back on spending and one in five “were experiencing financial difficulty due to Covid-19”. 

If you do buy the tickets, there is always the risk of catching the virus at your destination, so countries nearby that appear to be coping with Covid-19 become much more appealing; “travel corridor” became the buzz-phrase of the summer. What’s more, if your carrier does go bust while you’re on holiday, it is much easier to get home than if you were on the other side of the world. Given all this, it’s hardly surprising that many people ditched their plans to go far this summer in favour of a quick dash to the continent. As the European Travel Commission (ETC) says in its second-quarter report on tourism trends, “the resilience... of travel demand is likely to be greater for destinations that rely more heavily on domestic and short-haul travellers”. 

Long-haul carriers’ catch-22

“This is particularly relevant given concerns about the financial viability of many airlines,” the report goes on to note – which takes us back to the point about how long airlines can hold out. That British Airways has been burning through £20m a day and was forced to sell its prized art collection does not inspire confidence. Long-haul carriers are, therefore, seemingly caught in a catch-22: they are in financial straits because they cannot attract enough paying passengers and paying passengers won’t fly with them because they are in financial straits. The vicious circle turns until it stops. 

In the US airline sector the clock is ticking too. In March Congress gave airlines a $50bn bailout to tide them over until the autumn, when, it was hoped, a vaccine would be closer to being developed and passengers would be flying again. In return, airline executives were to refrain from undertaking major cuts to their staff and flight routes. That was until last Thursday. With no more state aid in sight, at least for now, American Airlines and United Airlines have begun to lay off 32,000 workers.

Cashing in on loyalty

But airlines, especially the long-haul ones, do have one ace up their sleeves: loyalty programmes. Last month Delta Air Lines said it was planning to borrow $6.5bn against its SkyMiles programme. “Frequent-flyer programmes are valuable – especially when people are staying home,” says Anna Szymanski on Breakingviews. That is because of what goes on behind the scenes when customers earn free miles through, for example, using credit cards. 

SkyMiles sells miles to third parties such as American Express for more than it would cost you to buy those miles from Delta. “So, the programme is still pulling in cash as people earn miles with their credit cards, even though they aren’t redeeming or earning so many [miles] on flights.” True, that means the schemes rely on people spending on their credit cards, which they didn’t during lockdown. But it’s much better than nothing and retail spending is returning, albeit slowly. United Airlines has valued its subsidiary tasked with running its loyalty scheme, MileagePlus, at $21.9bn.

You might also expect low oil prices to give airlines a lift. After all, prices fell to a two-decade low around $20 a barrel in April. Alas, most airlines won’t have been in a position to benefit. Many lock in an agreed price for months at a time as a hedge against spiking oil prices. Ryanair had hedged 90% of its fuel requirement at an average price of around $77 a barrel for the year beginning 1 April, according to Bloomberg. Air France-KLM is paying about $78.50 for two-thirds of its needs in 2020, while German flag-carrier Lufthansa is hedged at $63 for three-quarters of its annual usage. 

Where to look now

All this means investors hoping to profit from an eventual recovery in the sector will have to tread extremely carefully. So where should they look now? In the US, says Morgan Stanley, airlines “with high domestic leisure exposure, medium length of haul, strong customer loyalty and/or attractive fares will see demand come back first”. Hallmarks of the most robust operators will include “high margins, relatively strong balance sheets and management teams focusing on passenger revenue per available seat mile over capacity growth”. Morgan Stanley tips Southwest Airlines (NYSE: LUV), JetBlue Airways (Nasdaq: JBLU), and Delta Air Lines (NYSE: DAL) as possible buys.

On this side of the Atlantic, Budapest-based Wizz Air (LSE: WIZZ) is worth a look. It grew sales by 19% in the 12 months to March, doubling net profits to €281m. It had carried 1.56 million passengers in September, a 59% fall compared with the same month last year. But the outlook is auspicious. “It has sustained less Covid-19 damage than rivals,” says The Economist. Its customers tend to be younger and “less fearful of the virus”. Its fleet is relatively small, so a higher proportion of its planes have managed to stay aloft. Its costs are relatively low thanks to its “super-efficient” fleet of Airbus A321s. It has kept a lid on costs without irritating customers (in contrast to Ryanair). And thanks to layoffs and airports desperate for business, Wizz Air now has access to cheaper crew and landing slots. Perhaps most importantly, the airline’s €1.5bn in cash would last it 20 months, even if all of its planes were to stop flying, says CEO József Váradi.

Raid the duty-free shop 

“I remain of the opinion we are close to the peak of coronavirus hysteria,” says Eoin Treacy of Fuller Treacy Money. “That suggests it can only get better from here.” If he’s right, Swiss duty-free giant Dufry (Zurich: DUFN) could be worth a punt sooner rather than later. It is planning to raise up to CHF700m and China’s answer to Amazon, Alibaba, is reportedly buying a 10% stake. “With additional investors, there is now a much-reduced risk of insolvency and the share is highly leveraged to passenger volume recovery in the airline sector,” says Treacy. 

Investors should be under no illusions when it comes to this sector – the way ahead will be extremely volatile as news on travel restrictions and their impact on airlines’ profits keeps emerging. But when the backdrop is bleak and the outlook opaque, it is often a good time for brave investors to go looking for bargains.

Sars and the airlines: what happened last time?

Covid-19 isn’t airlines’ first run-in with a nasty coronavirus. In November 2002, a related virus causing severe acute respiratory syndrome (Sars) spread from China and infected neighbouring countries, along with Toronto in Canada. “By interrupting all human-to-human transmission, Sars was effectively eradicated” just eight months after the initial outbreak, according to medical journal The Lancet. There were 8,098 reported cases worldwide and 774 deaths. 

By that time, Asia-Pacific airlines had lost 39 billion in RPK, or around 8% of annual traffic, notes a 2006 report from IATA, at an estimated cost of $6bn in lost revenues. The damage wasn’t confined to the region’s airlines, however. Their North American counterparts lost an estimated 12.8 billion in RPK, equating to a 3.7% reduction in traffic, and $1bn in revenue. In April 2003, global passenger traffic fell by 18.5% compared with the same month a year earlier, with a drop of almost 45% in the Asia-Pacific region. 

Our experience with Covid-19 has, of course, been much worse, with the virus more transmissible than its forerunner. On Tuesday of last week the world passed the grim milestone of one million deaths. The final cost to airlines has also yet to be counted. In late March the IATA revised its estimate of the cost of the damage, made three weeks earlier, from $113bn to $252bn, assuming severe travel restrictions were to “last for up to three months, followed by a gradual economic recovery later this year”. That, too, now looks to have been overoptimistic.

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