How to invest as the aviation sector bounces back from Covid-19
Shares in airlines have soared over the past few weeks as hopes of a return to normality have risen. Do they have further to climb? And which will do best in the post-pandemic landscape? Matthew Partridge reports
Mass international travel spread Covid-19 across the globe. No wonder, then, that the airline industry has borne the brunt of governments’ restrictions on movement during the pandemic. This has affected all parts of the sector, with “some airlines going bankrupt, others being forced to seek state bailouts and most carriers having to make large numbers of staff redundant”, says Dr Alexander Grous from the Department of Media and Communication at the London School of Economics.
Still, recent signs that vaccines could bring the virus under control have fuelled optimism, with the share prices of many airlines higher than they were a year ago. But will the bounce endure?
How many passengers will return?
There is considerable uncertainty about the exact pace of the recovery in passenger numbers. Grous, who has completed several research projects on the future of air transport, takes the pessimistic view that the recovery “is likely to be slow and painful”, even in the short term.
Governments have adopted a “fragmented approach” to travel restrictions, with most countries requiring some form of self-isolation and some effectively banning both incoming and outbound travel to prevent the spread of new variants.
While the rollout of vaccines should reduce the need for travel restrictions, some countries have done better than others, with the result that many of those experiencing delays, such as France and Italy, are now facing a third wave of the virus.
Countries that have managed to vaccinate most of their population are understandably wary of allowing travel to and from those that have been less successful in reducing the number of cases. In the worst case, these “weakest links” could end up making it impossible for international travel to recover.
Tim Marshall of Invesco Asset Management’s UK Equities team is a lot more upbeat. He thinks that the number of passengers could return to its pre-pandemic peak within the next two years. Even European countries that have seen their vaccine programmes disrupted by supply problems are likely to have immunised most of their vulnerable population within the next two to three months, which should allow restrictions on both in and outbound travel to be lifted (or at least relaxed) by the summer. What’s more, once people are “given the green light to travel”, leisure travel should return quickly as people take advantage of the opportunity to go on foreign holidays.
The desire for holidays isn’t the only factor that will fuel a recovery in passenger numbers, says Marshall. The increasingly globalised nature of family life, with one in four children born in the UK having at least one parent who was born outside Britain, means that demand for travel is now also partly fuelled by the need to keep in touch with family and close friends in a way that cannot be replicated by Zoom or WhatsApp. Demand for both types of travel will be further boosted by the fact that many households have saved a lot of money during the lockdowns.
What US numbers tell us
Data from the US Transport Security Administration provides strong evidence that an effective vaccination programme can help travel recover quickly, says Frank Holmes, CEO of U.S. Global Investors, which runs the U.S. Global Jets exchange-traded fund (ETF).
The numbers of people going through airport security fell by 95% at the start of the crisis, from a daily average of 2.16 million in February 2020 to just 107,951 two months later. However, in the first half of this month, the average daily total had rebounded to 1.43 million.
Of course, 1.43 million passengers a day is still 40% down from April 2019, suggesting that the recovery is far from complete. Still, Holmes thinks that these raw numbers give a misleading impression about domestic travel, “since they also include international travel”.
International travel, which remains heavily restricted, accounted for around 700,000 passengers a day before the crisis. This suggests that domestic travel within the US is “much closer to pre-pandemic levels”. And given that more than half the US population has received at least one jab (and nearly a quarter have received both), Holmes expects numbers to increase further.
America isn’t the only air-travel success story, with China providing further evidence that it may be more resilient than people are predicting, says Todd Saligman, an equity investment analyst at Capital Group. China’s vaccine rollout has been relatively slow, with only 12.6 jabs per 100 people, but last month its “domestic passenger numbers had recovered to about 95%-98% of pre-Covid-19 levels”.
While international numbers are still “impaired”, this gives an indication “of what could happen across the rest of the world – at least in [large] domestic markets – once restrictions are lifted”.
Asia’s growing middle class bodes well
Saligman is also optimistic that in the longer-term leisure air travel is not only likely to bounce back, but will also “remain a secular growth industry”, thanks largely to growth in emerging markets. This is because “one of the first things people want to do as soon as they have enough disposable income is travel”.
Travel penetration is still “extremely low in developing countries”. Analysts estimate that fewer than 20% of people in the world “have ever been on an aeroplane”. With Asia’s middle class expected to “expand fourfold between 2012 and 2032 to around 3.5 billion in 2032”, this region will become particularly important.
However, while the number of people flying to a holiday destination is likely to keep on growing, the future of business travel is much more uncertain. Marshall admits that the substantial savings made by not paying for flights will make firms think twice about having their staff jet across the globe.
The experience gained during the pandemic means that it is almost inevitable that some kinds of work, such as information technology support and advice, “will mostly continue to be done via Zoom” rather than by sending a person to a remote office, even after the pandemic ends and restrictions are lifted. Nevertheless, most firms acknowledge that “seeing people in person is vital if you’re doing large business deals, or ones that cross borders”.
As a result, travel related to mergers and acquisitions, or meeting new customers, will continue. And large multinational companies will find that “face-to-face contact is vital if you want to transform or change a large organisation”.
Holmes agrees that “the simple reality is that a lot of... business has to be done in person”. Working on a major acquisition during the pandemic, he found that all parts of the deal, especially the due diligence and negotiations, have been significantly slowed down by travel restrictions. Having to do the deal over Zoom means that it has “taken me six months longer than it normally would”.
Which airlines will do well?
It is still very early to predict the winners and losers in the post-Covid-19 airline industry. Giles Parkinson of Aviva Investors warns that while the shares of most airlines are still below their pre-crisis levels, this does not necessarily mean that they are bargains.
Many carriers have had to sell assets and borrow money in order to raise cash. Others have issued more shares, either through a rights issue or as a condition of a government bailout, which means that existing shareholders will be diluted. Parkinson advocates seeking out airlines with strong balance sheets. Business travel is likely to take some time to recover, and may be permanently reduced in the medium term by the rise of Zoom, so airlines that make most of their money from short-haul leisure travel look more appealing than those skewed towards long-haul business travel.
Ed Legget of the Artemis UK Select fund also thinks that budget carriers, which focus on “friends, family and tourists”, such as Ryanair and Jet2, look more attractive than the state-owned large airlines such as Lufthansa, which have large fixed costs.
The budget carriers all made impressive returns on capital (a key measure of profitability) before the virus took hold and they look likely to emerge with good balance sheets. They could also become takeover targets as the European air-travel market consolidates into larger and more profitable companies.
The outlook for aircraft manufacturers
Legget is also optimistic about the companies involved in building aeroplanes. For one thing, most aerospace companies have strong military divisions, which are far less dependent on economic conditions than other aspects of their business.
What’s more, while airlines deferred some of their deliveries during the crisis, they still need to order new aeroplanes to keep up to date with industry trends, notably the shift away from super-jumbos towards smaller aircraft in order to maximise fuel efficiency. British Airways retired all of its remaining jumbo jets during the crisis and will need to replace the majority of its planes in the next few years.
Capital Group’s Todd Saligman agrees that replacement aeroplanes are starting to be a major driver of demand. While airlines used to order new aeroplanes only when they wanted to expand capacity, “today around 40% of planes are delivered in order to replace older aircraft”.
One reason for this is the growing emphasis on fuel efficiency, which plays a major role in helping firms maintain their margins by keeping their costs as low as possible (while also reducing carbon emissions).
Aeroplanes have become increasingly fuel-efficient over the last few decades. However, the latest generation of aeroplanes “are around 15%-20% more fuel-efficient than their predecessors, rather than the 5% -8% gain in efficiency we saw with the previous generation”. This is such a leap that even airlines normally content to hang on to their existing fleet “are finding that it makes economic sense to replace older aircraft”.
In the longer run, manufacturers are working on several “disruptive technologies” that could transform the ways aeroplanes are powered, says Bill O’Sullivan of Rolls-Royce. For example, Rolls-Royce is involved in a variety of “electrification programmes” that seek “to use a range of [pure] or hybrid electric technologies” as well as “investigating hydrogen and fuel-cell options for the longer term”.
The company is due to test its “Spirit of Innovation” aircraft, the world’s fastest all-electric aircraft, in the next few weeks, in the hope that it will set a new speed record for electric flight by reaching speeds “of up to 300mph”.
Maintenance becomes more important
Flying aeroplanes, or even building them, isn’t the only way to make money from air travel. Even those airlines that decide to upgrade their fleet still need to make sure that their aeroplanes are regularly maintained to a very high standard. Indeed, Aviva’s Giles Parkinson notes that since cutting corners in this area can lead to disaster, airlines are willing to pay large sums of money to ensure that any problems are spotted immediately and that spare parts have a high degree of reliability. As a result, the handful of companies permitted by regulators to carry out checks can make a lot of money from their captive customer base.
Another niche area likely to receive more attention from all part of the industry in the future is hygiene. In the past, price-conscious consumers were willing to accept that they would be exposed to other people’s germs, with catching the occasional cold or flu considered as much a fact of travel as jet lag.
However, Covid-19 has changed all that, with airlines forced radically to increase their level of cleanliness, says Frank Holmes. The last time he flew on a plane he was pleasantly surprised by the fact that it was “cleaner than any supermarket”. Already the big manufacturers, such as Boeing and Airbus, are working on systems to improve the quality of recycled air. I look at the best ways to invest in the airline industry’s future below.
The stocks and funds to buy now
One exchange-traded fund (ETF) worth considering is the Invesco STOXX Europe 600 Optimised Travel & Leisure UCITS ETF (Frankfurt: XTPS). This tracks the STOXX Europe 600 Optimised Travel & Leisure Total Return index.
Four out of the ten largest holdings are airlines (IAG, Ryanair, WizzAir and easyJet), although it is important to note that it is very far from a pure play on aviation: betting firm Evolution Gaming Corp is the largest single holding. The annual management fee is 0.3%.
The recovery is likely to favour budget airlines such as Wizz Air (LSE: WIZZ), as they are less dependent on business travellers. Wizz Air was originally set up to focus on central and eastern Europe, which had traditionally been underserved by the large airlines. However, it has successfully started to move west.
This strategy has served it well, with revenue increasing by 125% between 2014 and 2015, and 2019 and 2020, while it made a double-digit return on capital. Wizz Air made heavy losses in the chaos of last year, but it has plenty of cash on hand and currently trades at a reasonable 25.9 times its pre-Covid-19 earnings.
Another successful budget airline is Jet2 (LSE: JET2). Jet2 transports holidaymakers from regional airports around the UK, including Manchester, Birmingham and Leeds, to and from destinations in Europe, including Spain and the Mediterranean.
In the five years from 2014-2015 to 2019-2020, its revenue increased by 186%, representing a growth rate of over 20% a year, while it made strong returns on capital of around 10% a year. While it is likely to make only a small profit in the forthcoming fiscal year, it is trading at a reasonable 22 times 2019-2020 earnings.
As far as the larger carriers are concerned, Ed Legget of Artemis thinks that International Consolidated Airlines Group (LSE: IAG) is in a relatively strong position, thanks to its balance sheet and high proportion of direct routes.
Before the pandemic it enjoyed solid annual revenue growth of around 3%-5%, along with good margins and returns on capital. It is expected not only to recover most of its revenues, but also to return to profitability in 2022, yet it trades at a very low 2022 price/earnings (p/e) ratio of 13.
The last year has been a nightmare for engine maker Rolls-Royce (LSE: RR), which at one stage saw its share price fall by 80% from its January 2020 level. Its shares then recovered before falling again after it was forced to raise £2bn of capital last year, diluting shareholders. However, while sales fell by 30% in 2020, they should grow by 17% this year. The group also has exciting products in the pipeline, including the UltraFan turbine, which is expected to boost fuel efficiency further – by up to 25% compared with earlier engines.
Giles Parkinson of Aviva Investors likes companies involved in making spare parts. TransDigm Group Incorporated (NYSE: TDG) is a leading global designer, producer and supplier of highly engineered aircraft components for both commercial and military aircraft. Rivals struggle to gain a foothold in this specialised market and clients are happy to pay up for the products, so TransDigm was able to combine high sales growth of nearly 20% a year between 2014 and 2019 with large margins and a strong return on capital. While profitability dipped last year, TransDigm is expected to bounce back strongly, justifying its 2022 p/e of 36.