RESEARCH notes on airline stocks from UBS, one of the world’s most influential brokers, come with a wealth warning: “Over the long term, a diversified portfolio of airline stocks has reliably underperformed broader market averages.”
Investors who piled into Air Berlin when it floated last month have had a white-knuckle ride so far. The stock, which was listed at a deep discount to its original price tag, has already fallen by 12% since its debut.
Aer Lingus is celebrating its 70th anniversary and hopes to mark the milestone by floating on the stock markets in Dublin and London later this year. Air Berlin’s experience, however, casts a shadow over this planned initial public offering (IPO). The government and the airline’s management team, led by the chief executive, Dermot Mannion, had hoped to float the airline before the summer, but several issues got in the way and it is now expected to debut in September.
With fuel prices rising inexorably and equity markets heading south, Mannion will be hoping that market sentiment turns sharply in the next two months. Otherwise, the IPO might be grounded for some time to come.
Airline stocks are not for armchair investors looking for shares to buy and hold, according to Paul McNulty, a senior fund manager with Setanta Asset Management. “Airlines are generally not investment stocks — they’re stocks that you trade,” he said. “Stocks in the sector tend to be among the best performers when the overall market is rising, but they are likely to fall faster when the markets are declining.”
Recent choppiness in the equity markets has taken its toll on sentiment. Ryanair shares, for example, have lost 7% of their value since the start of April to €7.12, and more than 13% since the start of the year. In a little more than two months, Lufthansa has dropped 7.5% in Frankfurt, SAS has slumped 30% in Stockholm, Iberia has slid 12% in Madrid and British Airways has eased by 4% in London.
Yet industry followers point out that the sector is in much better shape than it was even a few years ago, following 9/11, global economic weakness and the war in Iraq.
Certainly, there has been a raft of positive figures emanating from the sector recently. British Airways unveiled a 21% surge in pre-tax earnings in the year to the end of March, to £620m (€900m), while Air France-KLM’s operating profits soared 69.3% to €936m. Closer to home, Ryanair announced last week that its net profit had jumped 12% to €302m.
Three years ago, carriers were struggling to fill seats, but demand in this highly cyclical sector has since been increasing, buoyed by an upturn in the broader economy. “Historically, passenger numbers have grown between 1.5 times and twice global gross domestic product growth,” said Jonathan Wober, a London-based analyst with HSBC.
Last year, global passenger traffic rose 7.6%, according to the International Air Transport Association (Iata). The sector would have done even better in recent years had it not been for soaring oil prices, says Wober. “Fuel prices over the past 20 years would usually have made up about 16% of airlines’ costs, second to labour. Now fuel accounts for a quarter of their costs.”
While most airlines enter into hedging contracts to guarantee set prices to meet their fuel requirements — normally six months in advance — these have become increasingly expensive. Ryanair said last week that it had hedged 90% of its summer fuel requirement at an average price of $70 a barrel, well above the $49-a-barrel level that it was hedged at last winter.
Ryanair’s new hedging level is only a few dollars below where crude oil is currently trading, at about $73, which suggests that Michael O’Leary, the carrier’s chief executive, sees fuel costs going in one direction over the next few months.
Until now, European airlines have had little problem passing on rising fuel prices to customers. The big flag carriers, such as British Airways, Lufthansa and Air France-KLM, have been able to do this through surcharges, while low-cost operators, such as Ryanair and EasyJet, have recovered their fuel costs by offering passengers fewer bargain seats.
“Whatever the reason, it is clear that demand for airline seats remains strong, thus having a beneficial effect on pricing,” said Chris Avery, an analyst at JP Morgan.
Speaking at Iata’s annual meeting last week in Paris, David Bonderman, the chairman of Ryanair and a founding partner of Texas Pacific Group, a private equity firm, warned his audience that the sector, overall, was heading towards turbulent times.
“Today is as good as it gets for the airline industry,” he said. So should investors be looking for the emergency exit? Wober believes the best time to buy into airlines is at the bottom of the cycle. “Margins in the industry typically go through 10-year cycles,” he said. “They bottomed out in 2001 and stayed under pressure for another three years. It’s much easier pinpointing the trough in hindsight, but we know now that we reached it three years ago.
“Whether we’re at a peak now I don’t know, but sometime over the next couple of years you would expect [margins] to move down again.”
Meanwhile, those looking to trade in the sector should look at earnings growth potential, according to Avery. Lufthansa is the analyst’s top pick among traditional flag carriers, as Avery thinks it will be able to overhaul some of its ailing businesses, including Thomas Cook, a joint travel venture, and LSG Sky Chefs, its catering unit.
Avery’s favourite low-cost carrier is EasyJet, after the group raised its full-year earnings guidance, largely on the back of cost-cutting.
McNulty likes the look of British Airways because of chief executive Willie Walsh’s ambitious plan to achieve cost efficiencies for the carrier. The group declared war on no-frills airlines in April, by announcing that it was slashing one-way fares by up to 50%.
When it comes to Aer Lingus, however, McNulty says its shares will have to be offered at a knockdown price if the September flotation is to stir up interest among investors.
This could cause a problem for the airline, which needs to raise €400m for new planes to expand its long-haul services and about €70m to plug a shortfall in its pension fund. “On the positive side, Aer Lingus is exposed to Irish consumers, who are in rude financial health,” said McNulty.
“However, its biggest competitor is Ryanair, which is well- respected and is the biggest low-fare player in Europe. There are also issues surrounding its pension-fund deficit, the government’s aim to hold on to at least 25% of Aer Lingus shares and the workers’ (14.9%) stakeholding.”
On balance, McNulty believes the Aer Lingus IPO will fly.
For most analysts, though, Ryanair remains the king in this sector. O’Leary has an unrivalled reputation for keeping expenses in check while aggressively launching new routes. Be aware, however, that Ryanair does not pay a dividend, so shareholders have to rely on share price appreciation to gain a return on their investment. It could be a long-haul trip.
