How "Shareholder Friendly" Should Airlines Be?

The term "shareholder friendly" has become synonymous with dividends and share buybacks. Investors generally like returns of capital, and oftentimes these initiatives do help to increase the value of shares. Airlines are starting to get into the business of being "shareholder friendly," so the question is: How far should airlines go in these initiatives?

Dividend bidding war
Until last year, Southwest Airlines (NYSE: LUV  ) was the only major U.S. airline to pay a dividend. This wasn't too surprising, since the preceding several years had been racked with airline bankruptcies and recession. Southwest's dividend was a mere penny per share per quarter, but in an industry without any other dividend-paying competitors, Southwest was king of airline dividends.

Following the reduction of billions of dollars in net debt, Delta Air Lines (NYSE: DAL  ) launched a plan to return $1 billion to shareholders through $500 million in dividends and $500 million in share buybacks. The yield on Delta's dividend was around four times that of Southwest's dividend, and shortly after, Southwest quadrupled its dividend.

Last July, Alaska Air Group (NYSE: ALK  ) , parent company of Alaska Airlines, joined the dividend party by initiating a payout comparable with Southwest and Delta on a yield basis.

Future initiatives
United Continental
(NYSE: UAL  ) has noted its intention to begin a dividend by 2015 even as the carrier continues an aggressive fleet modernization strategy. Further speculation exists that American Airlines Group (NASDAQ: AAL  ) could begin some sort of "shareholder friendly initiative" in the near future, as reports note tht the airline is sitting on more than $10 billion in cash.

The right time for initiatives
Major airlines managed to handle the 2008 recession rather well with no bankruptcies, except for the bankruptcy of AMR, parent company of American Airlines, where shareholders ended up better off than before the bankruptcy. Furthermore, thanks to a wave of consolidation and reorganizations that have resulted in more cost-effective labor structures, airlines are posting strong profits, with most analysts expecting even larger profits for 2014.

But it would be unreasonable to assume that all airline risks have just disappeared and to adopt a "this time is different" approach to airlines. The airline industry has a number of factors that inject above-average levels of risk into the business. Factors including exposure to oil prices, cyclical effects, high capital costs, and vulnerability to world events such as a health pandemic or terrorist attack, mean airlines must still be prepared for a rainy day. Because of this, there's a need for a sensible balance between "shareholder friendly" initiatives and preserving the health of the airline.

I see Southwest, Delta, and Alaska as the most qualified airlines to launch such initiatives at this point. Southwest has a decades-long history of consistent profitability (something extremely difficult to achieve in this industry), Delta has committed to reducing costs and has undergone major debt reduction, and Alaska has been able to remain relatively stable in this rather turbulent industry.

United Continental has been in a situation of expecting big earnings growth for next year for a couple of years now. A turbulent merger has been much to blame, but there is a bright spot in that the final touches are being placed on the merger, and we will soon see just how well an integrated United Continental can operate.

Before United Continental begins paying a dividend, I'd like to see some of these big expected profits come to fruition. But if the airline can live up to expectations, a modest dividend on par with other major carriers should be considered reasonable.

American Airlines Group has an interesting situation, where a large pile of cash sits on its balance sheet as it prepares to integrate American Airlines with US Airways. As integration risks still loom here, coupled with the airline's massive fleet modernization plans, I see American waiting longer before initiating a dividend.

But American could opt for share buybacks. Indeed, it already has, noting in its Q4 2013 results that it has repurchased approximately 14 million shares for more than $300 million in cash. At this time, I like a modest share buyback program from American for three main reasons: (1) shares trade at the lowest forward price-to-earnings ratio among major airlines, (2) buybacks from American Airlines Group helps to balance out the selling pressure from AMR creditors that saw their AMR bonds converted to common stock, and (3) a share buyback can be turned off if the airline has more trouble than expected with the merger integration.

The bottom line
Airlines have regained their footing and are posting strong profits once again. Although the industry's future does look bright, airlines shouldn't ignore the risks inherent in their industry. If industry trends continue, we could see United Continental join the dividend club, possibly followed by American Airlines Group.

While airlines are paying dividends, you shouldn't expect them to become high-yielding stocks, as the business model requires a large cushion of cash and significant reinvestment. As investors, we must remember to look at the fundamentals of a company and determine whether "shareholder friendly" initiatives really are good for shareholders.

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