The airline industry has been long ignored, if not outright bullied, by the investment community for decades. But that's starting to change -- even famous airline bear Warren Buffett put $10 billion behind the industry not too long ago.
In this week's episode of Industry Focus: Energy, host Sarah Priestley and Motley Fool contributor Adam Levine-Weinberg explain why the industry has seen such a turnaround in the last few years, and go over the most important things that investors need to know about airlines today. Find out which companies are completely dominating the industry, and which of them shine the brightest from an investing perspective, how different airlines are changing their strategies to appeal to more potential customers, and more.
A full transcript follows the video.
This video was recorded on Sept. 14, 2017.
Sarah Priestley: Welcome to Industry Focus, the show that dives into a different sector of the stock market every day. Today, we're talking energy and industrials. It's Thursday, 14th of September, and as promised, we're going to be discussing the airline industry. Joining me in the studio is Motley Fool contributor Adam Levine-Weinberg. Adam, thank you for stopping by, especially when you're just about to go on your epic European tour/U.S. adventure.
Adam Levine-Weinberg: Yeah, thanks for having me in! I'm glad to be here one last time.
Priestley: Well, you'll be joining us on Skype, I hope, from the West Coast.
Levine-Weinberg: I hope so. But it's not quite the same.
Priestley: No, it's not quite the same, and it'll be a lot earlier for you.
Levine-Weinberg: Yeah, it will be.
Priestley: Today, we're going to be talking about the U.S. airline industry, as we primed for last week. The industry has had a pretty bad reputation and has been avoided for decades by investors. Looking through the numbers, it's clear to see why. The sector suffered combined losses of $52 billion between 1977 and 2009. Warren Buffett even went so far as to call the industry a death trap in 2013, famously, or now infamously, after his change of tune. However, we argue that the industry today is not what it once was, and may, in fact, deserve a second look by a lot of investors. This is a huge topic, and I briefly want to offer some background. I believe the history of the airline industry is pretty fascinating.
Levine-Weinberg: It certainly is.
Priestley: It looks a lot different now than it has in the last 30 years. A lot of M&A, some successful, some not so successful, a lot of deregulation in the 1970s really ushered in a new era of competition and cheap transatlantic travel offered by British airlines, pressured the U.S. companies to lower prices. So, you had a lot of new carriers entering the market, opening new routes, and dropping fares. Unsurprisingly, this forced a lot of carriers to fold, or succumb to takeovers, which is why you have the environment that you do, that was created. At the end of this, and after the recent U.S. Airlines and American (NASDAQ:AAL) merger, the top four major U.S. airlines left standing are American, Delta (NYSE:DAL), U.S. and Southwest (NYSE:LUV). The top four have gone from a combined market share of 68% in 1990 to around 85% now. So, Adam, traditionally, as we've said, the airline industry has not been interesting to a lot of investors. So if someone wanted to take a fresh look at airline stocks, what industry basics should they be aware of?
Levine-Weinberg: As you just mentioned, the top four airlines now, American, Delta, United, and Southwest combined, have about 85% of the U.S. market. And that figure varies depending on how you measure it. But the point is, they are much bigger than the rest of the competition. Behind them, you have Alaska Airlines and JetBlue, which each have about 5% of the market, and then the rest is pretty small carriers. You have some interesting ones like Spirit Airlines and Frontier Airlines that are these really deep discounters, everything is a la carte, you pay for a seat in the plane and if you want extra legroom, you pay for that. If you want to drink, you pay for that. If you want to bring a bag, even just a carry-on bag, that costs more, as well. You have a bunch of different business models, but the four top airlines in the country really do dominate the market right now. So that has made it a little bit easier for them to earn money. Of the four, historically, Southwest Airlines has been consistently profitable, and the other three, which are the larger carriers, big international networks, and they also are the ones which serve smaller communities in the United States, as well. They have historically been death traps for investors, as Warren Buffett said. But the interesting thing is, Warren Buffett, through Berkshire Hathaway, now owns nearly 10% of all four of those top airlines.
Priestley: Yeah, he invested $10 billion, right?
Levine-Weinberg: He put a lot of money into the industry. We'll take a look today about why it is that he did that. In terms of the investment highlights, on the cost side, the two things to be aware of are labor costs and fuel costs, which represent the bulk of airlines' cost structures. If we were doing the show four years ago, I would say that fuel costs are, by far, the most important, but with the way that oil prices have come down in the last several years, especially since 2014, that's changed. It used to be that most Airlines were spending between 30%-40% of their revenue on fuel.
Priestley: That's a huge amount.
Levine-Weinberg: Yeah. Now it's generally in the 15%-20% range for most of these carriers. So it's definitely an important cost factor. But when fuel costs go up by 10%, it's no longer the sort of thing that takes an airline from being profitable to losing billions of dollars.
Priestley: Yeah. I think we should also comment that labor costs have been increasing. I think it was 7% year over year last year, and they've been able to absorb that cost because of the oil price fluctuations.
Levine-Weinberg: Yeah. That's true. Some of the savings in fuel costs has been offset in increases in labor costs, and you see that particularly on the pilot side. For a lot of these airlines, the pilots alone could be 15% of the labor force, maybe 20% at most, but they're making 40% of the payroll, or close to that.
Priestley: Which I'm OK with.
Levine-Weinberg: Yeah, you want your pilots to be making enough money that they're happy and well rested and content and going to fly the plane well. But it does mean that they have a lot of bargaining power, so you've seen pretty substantial wage increases for pilots, to the point where the wage rates for the captains with experience flying overseas routes, the wage rate is over $300 an hour at most of these carriers today, which is a lot higher than it was just five years ago.
Priestley: It sounds incredibly high. When you consider the fact that there's not that many people available, that's the reason that the talent is constricted. And also, it's not the pleasant job that I think a lot of people think it is. It's a lot of traveling, it's a lot of being away from your family. So yes, that's playing a huge role. And you mentioned earlier low-cost competitors such as Spirit. Sprint, sorry.
Levine-Weinberg: Spirit. You got it right the first time.
Priestley: Sorry, I got the telecoms on the brain. I think the unbundling of services is something we're definitely going to start to see on the higher-tier carriers, too.
Levine-Weinberg: Going off of that, on the revenue side, one of the interesting developments in the past 10 years, and it's continuing to develop even today, is how airlines have gone from being all the same in terms of how they price their product to being quite different. So you see that with, on the one hand, you have Southwest Airlines, which is the biggest domestic carrier in the U.S. It has about $20 billion in revenue. And while that's about half of what Delta, American, and United bring in, those three carriers have these massive international networks, as well. Southwest, if you look at them, they don't charge for bags. You can still check two bags for free. Carry-on bags, of course, are free, as well. They don't have any change fees, so if you want to change your itinerary even up to the day that you're traveling, you do have to pay any difference in the fare between what you purchased and the flight you changed to, but you can cancel or change with no penalty. And that's completely different from the other airlines, which typically will have $150-$200 change fees, they'll charge you $25-$35 per bag that you check, and they have a variety of other fees. So Southwest has really stood out by having this bundled product where there's no hidden fees. And they really promote that in their advertising.
Priestley: And I think they really appeal to the leisure traveler. I think there are two really distinct categories of travelers for airlines. Business travelers tend to be a lot more brand loyal, into the rewards program, they're a more lucrative traveler. And leisure, obviously much more price sensitive, and tend to be price loyal. But as you said, Southwest, without having any of the hidden charges, and also being priced competitively, too, makes an attractive proposition for people.
Levine-Weinberg: Yeah. And at American, Delta, and United, as I've said, they started adding these bag fees and high change fees. But what they also started to do more recently is, they're dropping a lot of their fares in the lowest fare classes. Airlines, as a very quick side note, have a very complicated pricing structure. Revenue management is a science that they really focus on. So they're trying to figure out, how can we squeeze the most money out of each flight that we can? And that's not necessarily by charging high fares across the board. They'll try to figure out basically on a customer-by-customer basis how much that person is willing to pay, and charge that fare. If you book really far in advance, you're probably a leisure traveler. Business travelers don't know their schedule four months ahead of time. So those fares tend to be low. And when you get very close to the date of travel, those fares can go up quite substantially. More recently, you've seen Delta, American, and United introduce these basic economy fares, where they've taken even more perks out of the fare structure. So for American Airlines and United Airlines, that goes as far as, you're not even allowed to bring a carry-on bag at all. And they do that so that people who are needing the carry-on bag, especially if you're a business traveler, you want to get off the plane quickly, you don't want to check your bag, you're going to have to buy the next fare class up. So that's a way of allowing these carriers to match a low-cost carrier's flight. So they can say, "We're offering fares as low as $49 in this flight." So if someone is really price sensitive, they'll snap up that fare. But a lot of people will buy up the higher fare classes, so they'll be able to maximize revenue while still offering low fares to the people who really want that. And most of the airlines seem to think that's necessary. They don't want to give up all that traffic to companies like Spirit Airlines and just only get the people who are willing to pay $150 or $200 one way.
Priestley: Yeah, absolutely. I think it's also worth mentioning, first-class travelers are obviously the most lucrative, and they generally make up about two-thirds of the revenue per flight. Is that right?
Levine-Weinberg: It depends on the route. There are some that are very leisure heavy, there are others that are very business heavy. In a route like New York to London, you're going to get business travelers paying for the business class cabins because they want the lie-flat seat. In that case, you do have a lot of the revenue coming from a pretty small portion of the passengers.
Priestley: Yeah, and a lot of the big Boeing airlines, they're very first-class heavy.
Levine-Weinberg: Yeah, for overseas flights, definitely.
Priestley: Like a lot of people, I have to fly to go see friends and family. And from a leisure-consumer perspective, as we talked about, for me, there's not much difference between the carriers. But from an investment perspective, what do you think is the better buy for investors now?
Levine-Weinberg: Historically, clearly Southwest Airlines has been the best of these four by a long shot for investors. It's the only one that hasn't gone bankrupt in its history.
Priestley: [laughs] That's a bonus.
Levine-Weinberg: Yeah. That sort of gives it the crown very easily. And I think that Southwest Airlines is still a pretty attractive company for investors to own. Its strategy of being different from everyone else in terms of trying to have friendly service, only flying one type of plane, all Boeing 737s, and having the no fees, relatively low fares. It's really worked. The company has consistently high profit margins. And it still has plenty of growth opportunities. The fact that it only flies one type of plane does limit what kind of routes it can fly, because the 737 doesn't have the range of the big, wide-body planes that are used for long-haul flights, but there's still a lot of room, especially with the next generation of planes that Boeing has just started to produce. They have more range just because they're more fuel efficient, so that will allow Southwest to go a little further and possibly add new routes. One thing that's been talked about a lot, for instance, is Hawaii. So Southwest is definitely a good combination of steady cash flow and significant growth opportunities.
Turning to the other three, Delta, American, and United all have very similar business models. They're all really focused on trying to win business traffic in their main hub markets. They run these hub-and-spoke networks where they fly to all kinds of little cities where other airlines don't want to compete because they're flying larger planes that don't really work there. So Delta, American, and United are trying to aggregate traffic from all these different little cities and from major cities around the U.S., and connect in their hubs to everywhere else in the country, and also to international destinations. So it's a much different business model than pretty much everyone else in the market.
Priestley: I read that Delta claims they invented the hub-and-spoke model around the '50s. Is that right?
Levine-Weinberg: I'm not sure about that. It seems plausible. Atlanta has been a big hub for Delta for a very long time, and it's still the biggest hub in the world for passenger traffic.
Priestley: And most people, if you're connecting, then you're experiencing the hub-and-spoke model as a consumer.
Levine-Weinberg: Yeah, exactly. But among those three, while they're very similar in terms of how they do business, they're quite different in terms of their financial profile. Delta Airlines is, by far, the most attractive one for investors, especially investors with a long-term outlook. They have what appears to be a much more sustainable business model. They have much higher profit margin, they benefit from the fact that they are less unionized than the other two carriers, which gives them a little more flexibility in terms of how they operate. And they also are much more disciplined about capital spending, so their free cash flow is much stronger than the other airlines. So just looking at last year's numbers -- Delta, American, and United are all about the same size, and they each have roughly $40 billion of annual revenue, give or take 10%. But while they're all the same size in terms of revenue, Delta produced $6.1 billion of adjusted pre-tax income last year, whereas American was $1 billion behind that, at $5.1 billion, and United was further back, with $4.5 billion of adjusted pre-tax income. Looking at cash flow, the difference is even greater. Delta produced free cash flow of $3.8 billion last year compared to less than $1 billion for American Airlines and $2.2 billion for United.
Priestley: So clearly they're ahead. I think a lot of that speaks to the general discipline and learning from past mistakes, especially CEO Richard Anderson, I feel like he really brought in a lot of long-term outlook, investing in minority stakes with overseas carriers, and those kinds of things, and arguably, buying vertical integration with the refinery, too. It's something that has been up for debate, whether or not that was a good idea. But it certainly shows long-term thinking, and risk taking, too.
Levine-Weinberg: Yeah. So Richard Anderson was the former CEO of Delta. He just moved on about a year ago and got replaced by his longtime No. 2, Ed Bastian, and they really did a great job navigating through the recession. A big merger between Delta and Northwest, which was a company where Richard Anderson had actually previously been CEO several years earlier. They basically put the two companies together, figured out how to wring out as many efficiencies as possible from the merger. It was really successful. They basically took two companies that weren't doing very well, were both in bankruptcy not that long before, and made it into one of the most profitable airlines in the world. As you said, they bought this refinery in Pennsylvania about five years ago; it's been a really interesting move to try to hedge against fluctuations in refining margins. A lot of airlines have historically hedged against oil-price changes, which you can very easily do with derivatives. You can buy futures on crude-oil contracts, and that basically protects you against changes in oil prices. But the problem is, that's only one part of what goes into the price of jet fuel. You also have the refining margin that goes on top of that. And that's varied pretty widely between -- it could be $5 a barrel, it could be $20 a barrel, depending on conditions. Right now, Delta is actually benefiting there, because Hurricane Harvey just last month knocked out a lot of the refineries towns in the Gulf Coast. Delta's refineries kept operating. So that's allowed them to not see the full price spike that has affected other airlines, which has caused a lot of airlines to reduce their margin forecasts in the last week or so.
Priestley: I think a lot of people were critical when he made that move, given the fact that, what's happened with the oil industry since then. But at the time, I do think it was a farsighted decision. And we don't know the projection for the oil market. So long-term for Delta, over the next 50 years, I think it's probably going to be a good idea for them.
Levine-Weinberg: Yeah, and they bought this refinery for about $150 million. The sellers just wanted to get out, basically for any price. So it's a very small investment relative to the amount of money Delta is dealing with on an annual basis.
Priestley: Yeah, it's about the same cost as a Boeing 787.
Levine-Weinberg: Right, and it's less than a month worth of profit for them. So if they have to close it because it doesn't eventually work out, they can do that, and it wasn't a big long-term risk, because they just weren't putting that much money into the project.
Priestley: Yeah. You touched on the employees being less unionized than a lot of their competitors. I think I like the way that they run their business with regards to their employees. They have a profit-sharing program -- they hand out the profit-sharing checks on Valentine's Day, which I think is great. And obviously, that shows benefit in their bottom line, the fact that they don't have to deal with a lot of these unions that have traditionally caused labor prices to go up, as we talked about with the pilot union. Do you think this is something that makes them stand out from the other two that we've discussed?
Levine-Weinberg: Just to dig in a little bit there, Delta's pilots are unionized. As I mentioned, pilots do represent a pretty high proportion of the overall cost. So they do have that cost pressure there. And they've also been giving quite generous raises to the rest of their employees, as well, because they want them to keep up with the rest of the industry, frankly because they know that if they're giving inferior pay to their employees, then they will be unionized soon enough. So it's not that they're getting huge cost savings from bullying their employees who aren't unionized, but it gives them a lot of flexibility. With a union contract, there's lots of rules and procedures and things that are meant to protect the employees, and when something unusual happens, it makes it harder to react. You have to go, renegotiate the contract, say that facts have changed and we need to change the process, and it can sometimes take years to do that. It may have to wait until the next round bargaining is scheduled for a new contract. So for Delta, just being able to change the work rules in a more streamlined way has definitely been good for them. If you look at, for instance, their maintenance personnel, most people who follow the industry would agree that Delta has the best maintenance -- tech ops team is what they call it -- in the industry. For years, Delta has had the oldest fleet of any major airline in the country, and yet it also tends to have the lowest maintenance costs on an available-seat-mile basis.
Priestley: That's incredible.
Levine-Weinberg: So it basically shows that they know what to do. They also have the best reliability of the three top carriers. So they've figured out ways to basically innovate and make sure they can provide a reliable product without having to spend a lot of money on updating their fleets. And this is a big reason why American and United are so far behind in terms of free cash flow. Part of it is the lower earnings, but part of it is because they're putting tons of money into fleet updating projects, especially since they've started to become profitable in the last few years. But the result is, they're putting basically all their money into these fleet projects. A narrow-bodied plane could cost you $40 million. A wide-bodied plane is going to cost you maybe $150 million. When you look at the capital spending, American Airlines has been spending about $6 billion a year, which is 15% of its revenue, just on fleet and other technology and capital spending of that sort.
Priestley: And Delta is starting to invest a little bit more in their fleet. Is that right?
Levine-Weinberg: Yeah. Delta has started to accelerate some of the retirement of its older aircraft types. It has a lot of McDonnell Douglas MD-88s, which were built in the late '80s and early '90s. So those planes are now, on average, a little over 25 years old, and that's generally considered the beginning of the end for planes in the airline industry. You can keep them running longer, but the maintenance costs tend to go up. It becomes less efficient. They're also, in terms of fuel efficiency, the technology is 1980s technology, so there's definitely much better technology available today. So they've started to retire those planes, and they also have some other, older models that are coming out of the fleet over the next five years or so.
Priestley: But they're doing that from a much better basis than the other two, right? A much better solid platform.
Levine-Weinberg: They're starting with better cash flow. Instead of trying to get the newest, most fuel-efficient, best-ever planes, they've been trying to, not bottom fish, but they're looking for deals -- what planes are manufacturers trying to sell? Bombardier, which is a struggling Canadian plane maker, they're coming out with a new plane that just became available within the last year, the CSeries, and they were really struggling to find a flagship customer. So this is considered one of the most revolutionary planes to come out in the last decades, but Delta got a really good price, to the point where Boeing actually filed a complaint with the government, saying that Bombardier was dumping these planes in the U.S., selling them for too low a price. So Delta got this 75 plane order at a really good deal, which will be very useful for their routes with lower traffic. Then they've been buying a bunch of planes from Boeing and Airbus, their largest narrow-bodied models, the 737-900ER and the A321, which have very good unit costs, but they're outgoing models. It's basically like buying last year's model at the auto dealer. You get a big discount because they're looking to get rid of them before they bring the new models in.
Priestley: Yeah. And I think a lot of airlines have the flexibility to do that. Newer airlines and newer airline engines are getting more fuel efficient, and I think there was a huge push in the aerospace industry to get the most fuel-efficient jet engines possible when oil prices were high. Oil prices have obviously come down since 2014, and now they have the luxury of running older models for longer because the fuel price is OK if it's less efficient. And also, as you said, not getting the most efficient model, which was really the main reason why people would be buying this year's version.
Levine-Weinberg: Yeah, and you have to balance the additional capital cost of buying a newer model, it might cost you $10 [million]-$15 million extra up front because there's massive wait times for these newer planes, whereas you can get the older ones on a much shorter lead time at a big discount. So you have to weigh that cost savings against the longer-term fuel-cost savings. And right now, it seems like, for many airlines, the older models look like a better long-term deal because you're not saving enough money on fuel to justify upgrading and getting the 12% or 14% fuel-efficiency gain from getting the latest technology.
Priestley: OK, awesome. S, bottom line on Delta, you think it's worth a second look by investors based on the fact, solid balance sheet, great long-term leadership. I think Ed Bastian taking over was a great move for a continuation of what had already been happening. Any other points you want to make to anyone of the investors out there?
Levine-Weinberg: I think free cash flow is the main thing to keep an eye on with Delta. They're obviously going to be ramping up their capital spending a little bit in the next year or two, but they're going to get some significant long-term benefits, and the capital spending should moderate after 2021, or thereabouts, as they go back to a more normalized pace of fleet replacement. So as long as that happens, I think Delta Airlines looks like a really compelling investment opportunity right now.
Priestley: Awesome. I would 100% second that. Thank you very, very much for coming in and sharing all of your airlines knowledge with everybody. Thank you very much, Adam!
Levine-Weinberg: You're very welcome!
Priestley: Well, that's it from us today. If you would like to get in touch, please feel free to email us at firstname.lastname@example.org, or tweet us on Twitter @MFIndustryFocus. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. For Adam, I'm Sarah Priestley. Thanks for listening and Fool on!
Adam Levine-Weinberg owns shares of Alaska Air Group, Delta Air Lines, JetBlue Airways, and Spirit Airlines and has the following options: long January 2019 $10 calls on JetBlue Airways. Sarah Priestley has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares) and Twitter. The Motley Fool recommends JetBlue Airways and Spirit Airlines. The Motley Fool has a disclosure policy.