The Better Buy in Airlines

While the airline industry used to be decried as a death trap for investors, airlines have been gaining more and more attention recently as the industry seems to be turning around.

In this Industry Focus segment, analyst Sarah Priestley and Motley Fool contributor Adam Levine-Weinberg talk about which of the four biggest airlines in the U.S. are the best buys. Find out why Southwest (LUV 0.97%) is in a separate class from Delta (DAL -0.06%), American (AAL 0.94%), and United (UAL 5.50%); why Southwest is and has been a solid buy for the last several decades; which of the other three is the best buy for long-term investors and why; and more.

A full transcript follows the video.

This video was recorded on Sept. 14, 2017.

Sarah 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?

Adam 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.