The U.S. airline industry has largely been a destroyer of capital in the years since the industry was deregulated in the late 1970s and companies were allowed to truly compete head-to-head for business. The federal rule changes created a boom/bust cycle of new competition squeezing profits when times were good and forcing bankruptcies and liquidations when the overall economy turned south. Storied companies like Eastern Airlines, TWA, Braniff, and PanAm disappeared from the skies during this era, costing airline stock investors billions of dollars in the process.

Fortunately, the shakeout from deregulation is now pretty much complete. A period of restructuring and consolidation in the early 2000s reduced the number of airlines competing and fortified the balance sheets of the survivors. Delta Air Lines bought Northwest, American Airlines Group merged with the combination of US Airways and America West, United Airlines Holdings combined with Continental, and Southwest Airlines bought AirTran.

The result is a domestic marketplace where four carriers control about 80% of the market, giving the companies greater wherewithal to make money in good times and weather downturns.

An airport domestic terminal with airplanes parked at the gate.

Image source: Getty Images.

Here's a good example of how much the airline industry has changed in the last decade: Warren Buffett, in his 2007 chairman's letter to Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) investors, said airline stocks were such a poor investment that, "if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down." Today, his well-respected holding company owns shares of the four largest U.S. airlines.

Consolidation has helped fuel profitability, but there are other factors as well. Armed with improved balance sheets, airlines have aggressively replaced their aging fleets with newer, more fuel-efficient aircraft, a trend that continues to this day. Many of those new planes have higher passenger capacities and are more fuel-efficient than the planes they are replacing, helping add to productivity and making each flight more profitable.

If airline companies are now good enough for Buffett, they might be worthy of a place in your stock portfolio. Let's take a look at the important things to know before investing in airline stocks. We'll also dive into a few attractive stock candidates that are good buys today.

What are some key airline industry metrics and terms to remember?

Airline pilots use a unique vocabulary to communicate with the control tower. Anyone who has tried to navigate an airline's financial statement knows a carrier's accounting department also uses its own industry-specific lingo. If you want to invest in airlines, there are some terms you need to know.

RASM: All flights are not equal to an airline's scheduling department. A transpacific voyage from Los Angeles to Sydney, Australia, for example, requires a far different revenue calculation than using the same plane to connect Las Vegas to Dallas. So, simply calculating plane capacity by the total number of daily flights or even just tallying the number of seats available for sale leaves out important financial considerations.

For this reason, airlines measure their passenger capacity using a metric called "available seat miles," which is the number of seats put on sale multiplied by the number of miles flown. So, a 1,000-mile flight operated with a plane that carries 200 passengers translates to 200,000 available seat miles.

RASM, or revenue per available seat mile, is measured by taking an airline's revenue in a particular period and dividing it by the number of available seat miles. Airlines will break it down further with passenger RASM, or PRASM, which takes into account only ticket sales and not cargo revenue. 

For example, if Foolish Airlines flew 200 billion available seat miles in a year and generated total revenue of $30 billion in that period, its RASM would be $0.15. In 2018, according to the U.S. Department of Transportation, the industry averaged a PRASM of just under $0.12, with Delta being the top performer at nearly $0.13 PRASM.

CASM: Similarly, CASM, or cost per available seat mile, is a measure of how much it costs an airline to fly one seat one mile. Investors can use RASM and CASM together to get a gauge on how profitable an airline is relative to its peers and how efficient it is. If Foolish Airlines had total expenses of $24 billion in the year where it had its 200 billion available seat miles, its CASM would be $0.12.

Most airlines will include their RASM and CASM numbers in their financial statements. While RASM and CASM can be useful comparison tools, it is important to look beyond the raw numbers. An international airline with a fleet that includes many different aircraft types is likely to have a much higher CASM than a domestic discount carrier, for example. But if that international airline can generate a revenue premium from extra services that come with international flights, it could be a more enticing investment despite the higher costs.

Load factor: While most investors have plenty of antidotal stories about how a particular airline is doing based on individual experiences with crowded or overbooked flights, the load factor is a more precise measurement of how full a company's planes are. Airlines typically calculate load factor by looking at RASM as a percentage of available seat miles. That's a more precise measurement than just saying 60 of 79 seats were filled on a particular flight, and it provides more insight into an airline's ability to consistently fill its planes.

Load factor is measured as a percentage, and despite how it may feel when you are on a packed plane, the airlines do not fill all of their seats. But they are getting better at it. The average load factor for the U.S. industry in 2018 was 84%, up from 67% in 1995.

International alliances: Airlines competing for lucrative corporate contracts want to offer their business fliers access to the world, and they do so by teaming with international partners. The global airspace is divided into three large marketing alliances, with one full-service U.S. airline belonging to each of the three. Delta Air Lines is a part of Skyteam, American Airlines partners with Oneworld, and United Airlines is a member of the Star Alliance. 

The three alliances all span the globe, although each does have strength and weaknesses in certain countries and regions based on having a domestic partner in that region. For example Star Alliance, which counts Germany's Lufthansa as a member, has direct access to more German cities than the others, though both Skyteam and Oneworld can fly passengers into key German markets from outside of Germany.

The alliances are all similar in size, carrying between 600 million and 700 million passengers per year.

Regional partners: The full-service airlines work with smaller carriers -- sometimes wholly owned subsidiaries and sometimes independents -- that fly smaller jets and turboprop planes primarily between smaller markets and various national hubs. The partners have separate labor deals and fleets of smaller aircraft that can better serve smaller markets where you can't justify the cost of sending a larger plane. Tickets on these partner flights are typically sold by the larger airline, though the portion of the trip operated by the partner will show as flown by partners like American Eagle, Delta Connection, or United Express. The larger airlines also handle the marketing and sometimes the airport logistics, while the regional partners handle the flying expenses for a pre-arranged fixed fee.

Although many of the regional airlines are now wholly owned subsidiaries or private, there are a few public companies in the sector. The largest is SkyWest, which flies for Delta, American, United, and Alaska. Mesa Air Group (NASDAQ:MESA) is also public.

Scope clauses: Airline route planners and schedulers are also bound by scope clauses in labor deals, which can limit the number and size of aircraft that can be flown by regional partners. Airline unions have included scope clauses in contracts to limit the amount of flying that can be outsourced to partners and protect their members' jobs.

The clauses are significant because airlines often complain that scope clauses can make them less competitive than rivals because they limit the number of smaller cities an airline can serve due to a lack of appropriately sized aircraft. They also cut into profitability by forcing airlines to fly larger jets into markets that can't support the added capacity.

International treaties: Finally, while it is not important for investors to memorize the Freedoms of the Air that govern international air service, it is good to know they exist. These are the international agreements that regulate an airline's ability to fly over or land in foreign countries, pick up customers in those countries, or travel between two international countries.

Most countries (including the United States) limit foreign ownership of domestic airlines. And in most parts of the world, foreign airlines are not allowed to operate domestic flights outside of their home countries. There are also typically regulations preventing airlines from operating between two foreign nations. European airlines, for example, are not able to compete with U.S. carriers by offering flights between two U.S. cities or between a U.S. city and a non-European city (like Chicago and Mexico City). These rules are also why Richard Branson, when founding Virgin America in the U.S., was forced to bring on outside U.S.-citizen investors to take a majority stake.

What are the largest U.S. airlines?

Airlines traditionally have fallen into one of four categories, and while the boundaries have blurred a bit in recent years, the designations still largely hold true.

Full-service airlines boast massive route networks and international partners designed to take you anywhere in the world and offer a range of cabin choices en route. Discounters provide fewer frills, and usually fewer destinations, but focus on lower costs. Regionals offer outsourced connections but rely on the full-service airlines for branding, marketing, and ticket sales. Contract carriers, which tend to be smaller and off the radar, fly mostly cargo and charter missions.

Here's a list of the largest U.S. airline companies, as ranked by their market capitalization, and where they fit in the industry spectrum.

Rank/Airline Market Cap Description

1. Delta Air Lines (NYSE:DAL)

$37.1 billion

Full-service

2. Southwest Airlines (NYSE:LUV)

$27.8 billion

Discounter

3. United Airlines Holdings (NASDAQ:UAL)

$21.2 billion

Full-service

4. American Airlines Group (NASDAQ:AAL)

$11.4 billion

Full-service

5. Alaska Air Group (NYSE:ALK)

$7.3 billion

Full-service

6. JetBlue Airways (NASDAQ:JBLU)

$5.0 billion

Discounter

7. SkyWest (NASDAQ:SKYW)

$2.9 billion

Regional

8. Spirit Airlines (NYSE:SAVE)

$2.6 billion

Discounter

9. Allegiant Travel Co. (NASDAQ:ALGT)

$2.3 billion

Discounter

10. Hawaiian Holdings (NASDAQ:HA)

$1.1 billion

Full-service

Data source: Yahoo! Finance, author. Market cap is current as of Aug. 30, 2019.

What are some key trends in the airline industry?

Historically, the knocks against airlines as investments have centered on the high fixed costs and fluid demand. Airlines spend hundreds of millions of dollars on new aircraft, taking on considerable debt in the process, and then need to be able to sell tickets at a price that allows them to recoup the investment.

During recessions (when airlines have typically gotten into trouble), it has been difficult for the companies to sell enough tickets at a high enough fare to cover all of those expenses. Even in good times, competition has limited pricing power (the ability to raise prices without losing customers). Despite frequent flyer programs and extensive marketing campaigns, a seat on a plane from Cleveland to San Diego is similar no matter what color paint is on the outside of the plane. While consumers love frequent flyer miles, they usually gravitate toward the lowest fare.

Corporate consolidation was supposed to address the lack of pricing power, but the issue is still present for some airlines to this day. Adjusted for inflation, the average U.S. domestic fare in the first quarter of 2019 was down 15% compared to the first quarter of 2015, according to the Bureau of Transportation Statistics.

Airlines have, however, gotten better at managing expenses and generating revenue from non-ticket sources. Most large carriers now lease a portion of their fleets instead of buying them outright, allowing the airlines to shift some of the cost liabilities that come with new aircraft off of their balance sheet and giving them more flexibility to grow and shrink their fleets than they would if the planes were all fully owned.

An airplane landing at night.

Image source: Getty Images.

Airlines are also using more sophisticated ticket-selling software, called revenue management systems, to pinpoint demand on particular trips and squeeze extra revenue out of high-demand routes. The software has gotten better at guessing how price-sensitive a passenger is based on how far in advance they are booking travel, and has predictive abilities that can help the airline scheduling department match the right-sized plane to the route to minimize empty seats.

They are also charging for more of the perks that past generations of flyers got for free. Items that were once included in the ticket price -- checked bags, seat assignments, and even snacks and drinks -- now come at a cost, particularly for the lowest-priced tickets. Added frills like boarding early and internet access also often come at an additional cost.

Consumers often complain that the airlines are nickel-and-diming them by charging extra, but the flights are mostly full and increasingly there are few choices to avoid the fees. The airlines will argue that by making the base fare cheaper and then having customers pay for only the extras they want, the companies are giving the passenger more of a choice and preventing individuals from having to pay for frills they won't use.

No matter which side you take in the debate, the result is that airlines have been able to generate additional revenue while still engaging in fierce pricing competition and the companies are now less susceptible to failure in the event of an economic downturn.

What are some reasons to avoid investing in airline stocks?

Few would argue that the airline industry hasn't transformed itself and isn't much more resilient than it has ever been before. Management is confident, with American CEO Doug Parker famously saying in 2017, "I don't think we're ever going to lose money again," predicting profits in good times and in bad.

Of course, the U.S. economy has been high flying since the 2008-2009 Great Recession and these newly revitalized airlines haven't really been put to a test yet. There are some challenges that restructuring and consolidation have not been able to alleviate, and investors still need to be on guard for potential downturns.

Fuel costs: Airlines are massive consumers of fuel, and are vulnerable to oil prices. In 2018, the global airline industry spent nearly $180 billion on fuel, representing nearly one-fourth of total operating expenses, according to an industry trade group. The specific type of fuel airlines need generally makes up a small portion of a refinery's total output, and due to changing trends in energy consumption and environmental pressure, jet fuel can sometimes be scarce and expensive in certain regions of the U.S.

The situation was so dire in the U.S. Northeast in 2012 that Delta bought a refinery in Pennsylvania to try to ensure the supply to regional airports.

Employment costs: Labor is another huge risk factor to monitor with airlines. Pilots, flight attendants, and mechanics, among other groups, are unionized at most airlines. Labor accounts for upwards of one-third of total airline operating expenses, and union contracts make it difficult for management to trim the size of the workforce or reduce costs when times are bad.

The latest round of airline restructurings included more profit-sharing for workers, which has eased what in the past had often been an acrimonious management/labor relationship. But there are still flare-ups from time to time. There are also multiple unions representing pilots, mechanics, and other work groups at various airlines. Those unions, at times, will compete to establish footholds at additional airlines. That puts pressure on incumbent union leadership to get an industry-leading deal every time their contract is up. That, in turn, puts steady upward pressure on labor costs across the industry.

The last new contract cycle saw wage rates climb in the range of 30% for most groups across most airlines, according to Cowen & Co. research. But those boosts were, in part, playing catch-up to pre-bankruptcy and pre-recession levels for workers at some airlines. There are many contract renewals to be negotiated beginning in 2020, and while increases are likely, airline investors can hope that they won't match the last round of hikes. Regardless, expect labor costs will increase in the years to come.

Even without labor tensions, the industry is facing a shortage of pilots, in part because years of experience is required before entering a commercial cockpit coupled with the mandatory U.S. pilot retirement age of 65. Labor has significant leverage in disputes with management and needs to be watched closely by investors.

Debt: The airline business, by its nature, requires companies to take on a lot of debt. There are several fixed costs that go into running an airline, including expensive airplanes, employee salaries, fuel, and ground equipment, and the onus is on the airline to sell enough tickets to cover those expenses.

When airlines have failed in the past, it has usually been because of an unexpected slowdown in travel demand that leaves a company unable to generate enough revenue to pay its bills. It's been a while since we've seen this happen to a major carrier in the U.S., but high-profile examples like the grounding of Iceland's WOW Air in early 2019 are reminders it can still happen today.

As mentioned above, airline balance sheets are generally much healthier than in years past, reducing the risk, but investors still need to be aware of debt levels when picking between potential investments. Debt levels can change over time, based on a company's need to borrow to buy new planes or management's desire to pay down borrowings instead of funding buybacks and dividends.

The table below is a snapshot of debt levels as of September 2019, looking at both total debt and a ratio of debt to assets. At that point, American by far had the most debt among major airlines and the highest ratio of debt to assets. This isn't necessarily a reason to avoid American -- the company at the time was coming off a planned spending campaign and was in the early stages of implementing a plan designed to pay down the debt -- but it is a factor that investors should consider when analyzing the airline industry.

AAL Total Long Term Debt (Annual) Chart

Airline debt measures data by YCharts.

Other concerns: Airlines, as major consumers of fuel, are sometimes the target of criticism over the industry's contribution to global warming. The companies have run various campaigns offering carbon offsets and, by and large, can deflect criticism because they are all culprits and there isn't a better way to travel long distances quickly. But over time environmental concerns, or airport congestion or other factors, could make alternates like rail more attractive for shorter trips.

There are also occasional equipment risks. American, United, and Southwest were all put at a competitive disadvantage in 2019 due to the grounding of Boeing's 737 MAX planes over concerns about safety. This required schedules to be juggled and growth plans to be curtailed. In years past, there have also been delays or complications when introducing other models or new engine types that at least temporarily caused an airline's growth to slow.

What are some indirect ways to invest in airline stocks?

If you would like to invest in airlines but don't want to pick out a particular stock, there are a number of industry exchange-traded funds, or ETFs, to consider. ETFs are baskets of different securities that are pooled together into a single entity, which then offers shares to investors that are traded on major stock exchanges. Each share of an ETF gives its owner a proportional stake in the total assets of the exchange-traded fund.

ETFs with exposure to airlines include the SPDR S&P Transportation ETF (NYSEMKT:XTN), which includes nearly a dozen airlines among its portfolio of 40-plus stocks that also includes ground transportation companies and other shippers. US Global Jets ETF (NYSEMKT:JETS) is more directly focused on airlines, along with airplane manufacturers, part suppliers, and other ancillary businesses like airport operators. JETS also has exposure to international airlines. Finally, the iShares Transportation Average ETF (NYSEMKT:IYT) tracks the Dow Jones Transportation Index, which includes airlines and other transport companies.

As mentioned above, another indirect way to invest in airlines, along with many other businesses, is to buy shares of Berkshire Hathaway. Delta and Southwest both rank among Berkshire's top 20 stock holdings, though the overall portfolio is more focused on financial and consumer goods companies.

What are some airline stocks to consider buying now?

Airline stock investors are well aware of the challenges currently facing the sector. The industry has been under more pressure in the summer of 2019 with news of a potential recession and the possibility of rising oil prices. Time will tell if Buffett and others are correct about airline stocks now being a solid investment option.

Either way, there are some strong airlines that investors can board and ride through the turbulence of the ups and downs of the business cycle.

Top Airlines to Buy Now

Key Features

Delta Air Lines

Best-in-breed, full-service airline that is an innovator in the industry with a high dividend and reasonable multiple.

Alaska Air Group

One-time overachiever held back in recent years as it integrated a major acquisition. The integration is largely complete, and the airline looks set to take off.

Spirit Airlines

A new generation of discounter with ultra-low fares and significant ancillary income. Seen as more vulnerable to a downturn and facing growing pains, this is a good addition to a long-term portfolio for a risk-tolerant investor.

Delta Air Lines: This airline has been at the forefront of most of the innovations of the past two decades. It was among the first to reorganize following the attacks of Sept. 11, 2001, and it kicked off the latest round of consolidation when it purchased Northwest Airlines in 2008.

In the years since, the airline has been at the leading edge of using software to transform fare pricing to better compete against discounters while still getting a premium from less cost-focused customers. It has also been investing capital to solidify its international alliances, and it owns large minority stakes (and board seats) in airlines based in the United Kingdom, Mexico, China, and Brazil.

A Delta plane on the tarmac.

Image source: Delta Air Lines.

Delta in recent years has been among the best financial performers among the airlines, consistently generating earnings results that match or beat expectations. It was the first of the restructured full-service airlines to introduce a dividend, and since 2016 has consistently offered the best yield among major airlines. It also consistently trades at a multiple to earnings below Southwest, and in line with its poorer-performing peers.

Alaska Air Group: Alaska Air for years was a quiet, niche airline focused on the Pacific Northwest. But it joined the consolidation frenzy in 2016 when it bought Virgin America. While still significantly smaller than the nation's big four airlines, Alaska has been attempting in the years since the deal to position itself as offering all of the frills and advantages of full-service airlines while limiting its route map to include only destinations where it either has a competitive advantage or that tend to have higher margins.

The integration of Virgin America hasn't gone as smoothly as hoped, but Alaska through it all has managed to retain the loyalty of its customers. The company believes it can consistently generate pre-tax margins of between 13% and 15%, nearly double what it generated following the merger, as it continues to reallocate Virgin's jets toward more-profitable routes and rolls out its version of a fare system to rival what Delta and some of the larger airlines are now working toward.

An Alaska Air jet in flight.

Image source: Alaska Air Group.

Alaska, in years past, was able to successfully walk the thin line of being as nimble as a discounter but offering a complete enough product and route network to engender loyalty among customers. As the integration moves toward completion, expect the airline to regain its former place in the industry, which has historically allowed it to generate outsize returns.

Spirit Airlines: This airline takes "no-frills" to the extreme, pioneering in the U.S. the "ultra-low-cost carrier" first made popular in Europe. Southwest Airlines decades ago made its mark by cherry-picking routes and simplifying the product that an airline offers to its passengers. Spirit has taken the model a step further, offering rock-bottom fares and then charging customers for perks like choosing a seat ahead of time, bringing carry-on luggage on board, and even snacks and drinks.

A Spirit Airlines plane coming in for a landing.

Image source: Spirit Airlines.

Spirit's philosophy has made it the target for a lot of customer complaints, but the model is still attractive enough for a subset of travelers who want affordable tickets and have no real need for add-ons. Spirit is regarded as a "spill" carrier, an industry term that implies it is only able to fill its jets when its competitors have sold out. But the airline's load factors have steadily improved as it has grown and now consistently stay north of 84% occupancy.

Because of the niche it fills in the industry, Spirit is often considered by investors to be among the most vulnerable to a downturn, but its flexible model belies those fears. This is not a blue chip investment choice and will likely be more volatile than other airline stocks, but Spirit is a fast-growing company with a lot of runway in front of it and should deliver for investors over the long haul.

Fly with confidence into this sector

The airline industry in the past has attracted a lot of critics, and justifiably so. It's hard to find an airline customer who doesn't have a horror story about a multihour flight delay or a vacation nearly ruined by a flight issue. But while delays are still common and legroom is now nearly nonexistent, the investment case for airline stocks has improved dramatically in recent years. Buffett today presumably is glad the Wright brothers succeeded at Kitty Hawk, and other investors should be as well.

It might prove to be overly optimistic to say there will be no airline troubles when the next recession eventually does occur. But there is strong evidence to suggest that the overall industry is healthy enough to survive a downturn. And with travel demand unlikely to evaporate, there is ample room to grow for the foreseeable future.

The airline business, almost uninvestable in for a generation, is now in play for a buy-and-hold investor willing to wade through the financial statements and find the best opportunities.