Foolish Fundamentals: Airline Operating Metrics

With the destructive history of airline stocks, you might wonder why my readers would care to know anything more about this industry. Fair point. Trouble is, even the worst industries produce winners from time to time. Major airlines recently have been among the biggest of the big winners. Have a look:

More airline stock stories are waiting in the wings. But let's start with a good grounding in basic terms and numbers, so you'll know how carriers measure success. Ready to begin? Good.

Before you board
For airlines, time on the ground is money lost. Only when the jet set is jet-setting do carriers make the moola they so desperately crave. Therefore, to know how well an airline is doing is to know:

• How long its planes are in the air.
• How much revenue it gets for that time.
• How much it costs to fly that much.

There are four common industry metrics that can help investors answer these questions:

• Available seat miles (ASM), which refers to the number of paid seats available to passengers multiplied by the number of miles those seats are flown.
• Revenue per available seat mile (RASM), which refers to total passenger revenue divided by available seat miles and represented in cents.
• Cost per available seat mile (CASM), which refers to operating expenses -- more later on how this gets tricky -- divided by available seat miles and also represented in cents.
• Break-even load factor, which, technically, is the percentage of aircraft seats that must be utilized in order for revenue to match expenses, assuming constant revenue per passenger mile and expenses.

No meals on this flight
It gets more confusing: Airlines tend to monkey with metrics in order to present the best possible picture to investors. CASM is a good example. Major carriers frequently exclude fuel costs from operating expenses, arguing that oil prices fluctuate wildly and that carriers shouldn't be penalized for costs they can't control.

That's not a terrible argument. Trouble is, there are many costs that airlines can't control. Witness what happened to JetBlue (NASDAQ:JBLU) in February. Its poor handling of weather delays at JFK will result in huge operating expenses that may be excluded from reported CASM. But is that really fair? I'm not so sure.

Then there's the math of the load factor, which says to divide revenue passenger miles -- that is, the number of miles flown by paying customers -- by ASM. The resulting percentage roughly approximates the capacity at which the carrier was flying during the reporting period. British Airways, for example, recently reported a 76.3% load factor, meaning its planes, on average, left their gates 76.3% full.

The breakeven load factor balances revenue with operating expenses to reveal when capacity equals profit. Or, in simpler terms, an airline with a breakeven load factor of 75% would, in theory at least, make money when its planes fly at 76% of capacity or better.

But this, too, has its problems. Breakeven load factor might be meaningless if fuel costs aren't included in the operating expense equation. The lesson? Be sure you know what is, and isn't, included in operating expenses. The best way to do that is to review quarterly and annual SEC filings.

I can't emphasize that last point enough. Even if these metrics are confusing, the filings will allow you to see whether there's been historic improvement. JetBlue's reporting is a Foolish model in that sense. A snapshot of operating performance from 2001 to 2005 is available here.

Before you deplane
One more thing. As bad as it is for major carriers now, it could get worse thanks to what's called the "Open Skies" agreement between the U.S. and the European Union. If ratified, it would reduce restrictions on overseas carriers in both regions, thereby creating more opportunity for foreign carriers to fly here and vice versa.

Most experts say that "Open Skies," which could go into effect next March, is a done deal subject to formalities. If that's true, there's likely to be two effects on transcontinentals such as United and Air France KLM. First, long-distance coach fares will decline thanks to greater competition. Second, expansion will be far easier, especially for the EU giants, which have historically been restricted to flying to the U.S. from only their home country.

There's no telling whether the inherent benefits of "Open Skies" -- higher ASM and RASM, for example -- will reach the bottom lines of American carriers. But I suspect those with loyal business and first-class clientele will do better than those without. Take stock of how well each carrier serves those with the deepest pockets as you evaluate the potential impact of "Open Skies."

Buckle up
Why invest in airline stocks? History says that widely despised industries are more likely to produce bargains than their more popular peers. Few industries are as truly abhorrent as airlines.

If you choose to study the transcontinental and regional carriers, look beyond the P/E ratio to the operating metrics that matter: ASM, RASM, CASM, and breakeven load factor. If they're improving much faster than their peers', and the market fails to recognize or reward the trend, you may be boarding a bargain right before takeoff. For a Fool, that's as good as it gets.

JetBlue is a Motley Fool Stock Advisor pick. Click here to get 30 days of free access to the entire portfolio, which is beating the market by more than 39%.

Fool contributor Tim Beyers, who is ranked 789 out of more than 25,400 in our Motley Fool CAPS investor intelligence database, would like to thank his dad, who worked in ground operations for United for 35 years, for insights that made it possible to write this article. Tim didn't own shares in any of the companies mentioned in this article at the time of publication. Get the skinny on all of the stocks in Tim's portfolio by checking his Fool profile. The Motley Fool's disclosure policy is always on time for departure.