Airline profits surged to record levels in 2014 and are poised to move even higher in 2015 as fuel prices have fallen significantly. But the airlines are not keeping all of the cash for themselves and are rewarding two key stakeholders: employees and shareholders.
Today, employees at many airlines are getting profit-sharing payments thanks to the success of the airlines they work for. But the airlines are not doing this just out of generosity. During times of slimmer profits, profit-sharing agreements were negotiated into many airline contracts, and now that profits have grown, these employees are getting millions in combined total payouts.
According to The Dallas Morning News, employees of Delta Air Lines (DAL -0.71%) will split $1.1 billion; Southwest Airlines (LUV -1.34%), $355 million; United Continental Holdings (UAL 0.55%), $235 million; and Alaska Air Group (ALK -1.85%), $116 million. North of the border, employees of Air Canada and WestJet Airlines will also see rewards from their employers' extra profits.
Besides generating good publicity, there are other upsides to profit sharing as well. One potential positive is that it motivates employees to produce greater profits for the airline since some of those profits will find their way back to themselves. But the effects of this are difficult to measure and have been debated among airline executives, so no clear conclusion can be drawn here.
Profit sharing also softens the blow to airlines from economic slowdowns, since it lowers the labor cost structure during times of losses or lower profits. In the cases of Delta, Southwest, United, and Alaska, profit-sharing payments vary significantly by the amount of profit made.
But management at American Airlines Group (AAL -0.72%) is taking a different approach. In the latest contracts with the airline's pilots and flight attendants, management successfully kept profit-sharing out. But in exchange, the airline's pilots receive base pay 7% higher than at Delta Air Lines, according to American's management.
During times of high airline profits, American Airlines will have the upper hand through lower profit-sharing expenses than rivals; however, American may find itself at a disadvantage if industry conditions worsen.
As airline employees receive profit sharing, airlines are looking to return capital to their shareholders as well. Last year, American Airlines Group joined Delta Air Lines, Southwest Airlines, and Alaska Air Group in offering a dividend, and in the same year, Delta boosted its dividend by 50% to $0.09 per quarter.
Besides dividends, airlines have been pouring money into share buybacks, with all the major U.S.-based airlines implementing some sort of stock buyback program. Right now, American Airlines is planning to use some $2 billion of its fuel savings to repurchase stock.
Despite the drop in fuel prices and forecasts for higher profits ahead, airline dividends have remained small in comparison to the market average. But this may be a deliberate move on the airlines' part. Unlike dividends, which raise a red flag if reduced or suspended, stock buybacks are more flexible and can be ended with fewer consequences to investor confidence.
Additionally, airline shares trade below the market average, with some airlines trading with a single-digit forward-price-to-earnings ratio. This allows these airlines to get significant value out of share repurchases. For example, American's share repurchase program could buy back about 5% of the airline's outstanding shares at the current price level and save the airline nearly $17 million in annual dividends -- all with shares trading at only five times forward earnings.
In the following quarters, some major airlines may decide to raise dividends if profits continue to remain high, and United, the only major U.S.-based airline without a dividend, may begin paying one; however, airline investors should not expect dividends to surge higher immediately as airlines look to maintain capital flexibility.
Airline investors should be aware that much of the forecast 2015 profits is expected to come from lower fuel costs. The increase in earnings expectations can be seen by examining 2015 earnings estimates and how they have soared as oil prices fell. But airlines will also need to maintain fare discipline and not give away the fuel savings in the form of lower fares.
Airline executives are taking pricing seriously, with Doug Parker, CEO of American Airlines Group, saying on a conference call that management will run the airline as if oil were at $100 per barrel. At Delta Air Lines, CEO Richard Anderson told the Detroit Free Press how the airline prices fares without regard to fuel costs. Even though pricing appears to be holding up, investors should not dismiss the risk of falling fares eating into fuel savings. Accordingly, investors should keep an eye out for reports of changes in airline yields and pricing power.
These fuel savings are also subject to changes in the price of oil. Since there are widely varying estimates on where oil prices are headed, the future of oil prices remains a wild card that could reduce the fuel savings if oil prices rise or drive savings higher if oil prices fall.
Sharing the wealth
Airline profits are now rewarding both employees and shareholders through different types of capital returns. With profits moving higher and valuations remaining low, investors with greater risk tolerance should see if any of these airlines fit with their investment strategy.