Why We're So Bearish on Legacy Airlines Is there never a good time to buy these perennial value-destroyers? by Chris Lozier | 03-10-06 | 06:00 AM | E-mail Article | Print Article | Permissions/Reprints We wouldn't recommend buying and holding a legacy airline stock now nor at any point in the airline industry cycle. There--we said it. I feel better already. Kidding aside, it should be no secret by now that we do not consider any airlines other than the very best low-cost carriers-- Southwest LUV and AirTran AAI--to be wise buy-and-hold investments. If we did, legacy airlines would not all have moat ratings of "none," and "speculative" risk ratings, and we would not model regional airlines (which partner with the legacies) as having steadily declining margins. That said, when Morningstar's fair value estimates are 20%-50% of Wall Street's target prices for an entire industry subsegment, we like to offer the occasional reminder of why. Two Things We're Not Saying We are not predicting the demise of the hub-and-spoke airline model, the operational foundation of the legacy carriers. Many of the markets served by such carriers are simply too thin to be economically attractive to low-cost carriers that fly point-to-point, no matter how low their operating costs. What's more, the air transportation system is very much a public utility in its import to states around the world. If the (mostly) free market for air travel can't correct itself, you can be sure that governments will step in as they have done many times in the past (witness the recent involvement of the Air Transportation Safety Board and the Pension Benefit Guarantee Corporation since 2001). Other changes like liquidations and consolidation might also benefit the majors to a limited degree. Ultimately, we expect most of the legacy airlines to be flying planes in 2020, though the structure, composition, and regulation of the industry may look quite different. Neither are we suggesting that money cannot be made by buying and selling airline stocks. These securities are extremely volatile, with betas (a measure of a stock's relative volatility) in the 2-3 range, implying frequent and sizable mispricings regardless of intrinsic value. One week spent observing the airlines will illuminate this crazy reality. In fact, if one could develop a way to consistently predict the short-term movements in these stocks, that investor could make a killing. Good luck doing that. We've had little success here, and even Warren Buffett was befuddled when he tried. The short-term game of speculating on the largely random movements of airline stocks is often illogical and maddening on top of running counter to Morningstar's investment philosophy. A Fundamentally Troubled Industry So what should investors make of our markedly low fair value estimates? Here is where we get to the crux of the matter. One of our most basic beliefs about the airline business is that it's becoming increasingly commodified with each day. We acknowledge that there will always be some people willing to pay more money for certain amenities, whether they be XM Radio XMSR, wireless broadband, extra legroom, or even a whole separate class of service. We further acknowledge that these passengers deliver greater profit margins. But as access to air travel continues to proliferate, even more customers who base their purchase decisions predominantly on price will enter the market. This phenomenon has contributed to the steady decline in real yields (passenger revenue per revenue passenger mile on a constant dollar basis) over many decades. Real Airline Yields 1950 15.04 1955 13.04 1960 13.41 1965 12.54 1970 10.08 1975 9.32 1980 9.09 1985 7.40 1990 6.70 1995 5.78 2000 5.52 2004 4.16 Source: ATA This measure cannot fall too close to $0 without airlines become insolvent, but we think real yields are approaching some non-zero asymptote. Basically, we see little--short of reregulation--that might precipitate permanently higher ticket prices. Sure, yields were up substantially in 2005 as bankruptcies and stratospheric fuel prices helped reduce industry capacity. Others will be quick to remind of yields on international flights, where low-cost competition is noticeably absent. And what if we see further consolidation like the merger of America West and US Airways LCC? To these optimists, we would point out the long history of new and existing airlines picking up capacity that has been dropped by others. We would also warn of proliferating "open skies" agreements that are bound, eventually, to invite lower-cost competitors into international skies. For these reasons, we expect real pricing yields to remain basically flat over the long term. On top of its commodity pricing environment, the airline industry is deeply cyclical. Because of their bloated cost structures, legacy players typically lose money in economic downturns, and P/E multiples become meaningless by definition. When times are good, P/E multiples can start to look very attractive. Investors should recognize that this does not mean that a major airline's intrinsic value varies over the course of the business cycle. In 1999, Delta Air Lines DALRQ traded as high as $70, implying a trailing P/E of just under 10. In 2005, about a year after we assigned the firm a $0 fair value estimate, Delta filed for Chapter 11 bankruptcy. Without question, 9/11, SARS, and record fuel costs expedited this decline. But aggressive low-cost carriers were in plain view in 1999, and a downturn was to be expected in the coming years based on the history of that cycle. So, did Delta's intrinsic value fall from $70 to $0 in those six years, or was it never anywhere near $70? Intrinsic Value vs. Price Targets Unlike sell-side analysts, who try to predict what stock prices will do in the next 12 months, we here at Morningstar are attempting to estimate the intrinsic value of businesses. Had we covered Delta in 1999 when the stock's P/E was attractive by most standards, our discounted cash-flow model would not have included the impact of the largely unexpected factors we noted above. However, our cash-flow forecasts would have incorporated an industry downturn, which, because it was more than a year out, was not considered by Delta's P/E multiples at that time. For differences like this, investors should expect to see stock prices--and Wall Street price targets--of airlines and other cyclical companies vary around our fair value estimate at different points in their respective cycles. Now that the current airline cycle is well into an upswing, for instance, these stocks are trading at 3-6 times our fair value estimates and 9-10 times next year's earnings forecasts. Yet despite massive restructuring efforts and positive industrywide trends, we simply expect the legacy airlines to produce weak cash flows because their business model remains less efficient in a highly commodified pricing environment. The effect is particularly harsh through cyclical downturns, for which we account in our models. As we noted above, forward P/E ratios do not capture these more distant struggles, and such earnings multiples may admittedly be better suited to the game in which short-term investors and speculators participate. But for the investor who is thinking about buying and holding a stock longer than a year or two, the method is severely limited. The bottom line is simple: We do not recommend legacy airlines to long-term investors who seek stable price appreciation throughout economic cycles. For those who want to gamble, please do so at your own risk.
