The airline industry has struggled to grapple with the disruptions wrought by the outbreak of the pandemic. With air travel brought to a near halt by government restrictions before being resumed at a snail's pace as consumers limit travel, it has been all but impossible to fill up planes, even on traditionally high-demand routes.
With lockdowns being lifted around the world and economic activity revving back up at last, many people are again hoping for a V-shaped recovery. Those hopes have helped buoy airline stocks up from their mid-May lows. Yet, while many industries will undoubtedly see a relatively rapid return to normalcy, airlines face a much longer – and harder – path back to normal.
Demand stays depressed
After collapsing to near-zero at the height of the lockdowns, air travel demand is not going to recover overnight. On May 29, American Airlines Group Inc. (AAL) CEO Doug Parker told investors to expect demand to remain depressed in 2021 (compared to 2019 levels).
Parker’s position is hardly unique. According Moody’s (MCO, Financial) June airline industry update, passenger demand will take years to fully recover:
“Health concerns, changes in corporate travel policies, potential restrictions on international arrivals, and lower discretionary spending because of weaker GDP and higher unemployment will constrain air passenger demand into 2022. Demand in 2023 could approach that of 2019 but the uncertain timing of the coronavirus receding on a more permanent basis makes forecasting a challenge.”
That slow path back to 2019 demand levels will weigh heavily on airline operators of all sizes. Things could get even worse if, as Southwest Airlines Co. (LUV) CEO Gary Kelly warned on May 29, a “brutal low-fare environment” precipitates an industry-wide price war.
Debilitated by debt
Even if demand recovers substantially by 2023 and a full-blown price war is averted, other problems will persist. Moody’s warned that airline companies will face new challenges thanks to mounting debt across the industry, despite the improving liquidity situation among the strongest players:
“Stronger and state-supported airlines have significantly improved liquidity since March. Rated airlines have sufficient liquidity to survive on average for about 450 days at current low activity levels...The airlines we rate will carry on average 20%-30% more debt in 2023 compared with 2019, with leverage on average 0.5x-1.5x higher.”
Even if industry leverage remains at the lower end of Moody’s outlook, it will still be a troubling situation. The airlines that entered the crisis with strong balance sheets, especially those that also received generous government bailout loan terms, will be best placed to recover.
Danger of disruption
Faced with crushing debt and limited pricing power, weaker airlines are likely to find it increasingly difficult to stay aloft. Industry consolidation may be a dominant theme of the next few years as bigger players crowd out or absorb their smaller, weaker peers.
Airlines may also have to contend with industry-wide disruption in the years ahead. New entrants, unencumbered by legacy debts, aging fleets and expensive union contracts, may emerge to push into the airline sector and challenge incumbents.
While asset-heavy companies have struggled in recent years, asset-light companies in the technology and software sectors have thrived. Upstart new entrants may be able to leverage this divergence to their advantage, similar to what has been seen in the automotive industry, most recently in the meteoric rise of Nikola Corp. (NKLA). Nikola crafted an image as a tech-style industry disruptor, and the market responded with overwhelming enthusiasm, granting it a tech company valuation multiple. Nikola’s ascent may offer some clue as to the level of interest a similarly positioned air travel upstart might garner under the right circumstances. The cost of setting up or restructuring an airline is massive, of course, but there is clearly considerable market appetite for disruptors.
My verdict
Things still look pretty bleak for the airline industry, in my assessment. Investors betting on a rapid turnaround in airlines’ fortunes should probably think again. Demand is likely to stay depressed for years, while competition for that reduced demand may spark ruinous price wars between carriers. The largest and strongest airlines should do all right in the long-run, but even they are liable to struggle for some time.
Ultimately, I cannot recommend the airline sector to investors at present, beaten down though they appear to be. While there is likely some long-term upside value in some of the bigger names, I fear they are outweighed by near-term headwinds. For investors interested in gaining exposure to the sector as it recovers, I recommend holding fire until later in the year, when the trajectory of passenger demand recovery will likely be clearer.
Disclosure: No positions.
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