2020 was the worst year in recent memory for the aviation industry as this business sector suffered billion-dollar losses as a result of the mobility restrictions imposed by governments in every corner of the world. However, the industry has been recovering at a steady pace since mid-2020, and the progress of the global vaccination program paints a promising picture of what the future holds for the airline sector. Even though there are potential risks that could interfere with the recovery of the industry, travel demand remains strong and airlines are gearing up to reach some form of normalcy by the second half of the current year.
Warren Buffett (Trades, Portfolio), surprisingly, dumped airline stocks last year, citing that a full recovery will take many years, but the market value of many airline companies has substantially increased in the last 12 months. Even on the back of these strong returns, some Wall Street analysts remain optimistic of more gains in the coming months.
Jefferies remains optimistic
Analysts at Jefferies are expecting a speedy aviation recovery and at least another 70% upside in airline stock prices as a result of improving macroeconomic conditions. Based on their findings, the relatively low fuel prices coupled with favorable route changes will help the industry thrive in the coming years. In a research note to clients, Jefferies analysts wrote:
"The consensus view around air traffic is that 2023 looks very similar to 2019, with domestic fully recovered and international largely returning to pre-COVID levels. Airlines currently trade at a 4.3 times multiple on the bull case scenario versus a historical average of 6X, implying ~70% potential upside across the group."
According to the International Air Transport Association, the losses incurred by the aviation industry in 2020 amounted to a staggering $118 billion and airline companies are on pace to book another $38 billion in losses this year as well.
U.S. airlines have received a substantial amount of support from the government to get through the current economic downturn. The $1.9 trillion stimulus package that was billed into law in February included $15 billion in aid for U.S. airlines, which was on top of the support the industry received in early 2020. Similar to how the government rescued many banks from collapsing during the fallout of the global financial crisis in 2008, federal lawmakers have moved swiftly to protect the airline industry from falling into an abyss. This government support is likely to help all the major airlines remain solvent until business picks up once again, which could be as early as the next summer.
According to data from IATA, U.S. domestic bookings are increasing at a faster rate than international ticket bookings, which makes sense considering the quarantine requirements announced by many travel destinations such as Thailand. Based on data for the first three weeks of March, domestic airline bookings have increased to 66% of 2019 levels, which indicates the strong demand for travel and leisure activities in the country.
A major negative development for the industry is the gradual increase in jet fuel prices. Airline jet fuel consumption declined in 2020 along with travel demand, and fuel prices remain below pre-recession levels. However, Goldman Sachs anticipates higher prices for crude oil as the demand will rise along with the resumption of manufacturing activities, which in turn will lead to higher jet fuel prices. This needs to be factored into the valuation model to determine whether the profitability of the airline industry will improve as expected in 2021.
Risks to the thesis
The ability of domestic and foreign airlines to generate higher revenue would be heavily reliant on the implementation of "vaccine passports." Many European countries, including Denmark, the United Kingdom and Estonia, are planning to launch vaccine passports as part of their strategy to facilitate international travel. The United States, however, is unlikely to follow a similar path, which was confirmed by government officials yesterday. White House Press Secretary Jen Psaki told reporters:
"The government is not now, nor will we be, supporting a system that requires Americans to carry a credential. There will be no federal vaccinations database and no federal mandate requiring everyone to obtain a single vaccination credential."
Going by the divided opinion of Americans on the rollout of vaccine passports, the airline industry is likely to welcome this recent decision as millions of Americans are yet to be vaccinated. In the unlikely event such a credential is introduced in the country, it will be an obstacle to a smooth recovery from the airline sector.
Airline stocks to look out for
Although there are many companies to choose from, it makes sense to invest in equity securities of companies that have a strong presence in the domestic market. In addition, investing in airlines with a strong liquidity position could turn out to be a prudent decision considering the significant uncertainties surrounding the recovery of the industry. Below are two companies that provide meaningful exposure to the expected recovery of the airline industry while limiting the risks associated with it.
Southwest Airlines Co. (LUV, Financial) announced recently that it has placed an order with The Boeing Co. (BA, Financial) to purchase 100 Boeing 737 Max 7 jets (smaller model) to retire its older fleet. The company is already among the airlines with the youngest fleets, and these investments will help Southwest achieve cost efficiencies in the future. In a statement released in March, Southwest noted:
"This cost-effective order book with Boeing allows the Company to maintain the operational efficiencies of an all-Boeing 737 fleet to support its low-cost, point-to-point route network."
The company is also the leading domestic carrier in the United States, so it would not come as a surprise if Southwest becomes the first major airline to report profits later this year.
Delta Air Lines
Delta Air Lines Inc. (DAL, Financial) operates both domestic and international airlines. The company is planning to put behind their Covid-19 era policy of flying a limited capacity by blocking the middle seats in aircraft and is instead planning to operate at maximum capacity beginning May 1. This will help the company bring in much higher revenue in the second half of the year in comparison to the prior-year quarter, which is likely to drive its stock price higher in the market.
To revive the demand for international traveling, Delta intends to extend its routes to destinations in Iceland from U.S. airports. Extending routes to other parts of the globe is an excellent way to rebuild the lost momentum for ticket bookings, but the challenge that comes with this is Iceland only welcomes visitors who are fully vaccinated. Going by the current pace of the vaccination program, many Americans will be able to fly internationally with Delta in the coming months, which should be a driver of company revenue.
The airline industry is well positioned to recover sharply in the second half of the year, but investors need to be cautious in selecting the right company to invest their money because of the double-digit share price appreciation enjoyed by many companies representing this industry in the last 12 months. The correct choice would be to go with a strong domestic player, and Southwest Airlines fits this description. Delta Air Lines, on the other hand, will help investors gain exposure to the expected uptick in international travel, but its balance sheet strength needs to be monitored carefully.
Disclosure: The author owns shares of Southwest Airlines.
Read more here:
- Wall Street Analysts See More Upside in Chewy
- Why Fears of a Rate Hike Are Overblown
- Why Uber Was Named a Top Pick for 2021 by Morgan Stanley
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.