David Tepper (Trades, Portfolio)’s eye for a deal and airtight vision for companies and trends did not defend against the affect of the unexpected shakeup in the European Union on two of his 10 largest portfolio equities.
In the past five trading days, the Appaloosa Management founder’s Delta Air Lines Inc. (DAL, Financial) fell 14% and Southwest Airlines Co. (LUV, Financial) fell roughly 9% as airline stocks as a group edged lower. The NYSE ARCA Airline Index fell roughly 7% for the same period, compared to 3.4% for the Standard & Poor’s 500.
“They’ve been probably over-punished relative to the actual financial impact, but all that is function of uncertainty. The market doesn’t like that,” Bob Mann, president of R.W. Mann & Co., an airline industry analysis and consulting firm. said.
As markets recoil from the U.K. break from the EU, concrete factors resulting from “Brexit” will also affect airlines’ businesses.
“For companies that have a lot of international exposure you have the likelihood that this change will hurt the economic growth in the EU and U.K. and since air travel demand correlates to GDP, its drop would result in a drop in demand, and that would manifest as lower earnings,” Mann said.
A separation from the EU could also force an economic shift for the U.K. and cause London to lose its status as center of the European and global financial community. Airlines, therefore, would lose the revenue from bankers, attorneys and other financial players whose frequent flying they have historically benefited from.
Economic volatility could also exacerbate the ever-present currency risk inherent in airlines. The British pound sterling (BGP) has already hit a 31-year low of $1.3151 Monday.
Further, uncertainty would subdue not only markets, but confidence in spending, whether on business travel or direct foreign investment. For long-term investors, the question becomes whether this confluence of factors constitutes a short-term setback and buying opportunity, or a depressed price due to a murky future.
“Those are going to be held in abeyance until things sort out,” Mann said. “It could be a temporary drag to permanent shift in the way travel operates.”
Mann estimated that it will take two or three months before the U.K. and EU establish what their separation process will be. Then, it might take Europe, the U.K. and the U.S. roughly two or more years to unravel and restructure a web of flight agreements. The three have operated under an open skies arrangement since 1992 but with the U.K. separating, the U.S. and U.K. will have to reestablish a bilateral agreement.
How deeply these factors damage a company will depend largely on their individual make up, mostly their exposure to Europe, according to Seth Kaplan, managing partner of Airline Weekly.
“Basically, Southwest looks to be down along with the market... no particular Brexit exposure,” He said. “Delta owns 49% of Virgin Atlantic plus has a giant revenue and cost-sharing transatlantic joint venture with Virgin.”
Delta was Tepper’s largest airline and fourth largest equity position at the end of the first quarter (Tepper will report his action with the stock in his second quarter portfolio filing) after he cashed out his third airline position, United Continental Holdings (UAL, Financial). He held 8,594,855 shares of Delta, the most since 2013. Tepper also increased his total position by more than 40% in the nine months ending March 31.
Delta also stands as the most vulnerable to prolonged trouble from Brexit. Along with its Virgin (VA, Financial) joint venture, it has significant exposure to the U.K., with the second largest position at Heathrow Airport.
But the airline could have a soft landing. Cities such as Paris, Brussels and Frankfurt are likely to assume some of the demand from the dissipating financial market of London, resulting in more flights. Other airlines with British exposure, such as American (AAL, Financial), face similar obstacles.
“American Airlines, down a lot too, has an even bigger revenue-sharing joint venture with British Airways, although it doesn't own any equity in British carriers,” Kaplan said.
Southwest Airlines offers no flights to the EU or U.K. and has the least exposure to the “euro-carnage,” Mann said.
Tepper held 4,360,961 Southwest Airlines shares according to the latest records available, taking up 3.45% of his portfolio. He started buying the stock in the third quarter and increased his position by 166% by March 31. Year to date, its shares have gained 9%, including a 4.5% pop Wednesday. It has a P/E ratio of 11.5, near a decade low.
Brexit adds fresh issues for an industry that had traditionally faced intense competition and business challenges beforehand. “Equity owners have not been rewarded adequately for risking their capital in most years,” according to a July 2015 IATA economic summary. “The average airline returns are rarely as high as the industry’s cost of capital,” the report said.
It expected return on invested capital to jump to 7.5% for the year, however, translating to $700 million and $4.9 billion in value for investors due to lower fuel prices, increasing ancillary revenues and consolidation.
“But it should be clear that $29.3 billion net profit, while exceptional for the airline industry, is really only just sufficient to pay investors a ‘normal’ return for risking their capital,” it said.
The temporarily lower price for fuel, which is usually the biggest expense for airlines, has also reflected little in price or value appreciation.
“It has stimulated demand, clearly, but half of the reduction in energy cost has been returned to the market in lower fares, one-third has been returned to employees in wages and benefits, and only about 15-16% has been flown through the bottom line to benefit shareholders in dividends and share price appreciation and buybacks,” Mann said.
“Unfortunately all the share price appreciation has been blown out the window, so we’re back to 2012-2013.”
The Brexit-related troubles for airlines, at least, will not last forever.
“Nothing will change soon," Mann said. "But at some point things will change and uncertainty will be peeled away from the market, and I think there will be an overall increase in demand and earnings."
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