During 2020 and 2021, COVID-19 caused severe disruptions to the travel industry causing the stock prices of all major airlines – Southwest, United, Delta and American Airlines – to drop significantly. Now that COVID is in the rear view, let’s take a look at these airlines stocks to see if there is a potential for investment.
In this post, I will take a look at four major airlines in the US and understand their performance post pandemic, growth outlook, stock value and in the process understand an airline business. Finally I will provide my fair value for these companies.
Stock performance in 2022
Every major airline in the the US was equally hit by the travel disruptions due to the pandemic. This is clearly evident from the stock performance of all four airlines. Stock performance for all four was not very different till mid of 2022 however as travel restrictions eased and demand for travel grew we start to see clear distinction between United, which has started to lead the pack.
United Airlines has had the best stock performance out of the four mainly because of strategic steps that they took during pandemic. Unlike other airlines, United did not restrict capacity on its flights and did not retire as many air-crafts in its fleet. Other airlines took various measures to restrict capacity. For example Delta restricted passengers from booking the middle row seats to ensure distance between passengers while on-board but United instead worked on proving that the aircraft’s air filtration system was sufficient to prevent the spread of covid and did not restrict passenger capacity on board.
Furthermore, United, unlike others, did not retire a major portion of its fleet so when the travel demand increased United was in a better position to handle the increased demand from travelers. This is seen from United’s higher percentage of revenue increase as compared to others (see section: Growth and Margin below) and hence better stock performance.
Southwest’s stock, on the other hand, is the worst performer of the bunch. This is because Southwest retired a major portion of their fleet and is unable to grow it now due to delivery problems from Boeing’s 737 MAX (Boeing has not received certification for 737 MAX due to fatal crashes in 2018/19 which grounded the aircraft worldwide). Southwest, unlike other airlines, operates with only a single type of aircraft in its fleet, Boeing 737, which makes it extremely dependent only one company and only one kind of plane. Advantage of this “single plane” operating strategy is that Southwest has to spend less on training and maintenance compared to other airlines which translates to cheaper fares for it’s customers, however the disadvantage is clearly over-reliance on a single company/type of airline making it particularly susceptible to supply chain and regulatory issues faced today.
Operations of an airline industry – Closer look
The airline industry is a complex and highly competitive business that involves a wide range of activities, including route planning, aircraft acquisition/maintenance, ticket sales, customer service, and safety and security measures. It is also highly regulated, and airlines must comply with a range of safety and security regulations, as well as environmental standards.
Additionally, airline industry is also extremely volatile, airlines are also affected by external factors such as fuel prices, weather, and geopolitical events, which can have a significant impact on their operations and profitability. All three of these factors are outside of the airline’s control.
And lastly, the air-crafts themselves are a depreciating asset which needs frequent maintenance, and has to be replaced after certain number years or miles flown. Fleet replacement is a very capital intensive process but is an absolute must to get more fuel efficient planes that offer latest on-board tech that help provide better service to it’s customers.
Competitive nature of the business forces airlines to differentiate themselves through various strategies, such as offering low-cost fares, premium services, better planes, or specialized routes. Most airlines also have frequent flyer programs and other loyalty initiatives to incentivize repeat business from their customers.
To provide the lowest possible fares to attract the most customers, a lot of effort goes towards keeping the cost of operation as low as possible by careful planning, efficient operations, and effective management. Major costs of operating an airline are fuel, fleet and labor. Let’s take a closer look at each…
Fuel: fluctuations in prices of jet fuel and its availability have a major impact on operating margins. Companies generally have fuel hedging contracts to offset some of the volatility in fuel prices. However even after hedging, companies are still very much exposed to fluctuations in fuel prices. So companies instead prefer to invest in the latest air-crafts which are more fuel efficient.
Fleet: Cost of fleet is another major expense which companies have to periodically invest in mainly because an aircraft is a depreciating asset with a fixed number flights before end of life. Also upgrading an aircraft with latest technology improves not just operating efficiencies like – fuel, capacity and range, but also improves passenger experience with more onboard services like wifi and live/streaming entertainment.
Labor: various labor unions represent interest of different employee groups working in this industry. Some of these are Flight Attendant Union, Pilot’s Union, Mechanics and Technician’s Union to name a few. Presence and influence of unions may differ from airline to airline.
State of fleet
| Mainline | Regional | Average age | |
| United Airlines (UAL) | 868 | 470 | 16.7 years |
| American Airlines (AAL) | 925 | 536 | 12.2 years |
| Southwest (LUV) | 770 | – | 12 years |
| Delta (DAL) | 708 | 352 | 14 years |
All four companies are in various stages of upgrading their fleet.
United Airlines has ordered 270 new planes as part of its United Next plan and expects them to be delivered in 2023 and 2024.
Delta in 2022, already took delivery of 69 aircraft that were, on average, 25% more fuel efficient per seat mile than retiring aircraft, and contributing to a fleet-wide fuel efficiency improvement of 4.1% compared to 2019. They have also announced a series of new aircraft purchase agreements, which will continue to improve fuel efficiency.
American Airlines has also planned aggregate expenditures of approximately $12.3 billion for 180 aircraft purchase commitments and certain engines for years 2023 through 2027. About 60 of these aircrafts are expected to be in service within two years.
Southwest added 68 Boeing 737-8 (“-8”) aircraft to its fleet. While the Company was contractually scheduled to receive 114 Boeing 737 MAX (“MAX”) deliveries in 2022. 46 of these aircraft were undelivered due to The Boeing Company’s (“Boeing”) supply chain challenges and delays in the Boeing 737-7 (“-7”) certification. Southwest also has 417 firm orders of MAX aircraft to be delivered through 2030.
Balance sheet comparisons
| LUV | UAL | DAL | AAL | |
| Total Cash | 12.29B | 16.41B | 6.53B | 8.97B |
| Total Debt | 9.43B | 37.30B | 31.71B | 43.69B |
| Current Ratio | 1.43 | 1 | 0.5 | 0.71 |
| Quick Ratio | 1.28 | 0.91 | 0.37 | 0.52 |
| Total Debt to Equity | 88.25% | 540.89% | 481.77% | NM |
All the airlines have adequate liquidity to weather any potential downturn, planned capital expenditures and debt maturities. Southwest has the least amount of debt at YE 2022 which is also well below its total cash. Southwest is also expected to further decrease its debt in 2023 and 2024 to approach pre-pandemic leverage levels.
American Airlines has the most debt on the balance sheet due to heavy spending on fleet renewals and share repurchases in the years prior to the pandemic. However, the company has a de-leveraging goal of reducing total debt by $15 billion by YE 2025. Delta has also repaid $3.9 billion of debt in 2022 and also stated to further reduce leverage.
Out of four, Southwest has the healthiest balance sheet not only due to lower debt and higher level of cash, but also higher amount of unencumbered assets which can be used to get access to more capital if needed. This is also seen from higher Fitch credit rating for Southwest compared to others.
Growth and Margins
| Southwest | United | Delta | American | |
| Revenue Growth (YoY) | 50.82% | 82.49% | 69.18% | 63.88% |
| EBIT Margin | 4.61% | 5.71% | 7.63% | 4.55% |
| Net income margin | 2.65% | 3.93% | 3.51% | 3.39% |
On thing to note here is that Delta has traditionally commanded higher margins as compared to others. This can be attributed to its better on-board services and hence command a premium in prices compared to other airlines.
Returns
| Southwest | United | Delta | American | |
| Return on Equity | 5.11% | 12.36% | 25.18% | NM |
| Return on Assets | 2.94% | 2.75% | 3.56% | 2.10% |
| Return on Total Capital | 3.21% | 3.55% | 6.19% | 3.63% |
Valuation comparison
| Southwest | United | Delta | American | |
| P/E GAAP (FWD) | 11.96 | 5.98 | 7.23 | 9.89 |
| P/E GAAP (TTM) | 37.5 | 22.86 | 18.08 | 81.37 |
| DCF value | $69.16 | $90.31 | $79.76 | — |
Based on my DCF valuation and stock price (as of May 22, 2023), United an Delta are both undervalued by 50% and Southwest is undervalued by 60%.
Assumptions for DCF valuation
| Revenue growth | 2023 | 2024 | 2025 | 2026 | 2027 |
| Southwest | 14% | 7% | 7% | -2% | -4% |
| Delta | 10% | 3% | 3% | -2% | -5% |
| United | 17% | 5% | 6% | 4% | 1% |
| Southwest | Delta | United | |
| Operating Margin | 13% | 13% | 8% |
| Tax rate | 25% | 22% | 21% |
| Terminal growth | 3% | 3% | 3% |
| Discount rate | 6.83% | 6.03% | 6.21% |
In Conclusion..
The airline industry do seem to present a very lucrative investment opportunity where companies do seem to be quite under-valued. However, we also need to be mindful that undervaluation here is not due market’s ignorance but rather due to uncertainty caused by macro-economic headwinds like inflation raising operating costs (especially wage inflation), volatile fuel prices and supply chain disruptions causing backlog of new aircraft delivery to name a few. Despite these headwinds, travel demand has continued to rise thought 2022 and furthermore, due to limited supply of flight seats airlines have been able to charge higher ticket prices.
During the pandemic, the airline industry around the world faced severe challenges. Year 2022 was the year of recovery while still facing challenges with volatile fuel prices, inflation raising operating expenses, supply chain disruptions causing delays with aircraft delivery.
Looking forward, the travel demand outlook for 2023 should be healthy with growth expected from business and international travel which was less in 2022. Meanwhile, delays in fleet growth due to ongoing pilot shortages and delivery delays from the aircraft OEM’s will continue to impact supply side of things which may support high ticket prices and offset rising operating costs.
Disclaimer
The opinions expressed in the Blog are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security or investment product. It is only intended to provide education about the financial industry. The views reflected in the commentary are subject to change at any time without notice.