The State of the Sky – Airline Stocks are Cheap and Deleveraging

Everything is going up in the airline business. And it is more than just the planes.

Demand is going up. Capacity is going up. Prices are going up. Wages are going up. Debt is already way up.

Maybe most important, free cash flow looks poised to go up as well.

That’s my conclusion after diving into the industry outlook this last week. 

We have had a big winner for subscribers in the airline space, a name up 50% in the 2 weeks since we recommended it.  With that win in my pocket I wanted to get a better idea of the broad landscape to see if there is more to come.

I listened to every Q4 conference call from the major airlines. Every last one of them.

There was a common refrain: 2022 was a year of getting back to normal. Sure, there were hiccups. But that is past us now. Those were technology glitches and a once-in-a-lifetime weather event. 2023 will be up, up and away.

It was a reassuring picture. A bullish tone.  

BUT THERE ARE SOME PROBLEMS
ON THE WAY TO FREE-CASH-FLOW NIRVANA

The first problem is a pilot shortage and a worker shortage.

The 4 biggest airlines alone (Delta (DAL – NYSE), American Airlines (AAL – NYSE), Southwest and United) are planning to hire 8,000 pilots this year. The typical supply of pilots across the industry is typically 6,000-7,000.

Yet the supply of pilots is getting worse, not better.

For one, companies need to staff at higher levels to account for weather issues, sickness (yes, COVID still) and recent legislation that makes it a lot easier to call in sick.

For two, COVID led to retirements and a lapse in training, meaning there are less new and available pilots today than in past cycles.

American Airlines plans to hire 2,000 pilots in 2023. On their Q4 call they described “a shortfall” of pilots that is keeping them from flying “all the aircraft they would like to fly”. 

In response American is “greatly increasing pilot pay” and going through “the greatest training cycle of pilots that we’ve ever experienced”.

It is not just pilots. Across the industry is a big FOR HIRE sign. Alaska Air Group hired 8,000 people in 2022 and is expecting to hire 3,500 more in 2023. Southwest, in the wake of their Christmas disaster, is hiring over 7,000 employees in 2023. American described their “unprecedented hiring” on their Q4 call.

It doesn’t come cheap. Labor costs account for “north of 60%” of the unit cost increase versus 2019 according to Spirit.

It is not surprising to hear comments like those from Southwestern which saw YoY costs per Available Seat-Mile (ASM) up 14-18% from 2019 “primarily due to additional labor accruals”.

At the same time labor is tight, more staff is needed to just stand still. 

United Airlines believes that for the same seat-miles the industry now needs 10% more pilots and 5% more aircraft.

Today UAL runs with a staff buffer of 5-10% and a rather incredible 25% more spare aircraft than they were before the pandemic. 

GROWTH, GROWTH, GROWTH

What the industry really needs is to catch its breath. But business is not slowing down to let it.

United Airlines presented the following chart with their Q4 results.

Source: UAL Q4 Investor Presentation

Over last 20 years domestic airline revenue has been a very consistent 0.5% of GDP.

While that changed during COVID, we are now returning to that level. United expects to get back to the pre-pandemic level this year – implying another 15% revenue (and demand) growth in 2023.

So far, their projection is bearing out, recession be damned. Take the following clips from Q4 calls, most of which happened in the last couple weeks:

• American Airlines said “demand is strong” and post-holiday bookings are off to a “strong start”. They said this is their “best-ever post-holiday booking period.”
• Spirit Airlines said “the revenue environment in the fourth quarter remained strong”, and that their revenue per seat mile for the quarter was up 17% as compared to 2019.
• Delta said “consumer demand remains healthy” and their advanced bookings for Q1 were “significantly ahead” of 2019 on “both yield and load factor”
• United Airlines said they expected demand to “return to at least 2019 levels” and that they thought “it could go higher”.
• Southwestern said that for March “leisure booking, and yield trends were strong and in line for “a high-demand travel month”.

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Across the board demand for air travel is not abating. In response airlines are ramping up capacity across their routes:

• Spirit said that they still expect capacity to be up 19% to 22% this year.
• Southwestern expects 16-17% capacity growth in 2023.
• Alaska Air Group (ASK -NYSE) expects 8-10% capacity growth in 2023.
• American Airlines expects capacity growth of 5-8% YoY.
• United expects capacity growth in the high teens YoY

BUT…. the key word in each of the above points is “expects”.

There is a lot of demand and lofty aspirations to grow capacity to meet it. But whether it can be done is another story.

Can the airline industry keep up? Or is the industry’s capacity aspirations for 2023 “simply unattainable”.

It wouldn’t be the first time. In 2022 capacity growth was 7% less than the initial guidance of the industry. We are already seeing cracks.

Spirit noted on their Q4 call that they “have been notified by Airbus that a number of our expected 2023 deliveries will be delayed until 2024, which may cascade some aircraft into 2025, all reducing the number of aircraft delivered from Airbus and our lessor partners by 7 [shelves] in 2023.”

ALL THAT DEBT DOESN’T HELP

COVID has littered the airline industry with debt.

The US airline industry was saddled with 50% more debt in the year after COVID.

Source: State of US Commercial Aviation

Only one airline has investment grade credit. Across the spectrum the credit worthiness of airlines has deteriorated.

Source: State of US Commercial Aviation

This is going to set up a significant deleveraging cycle for the industry.

We’re seeing that already. American Airlines has been the first to tackle it head on. American came out of the pandemic with $38 billion of debt – nearly $14 billion more than they ended 2019 with.

They have a goal of $15 billion of debt reduction by 2025.  And they are making progress: American has paid down $8 billion so far and expects to pay down another $3.3 billion in 2023.

By the end of 2023 American Airlines expects to have a lower net-debt to EBITDAR ratio than in 2019.

The trouble is balancing that debt paydown with the desire (and need) to expand. It is tough to do both at the same time.

This is only made more difficult by rising rates.  Aircraft rent and/or debt service is another cost increase as interest rates have risen. According to Spirit, rent cost increases will be another 10–15-point operating headwind this year.

FREE CASH?

If there is a bright side, it is that all this revenue is driving improved cash flow and with it, free cash even as the cost side rises.

United Airlines said that their “unit revenue outlook for February and March is “roughly 25% higher than 2019”. Their booked revenue is even better – up 30-40% over 2019.

Delta gave guidance of 15-20% revenue growth for 2023.  United expects industry revenue up 15% this year. While Southwest did not give full-year revenue guidance, they did guided revenue up 20-24% in Q1 2023.

All this extra revenue will translate into earnings and free cash.

American Airlines expects to generate “operating cash flows of approximately $5.5 billion and free cash flow of nearly $3 billion” in 2023.

United Airlines expects EPS of between $10 and $12 for the full year a big increase over $2.50 EPS in 2022. That would also put the stock at under 5x earnings.

United expects cash flow to be more than $8 billion, which would put it at more than half the current market cap.

Delta expects to grow “earnings of $5 to $6 per share and free cash flow of over $2 billion” in 2024. Delta had EPS of $3.20 per share in 2021.

Delta actually went a step further and looked ahead to 2024. They expect EPS of over $7 in 2024 and free-cash flow of over $4 billion. This would put Delta at about 6x free cash flow.

You put it all together and while there are a lot of gives and takes, the bottom line is that cash is king.  There are big dislocations in the airline industry but as long as there is plenty of money to be made from it that is what investors will focus on.

Yet the stocks so far are very inexpensive, in this market you might even call them downright cheap.

That makes this a very interesting sector for me. While we’ve had one big winner in the space so far (CLICK HERE TO GET NAME & SYMBOL), I am inclined to look for more.