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When Warren Buffett speaks, investors all over the world take notice. So when the Oracle of Omaha said in 2002 that airlines were a “death-trap for investors,” people took notice.
“If a capitalist had been present at Kitty Hawk back in the early 1900s, he should have shot Orville Wright. He would have saved his progeny money,” said Buffett at the time.
“But seriously, the airline business has been extraordinary. It has eaten up capital over the past century like almost no other business because people seem to keep coming back to it and putting fresh money in. You’ve got huge fixed costs, you’ve got strong labour unions and you’ve got commodity pricing. That is not a great recipe for success.
“I have an 800 (free call) number now that I call if I get the urge to buy an airline stock. I call at two in the morning and I say: ‘My name is Warren and I’m an ‘aeroholic.’ And then they talk me down,” Buffett told the UK’s Telegraph newspaper in 2002.
But fast-forward to late 2016, and Buffett surprised investors by buying back into the major US airlines. In February this year, his Berkshire Hathaway investment behemoth doubled its holding in American Airlines Group, lifted its stake in United Continental Holdings sixfold, took a large position in Delta Air Lines and spent US$2.4 billion on a new position in Southwest Airlines.
Berkshire Hathaway is now the largest shareholder in United Continental and Delta, and is a top three shareholder in Southwest Airlines and American Airlines. Buffett has described the investments as a “call on the industry itself” rather than a choice of individual companies, but clearly, he has decided that what has historically been a loss-making industry has turned itself around.
So has the investment performance.
The New York Stock Exchange (NYSE) Arca Airline Index has risen 19.4% in the last 12 months, outpacing the 17.8% gain of the S&P 500 index. The only pure-play global airline exchange-traded fund (ETF), the US Global Jets ETF (JETS), has done even better, surging 31.7% in the same period. JETS holds stocks in most of the major global airlines – its four largest holdings are American Airlines, Delta Air Lines, Southwest Airlines and United Continental, but Qantas is also in there, at 1% of the portfolio.
Australian investors have several avenues into the airline industry, beginning with the nation’s flag carrier, Qantas.
Buffett could be talking about Qantas: the Australian flag carrier has shown a spectacular transformation. Just three years after a dire $2.8 billion loss in 2014, Qantas earned underlying pre-tax profit of $1.53 billion in FY17, the largest in its history. Led by Alan Joyce, the company’s management team has done a great job on all of the things that Qantas can control, in its costs and capacity management, and has benefited from the prevailing low fuel prices.
The international division is doing it tough – underlying earnings fell 36% in FY17 – but domestic operations are very strong. Despite a 1.4% decline in revenue in FY17, Qantas’ domestic division boosted underlying earnings by 12%.
Two-thirds of Qantas’ income comes from domestic and frequent fliers. The domestic division – which lifted its revenue by 5% in the second half of FY17 – should continue to buttress Qantas, and the international division is positioned to benefit from Asian consumer growth and the Australian tourism boom. In August, Qantas surprised the industry by dropping Dubai as the stopover point for its Europe-bound flights, reverting to Singapore after five years – even while extending its partnership with Emirates for an additional five years.
Qantas chief Alan Joyce said the Emirates partnership had “evolved to a point where Qantas no longer needs to fly its own aircraft through Dubai,” which meant that the Australian carrier could redirect some of its A380s flying into Singapore and meet the strong demand it was seeing in Asia.
With one move, Qantas has bolstered its market share on the Australia-London “kangaroo route” by restoring Singapore as the stopover destination, while opening up the access to on-flights into Asia, positioning it to benefit from growing two-way flows between Asia and Australia.
The company has published guidance for a better-than-expected annual underlying pre-tax profit of between $1.35 billion–$1.4 billion in FY18, on the back of the strength of the domestic operation. At $6.13, Qantas trades on a consensus forecast price-earnings (P/E) ratio of just 10 times FY18 earnings – that is well below the global average for airline stocks of about 11 times earnings. As one the world’s most profitable airlines, Qantas arguably should trade at a premium to the average P/E multiple for its global airline peer group.
The analysts that follow Qantas see plenty of scope for the price to keep rising: on Thomson Reuters’ consensus, the analysts’ consensus target price for QAN is $6.75. The catch for income-oriented investors, however, is that Qantas is not a lucrative dividend payer, and the dividend is not fully franked.
* Reports in NZ$
Like much of the New Zealand stock market, Kiwi flag carrier Air New Zealand is also listed on the ASX, where the stock has surged from $1.69 a year ago to $3.14 – AIZ has also racked up a highly creditable five-year total return of 37.6% a year.
Air New Zealand reported its second-highest pre-tax profit of NZ$527 million ($383 million) in FY17, although that figure was down 20.5% on the record FY16 result. Net profit was down 17% to NZ$382 million, but the company lifted its dividend by 5%, from 20 NZ cents to 21 cents.
Air New Zealand said in its result that fierce competition had begun to ease, as rivals reduced capacity to New Zealand. The airline’s 1-cent (10%) lift in its final dividend was seen by the market as showing its confidence on the medium-term earnings outlook: Air New Zealand did not give formal guidance, but said that based on the current market conditions and assuming fuel prices remained at USD60 per barrel, it was “aiming to improve upon 2017 earnings.”
Air New Zealand currently trades at NZ$3.475 in NZ ($3.15 on the ASX). The most bullish broker on the stock is Macquarie, which has a target price of NZ$3.90. UBS, Credit Suisse and Deutsche Bank all have target prices lower than NZ$3.475.
The other problem for Australian investors is that the imputation credits from fully franked New Zealand dividends are not available to Australian residents: the New Zealand government refunds the imputation amount to foreigners, minus 15% withholding tax. This refund is paid as a supplementary dividend, increasing total dividends received by foreigners by about 18%. This makes New Zealand dividends not as tax-effective for Australian investors as local stocks paying fully franked dividends: this is a very important consideration for SMSFs.
The other main airline exposure on the ASX is Virgin Australia Holdings (VAH) – but at 18.2 cents, Virgin Australia has lost investors plenty from its peak of $2.31 back in 2007. Virgin Australia reported a loss of 2.8 cents a share in FY17, and while analysts expect the company to turn that around to earnings per share (EPS) of 0.9 cents this year, the consensus is that VAH is not an investment proposition. The airline is paying down debt after posting five consecutive years of losses.
Other airline investments on the ASX include Regional Express Holdings (REX, $1.42) and specialist aviation supplier to the resources industry, Alliance Aviation Services (AQZ, $1.285). Of the pair, AQZ is a fully franked dividend payer, with a FY18 forecast yield of 3.5%, but analysts see the stock as fully priced.
Investors can also play aviation by investing in Sydney Airport (SYD), which offers a 4.8% unfranked yield for FY18, and is a strong generator of cash. Sydney Airport is one of the prime beneficiaries of Australia’s growing attractiveness to Asian tourists, but at $7.13, SYD trades very close to its analysts’ consensus target price of $7.11.
The US Global Jets ETF (JETS) will also have its appeal to investors who want to tap into a diversified investment in the major global airlines and aircraft makers. JETS is priced in US$, so Australian investors would bear currency risk, but it certainly gives a much broader exposure to the global industry than any investment they can make on the ASX.