Deciphering the market’s message about the airline industry

The market weighs in

The airline industry is segmented into the mainline passenger airlines of United Continential (UAL), Delta Airlines (DAL), and American Air Lines (AAL), low-cost passenger airlines Southwest (LUV) and JetBlue, and low-cost passenger airlines Allegiant and Alaska. Although a passenger-airline-only exchange-traded fund isn’t available, you could gain exposure through IYT.

Deciphering the market’s message about the airline industry

As you can see from the chart above, the market is valuing industry participants widely. The chart above shows the U.S. airline industry in terms of enterprise value divided by last-12-month earnings before interest, depreciation, and amortization. Enterprise value is the equity market capitalization of the company plus the market value of the debt outstanding. EBITDA is a shorthand measure of a company’s free cash flow. As we’ve seen, airline companies have significant cash flow requirements, but EBITDA supplies a common metric for valuing companies.

Here’s the point

The passenger airlines with more profitable markets and efficient operations like Allegiant are valued more highly by the market. Allegiant Travel Company is a leisure-focused passenger airline flying point-to-point between smaller cities and popular destinations nationally. The smaller, narrower-focused route passenger airlines trade below the industry average. The industry group trades at 5.9x, with the mainline carriers trading near the average.

What to watch for

Traffic in the industry is driven by business travelers, who are less price-sensitive, while leisure travelers drive volumes in the peak travel months. Therefore if the economy continues expanding, the airline industry should do well. Indicators include North American GDP and U.S. consumer confidence. Expanding this globally, for this is an interconnected industry, would include watching GDP in China, Japan, and Germany and an indicator for the global business climate.

Don’t forget the fuel

Airline carriers’ cost structure is impacted by the price of jet fuel. Generally, this can be 30% to 35% of expenses for an airline. In looking at the industry, you should keep an eye on prices in New York, Singapore, and Antwerp. However, most airlines significantly hedge their exposures. Delta went so far as to purchase a refinery in the U.S. to hedge its fuel costs. Hedging adds a cost, but a swing in fuel costs could take down an airline if it’s not hedged.

More room to run?

The S&P is trading at 12.7x trailing 12-month EBITDA. The airline industry is trading at 6x trailing 12-month EBITDA. The airline industry has restructured. Overall, the industry’s ROIC is greater than its WACC. Assuming the U.S. and global economy continues expanding, you could see the airline industry coming into alignment with the S&P 500 index, which would provide a good return.