Airlines turbulence should unnerve investors

The fear of owning airline stocks – a condition known as “Qantophobia” – is a terrible affliction for those who have watched capital-hungry aviation companies produce awful shareholder returns.

Think Qantas Airways, Virgin Australia Holdings, Air New Zealand and myriad international airlines.

Qantas Airways has a 10-year average annual total shareholder return of negative 1.7% and the dubious honour of having a market capitalisation that is less than all the capital shareholders have tipped into it over 15 years.

Air New Zealand, which has done better recently, has a negative 1.2% return over that period. Virgin’s average annual total shareholder return of negative 17.5% over five years has further confirmed the airline industry’s weak economics and status as a sector investors should avoid.

Beneath the wreckage are some well-performed micro-cap airline stocks that barely rate a mention, however they have attracted investor interest because their fundamentals appear to have bucked the trend.

This week’s note is a salutary lesson for those tempted to stray from my long-held warning against airlines, despite what the numbers say.

Regional Express Holdings (Rex) has an average annual total shareholder return of 8.2% over five years – and a reputation as Australia’s most profitable airline.

Alliance Aviation Services, a 2011 float, raised $74 million and listed at $1.60 a share. It trades at $2.05, after peaking at $2.36. Like Rex, Alliance benefited from rising mining sector demand for fly-in/fly-out workers who commute between regional cities and mine sites.

However, fears about a slowing mining sector in recent years – and lower demand for charter flights from resource companies – have weighed on Rex. Its stock has been especially volatile in the past six months, amid a disappointing interim profit report in February and sharply lower profit guidance.

From a 52-week high of $1.24, Rex tumbled as low as 98 cents, before recovering to $1.12. It is still overvalued.

And it is difficult to look past the airline industry’s many turnoffs. These include: large capital requirements to buy and maintain planes; hard-to-predict fuel costs; a combative industrial relations setting; and high sensitivity to unfavourable currency movements. Another layer of unpredictability comes from weather, regulatory risk, terrorism and plane crashes.

The core problem is a weak business model. Most airlines do not have a clear sustainable competitive advantage, the industry is commoditised and has falling profit margins, and customers have low switching costs because they can easily move between airlines to get a better price. Overcapacity characterises the local industry, and competing mostly on price or service is a tough business.

These problems are shown in the return on equity (ROE) from big airline stocks. Qantas’s ROE, for example, was barely positive in FY12, Skaffold analysis shows. That followed an appalling 5% ROE in FY11, and an ROE of less than 3% in the two preceding years.

Little wonder Skaffold rates Virgin as a C5 company and sub-investment grade.

Rex has its own problems. Soft regional economies and a slowing mining sector have hurt demand for regional airline travel. Rex subsidiary Pel-Air unexpectedly lost the Ivanhoe contract from March 2013, and more contract losses seem inevitable as the resource sector cuts, cancels or defers projects and needs fewer workers. General corporate belt-tightening and cost-cutting by state governments, which will surely lead to less travel by public servants, are other challenges.

Rex reported a 2.7% fall in revenue for its first-half FY13 result to $135 million (over the previous corresponding period), and a 32.8% slump in net profit to $9 million, below consensus analyst forecasts. Softer passenger demand meant it could not pass on rising costs, mostly from fuel and the excise duty from the carbon tax, through higher fares.

More troubling was Rex’s guidance for a full FY13 profit to be 35-40% below the previous year’s result. Management said: “Increasing government taxes and regulations are dampening domestic expenditure, resulting in slowing passenger demand”. Rising costs, especially fuel, have also contributed to the negative outlook.

Another problem was the attrition rate for Rex pilots in the December half. More of its captains resigned, which in turn contributed to a higher-than-usual flight cancellation rate. Losing pilots to better-paid jobs in the big airlines is a constant threat, and a reason why Rex opened the Australian Airline Pilot Academy in Wagga Wagga in 2010.

These problems are starting to bring Rex back to the field. An average ROE of almost 16% over the past five financial years is solid rather than spectacular for a small-cap growth stock, and miles ahead of other airline stocks that have suffered from low single-digit ROE. But Skaffold forecasts Rex’s ROE to fall from 14% in FY12 to 8-10% in the next three years.

Rex is making less profit from a higher base of shareholder equity, the big downgrade in earning guidance has spooked the market, the mining sector remains in the doldrums, and Qantas could easily become more aggressive on regional routes, via QantasLink. Few, if any, headwinds for Rex will become tailwinds in the next 12 months.

Strategically however, Rex has not done much wrong. The concept of fly-in/fly-out workers, while currently under pressure, will likely spread to other industries in the coming decades as Australian business demands a flexible workforce. Expect to see more workers in capital cities flying to regional centres for part or all of their work week, which would be good news for Rex.

Moreover, the lack of rail infrastructure and insufficient investment in highways will strengthen the competitive position of air travel against competing forms of transport. Longer term, regional air travel could be a terrific industry – provided the major airlines stick to larger routes. And that’s another bet (the one against irrational competition) that I am not prepared to make.

Roger Montgomery is the chief investment officer at Montgomery Investment Management. If you would like the opportunity to discuss your portfolio and investment options with Roger or his team simply email office@montinvest.com.