Since the middle of July, the business headlines have been relentlessly scary as governments, corporations and individuals scramble to stay afloat in a weak global economy. Yet for airline industry executives, each day brings more good news. Oil prices are falling and look set to fall even more in coming weeks.
Crude oil was above $110 per barrel in late April, but has since fallen to about $84. Now that the crisis in Libya appears to be resolved, it should start boosting output back up to prior levels, right at a time when global oil demand may be trimmed a bit in the face of an economic slowdown. At this point, a move toward $70 oil may be in the cards as these factors play out.
Whether we're talking about a $25 drop in crude oil now, or an eventual $40 (total) drop from that late April peak, airline executives are overjoyed. Jet fuel (which is further refined and a bit more expensive than underlying crude) is the single-biggest cost for an airline outside of labor. When oil was surging, many carriers such as AMR (NYSE: AMR), the parent company of American Airlines, had to brace investors for rising losses while others such as United Continental (NYSE: UAL) and U.S. Airways (NYSE: LCC) had to make-do with ever-smaller profit forecasts.
Now, get ready for analysts to start to boost their profit forecasts. Once they do, investors are likely to take note of this industry's rock-bottom valuations. For example, DAL), which remains my favorite airline play, trades for about four times projected 2012 profits.(NYSE:
Of course, many question the wisdom of owning airline stocks in a slow economy. After all, aren't these the same companies that have flirted with bankruptcy many times before? Well, with the exception of AMR, all of the major carriers have learned to run their businesses in a much different manner, holding down labor costs, route capacity and their order books.
And their balance sheets are now truly healthy. Delta, for example, has access to more than $5.5 billion in cash and credit lines. Crucially, we're not seeing price wars that have historically sapped airline profits, either. This is the result of early decisions to pull back capacity on unprofitable routes. Simply put, the pullback in oil means carriers can operate profitably even as unemployment hovers around 9%.
It's not just the airline stocks that should look more appealing, but also the ancillary businesses that serve them. Here are two airline-related names that should flourish as investors realize the broader industry isn't about to enter into a deep swoon.
BE Aerospace (Nasdaq: BEAV)
This company helps airlines build out the interiors of new planes and upgrade the interiors of older planes. It's a "rain-or-shine" business model that should do well whether carriers upgrade their fleets or extend the useful life of existing planes. For example, in the economic downturn of 2009, when carriers put a freeze on new plane deliveries, BE Aerospace saw sales drop just 8% to $1.9 billion because the refurbishment end of the business fared well. Free cash flow still exceeded $50 million, the third-best performance in company history (behind 2008 and 2010).
Even though the company's dual-pronged exposure reduces cyclicality, shares still trade well below the historical average of 18 times forward earnings, and can currently be had for less than 12 times projected 2012 earnings.
Looking past the near-term economic challenges, this is a business model built for solid growth over the long haul. BE Aerospace has been providing an expanded level of services and products to airline carriers in recent years, moving beyond the core focus of seats into lighting, HVAC systems, cooking systems and other cabin amenities. This has fueled 20% compound annual growth during the past five years.
The broadened skill set should really pay off because carriers are expected to eventually make a big push to upgrade their fleets to much more fuel-efficient widebody planes that have recently been released by Boeing (NYSE: BA) and Airbus (such as the 787 Dreamliner and the A380, respectively). Merrill Lynch analysts note these planes can carry five times more "shipset content" than smaller planes, as they "usually have more luxurious premier/first class furnishings... and generate higher demand for seating and food and beverage equipment." As an example, every Airbus A380 being outfitted for Emirates Airlines carries an estimated $5 million worth of BE Aerospace gear. With shares near a 52-week low, this is a great entry point for this long-term winner.
Aircastle (NYSE: AYR)
This is the "little engine that could," that is, until it couldn't. Shares of this aircraft leasing firm were steadily climbing toward book value of $17.90 a share, but the recent market weakness has wiped out all of its earlier 2011 gains.
With shares now trading for just 60% of book value, it's time for investors to jump back in.
Aircastle buys planes directly from manufacturers and then leases them to airlines and other customers. Aircastle assumes the risk of ownership, but the profit spreads can be immense when times are good. Judging by Aircastle's cash flow statement, times are quite good: Free cash flow (FCF) has steadily risen from $60 million in 2007 to $343 million in 2010.
The key question is whether airline carriers will hit a deep slump and Aircastle will need to take back many of its planes, running into its own financial trouble. This was a fair question when the airlines were reckless with their balance sheets. But as they've taken a much more mature approach to expansion and financing, they simply aren't the "bankruptcies waiting to happen" that they once were. So Aircastle's deep discount to book value seems to anticipate a possible dire future that is very unlikely to ever happen.
Risks to consider: In a nutshell, I think these companies are still set to make money if the event of a mild recession, thanks to lower oil prices. But a really deep recession would deeply cut ai travel, also causing airfares to plunge and losses instead of profits. Since these companies still have debt, investors would shun them if they were in money-losing mode, for fears that the bankruptcy risk would be back on.
Action to Take --> The pullback in oil prices is more of a positive for these stocks than the global economic weakness is a negative. As a result, look for analysts to maintain or even boost their profit forecasts for the industry when quarterly results are released in late October. But you could be early to the game by pouncing on any of these three stocks beforehand and enjoy what is likely some major unrealized upside.