Pricing power crucial for airline stocks

Warren Buffett's recent interest in airlines has seen stocks go up globally

It is not only Warren Buffett or Chinese investors who are keen to increase their exposure on aviation stocks. Buffett’s Berkshire Hathaway has lapped $9 billion worth of US aviation stocks over the past few months, reportedly on expectations of consolidation and structural changes in the US aviation sector. China’s top three airlines have gained the most among Asian airlines this year. In India, SpiceJet and Jet Airways ran up 18 per cent each over the past week on a favourable demand outlook, expectation of steady crude oil prices and reasonable valuations. Gains for InterGlobe Aviation, which runs IndiGo Airlines, at 2.5 per cent were muted, given that its valuation on a one-year forward basis makes it one of the most expensive aviation stocks in Asia.

The recent trigger was the January passenger growth numbers. The sector carried nearly 10 million passengers, up 25 per cent over the January 2016 number. Domestic passenger growth, for 15 consecutive months, has  grown in excess of 20 per cent. Analysts at JM Financial attribute this to lower ticket prices and an improving economic outlook. Industry load factors, which stood at 88 per cent in January, have been consistently higher than the 80 per cent for about a year now. Load factor measures the utilisation (seats sold) of available capacity.

Mayur Milak of Anand Rathi Research says the 23 per cent year-on-year rise in number of passengers during April 2016-January 2017 indicates a structural upswing in demand. Passenger growth is expected to be over 20 per cent annually over FY17-19, says Milak. Demand is likely to be strong on the back of increased regional coverage and expansion on international routes. Prices, however, are expected to be softer, as more supply comes in, forcing airlines to keep utilisations higher. And, hence, remains a monitorable.

While demand is expected to be strong, the other key trigger is crude oil prices. This remains the single biggest factor influencing pricing power and profitability. A recent World Bank’s forecast said crude oil prices over the next year would be about $55 per barrel. An analyst at a domestic brokerage says as long as crude oil prices stay below $60 per barrel, airlines have a pricing lever to keep passenger loads and utilisation high. Margins had expanded rapidly over the past two years, with the fall in crude oil. 

Estimates suggest 60 per cent of the airline demand is elastic and responds to price drops. A 10 per cent increase in crude oil prices will impact the operating profit margin by about 350 basis points, estimate analysts, while adding that cost rationalisation by key players could be one of the ways in which some of the fall in margins could be protected. The other event which will help the sector gain is any consolidation, which helps all airlines gain market share as was the case in FY12, when Kingfisher Airlines went out of business.

While a relatively stable rupee has also helped on profitability, not everyone is convinced about airlines in India making money on a consistent basis. An analyst at a leading domestic brokerage said while demand remains strong (23 per cent growth), there is adequate supply (20 per cent) which will put pressure on pricing and yields. In the December quarter, for example, despite a healthy double-digit growth in revenue, IndiGo and SpiceJet reported 11-16 per cent decline in yields, amid rising competition. 

In this backdrop, analysts advise that investors wait for consistent profit performance, especially from Jet Airways and SpiceJet, before taking an exposure on the sector. Some of the volatility in performance is reflected in their stock prices and valuations. For now, Jet Airways and SpiceJet trade at 0.2 and 0.6 times their market capitalisation, to sales, respectively, which is hardly demanding, while IndiGo’s 1.6 times on the same metric is considered to be expensive.