Behind high flyers, aviation engine room holds investor value

Commercial airlines are notorious for destroying shareholder capital, but the broader aviation industry should not be off limits.

Commercial airlines are notorious for destroying shareholder capital. But that doesn’t mean the broader aviation industry should be off limits for prudent, long-term, global-minded investors.

In fact, despite the bad reputation that precedes some of the world’s largest and best known airlines (regarding investment returns, service can be the topic of a follow-up column), there are some wonderful businesses around the globe that cater to the carriers, their passengers and savvy investors.

During the past three decades there have been dozens of bankruptcy filings made by US airlines. In fact, before being acquired by American Airlines in 2013, US Airways had actually gone bust on two separate occasions in the space of a few years.

As a group the US airlines have failed to achieve returns on their invested capital that exceed their cost of capital, according to a decade-long study by Aswath Damodaran at New York University’s Stern School of Business.

Nonetheless, profitability in the sector has turned up in the past year as the oil price has declined, the US dollar has strengthened, and the number of competing airlines has declined through merger activity. Our leading listed aviation stock — Qantas — has revived. Across the international sector share prices are near record highs.

While the US market has experienced a wave of consolidation that has concentrated control of the domestic routes in the hands of a few big players — American, Delta, Southwest and United carry 80 per cent of passengers — the European market is much more competitive. In Europe, the big players account for just 50 per cent of the market. Low-cost carriers such as Ryanair have been gaining market share by offering passengers no-frills point-to-point travel options.

At the same time Emirates, Etihad and Qatar have expanded capacity in Europe by 17 per cent annually during the past decade when the traditional airlines have added seats at less than 3 per cent a year; indeed, senior management at Germany’s Lufthansa recently complained in a letter to US government departments about this trend. Lufthansa’s complaint is that the Gulf carriers have captured more and more traffic between Europe and Asia by offering high standards of service without regard to cost, funded by their respective states.

At the same time, traditional carriers have had to cut routes, delay new plane orders and fight with pilot and cabin crew unions to reduce costs just to stay in the game. This intense competitive environment has meant Lufthansa has invested more than €10 billion ($14.5bn) in its asset base since 2006, yet earnings are almost unchanged. Across a similar period Air France’s return on capital is barely positive. After a rebound in both companies’ share prices towards the end of last year, fundamental reality is taking hold and the stocks are down between 15 per cent and 20 per cent this year. The outlook for airlines and their share prices evidently is not for clear skies.

The plane manufacturers themselves are on a different flight path. The business of developing, manufacturing and selling large aircraft for use by commercial airlines is concentrated on two large players: US-based Boeing and French-listed Airbus. This has become even more apparent in the past few years as airlines seek to increase efficiency by streamlining their operations on to a select few platforms from a smaller number of providers. A duopolistic market structure has allowed Boeing and Airbus to earn very high returns on capital, typically exceeding 20 per cent, across long periods and this seems set to continue.

The two big aviation manufacturers are well placed to capture multi-decade secular tailwinds. Boeing projects that during the next two decades more than 38 thousand new planes will be ordered at a cost of $5.6 trillion, doubling the world’s fleet of passenger planes.

All these new planes will cater to passenger traffic that is growing at almost 5 per cent annually, and will reach seven billion passengers by 2034, driven primarily by emerging countries in Asia-Pacific and Africa.

Boeing’s stock price is also near a record high, and represents 17 times next year’s earnings per share.

Manufacturing isn’t the only industry catering to the airlines with much better economics than their carrier customers. Engines are a separate purchasing decision for airlines. However, the decision typically comes down to one of two choices, and some plane models have an exclusive engine provider. On larger wide body aircraft Rolls-Royce, headquartered in London, and Engine Alliance (a joint venture between US-listed GE and Pratt & Whitney, itself a subsidiary of US-listed United Technologies) are the options. Narrow body aircraft are fitted with engines from CFM (a joint effort between GE and France’s Safran) or Pratt & Whitney. Rolls-Royce and Safran, the purest engine plays, often generate returns on capital above 20 per cent.

Certainly the airlines themselves have often found it difficult to offer equity investors a return of capital, let alone a return on capital.

However, investors who are able to look along the aviation supply chain and around the world just may be able to find some great opportunities to compound their wealth over a very long runway.

Roger Montgomery is founder and chief investment officer of the Montgomery Fund.