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Ready for takeoff or permanently grounded: What is the outlook for aviation stocks?

 

In recent years the aviation industry has faced its fair share of brick-bats; events such as 9/11, the Global Financial Crisis and the Icelandic ash cloud all clobbered the industry, yet each time it bounced back stronger than ever – writes Tabitha James.

However the global pandemic, in which many believe aviation played a major role in creating, leaves it facing the worst downturn in its history and an existential threat.

Around the world, most flights are grounded as countries have locked down their borders to try to halt the spread of the virus; despite robust lobbying to be allowed to remain airborne, slogans such as Gatwick’s ‘Keep Healthy, Keep Safe and Keep Flying’ or Ryanair’s now banned ‘Jab and Go’ have fallen on deaf ears.

Revenues have disappeared leaving the airlines burning through cash reserves and seeking state support in the form of guaranteed loans, bailouts or furlough payments; however, their recovery remains uncertain, leading many to believe that the future of aviation may look very different to the frenzied growth of the recent past.

TV screens were awash with advertisements over Christmas targeting ‘hard working families’ offering the holidays they deserved, and much optimism came with the roll out of the vaccines; however, things have not progressed in the way the industry would have hoped – there have been issues of supply, although the UK did act quickly and decisively in approving and starting to administer the vaccines, but new variants of the virus have led to strict new lockdowns to combat the second wave.

According to Joachim Kotze, equity analyst at Morningstar, companies such as Air France and Lufthansa, will emerge with huge debt piles that could take years to repay and may require them to restructure.

In what has been a dramatic ten months the retirement of whole fleets of 747s has been brought forward and the future of the A380 behemoths called into question; the closure of Norwegian’s long haul business could spell the end of the long-haul budget sector, and there is an increasing belief that the ‘hub and spoke’ model will be replaced by more point to point flights with smaller planes.

Given that operators were already working with wafer thin margins, there is no guarantee that traffic volumes will ever return to 2019 levels, particularly as an increasingly vocal environmental lobby seeks to hold countries to account in delivering on their Net Zero 2050 obligations.

Although there is no certainty of a recovery, should it occur, Mr Kotze believes that the short haul domestic and regional leisure travel would recover first, to the benefit of low-cost airlines such as Ryanair, EasyJet, and Wizz Air; this could be followed by a more prolonged recovery at international and business related travel, impacting network airlines such as Lufthansa, the British Airways Parents, IAG and Air France-KLM.

The historical resilience of the aviation industry, in even the most dire circumstances, suggests that the best, or the most agile companies can usually find opportunities and Mr Kotze believes that there will be really good opportunities for airlines that are well-positioned.

A major opportunity is likely to be in cost reduction; as BA’s controversial ‘fire and re-hire’ scheme shows, the industry has been anxious to reduce what it sees as bloated staff costs. Staffing is the second largest cost for the industry after fuel, and due to historical and restrictive labour agreements, one that will undoubtedly be targeted for cuts, particularly for network carriers which are heavily unionized.

Because of the very real threat that employment levels in the sector will never return, airlines are likely to take the opportunity to renegotiate with unions as the bargaining power is shifted and perhaps use this to lower the staff cost component.

A potential is that future agreements are based upon more seasonable labour allowing airlines to balance their costs with demand seasonality.

Airlines with strong balance sheets and good liquidity such as Ryanair and Wizz Air can interpret this as an opportunity to negotiate attractive discounts with aircraft suppliers; Ryanair has snapped up 75 additional 737 MAX aircraft and Wizz Air has had Airbus sharpening its pencils as it seeks to negotiate attractive discounts from forecourt prices and also more keenly negotiate with ground handlers and airports for landing fees.

Whilst acknowledging that the outlook for the industry as a whole is extremely uncertain, Mr Kotze says that he is ‘more optimistic’ about the growth prospects for both Ryanair and Wizz Air, but that his top pick is EasyJet. Based on a risk-reward ratio he said that a fair value estimate of £10.90 represents about a 30% upside from the current or prevailing share price.

Mr Kotze also believes that there are additional opportunities for the group, the biggest of which is a ‘long overdue’ cost restructure because EasyJet has lagged low-cost peers in terms of their cost structure.

He makes the important point that EasyJet differs slightly from their low-cost peers Ryanair and Wizz Air, in that it focuses on primary airports, whereas their peers serve secondary airports; because of that it shares a greater route overlap with that of their network legacy carriers such as Air France, British Airways, and Lufthansa.

This gives EasyJet the opportunity to focus on consolidating their positions at their key hubs in Europe and attempt to try to gain share on the high traffic routes at primary airports. This could allow the carrier to benefit from business travel downtrading as we emerge from the downturn and they could also benefit from an early uptick in short or intra-European leisure travel.

Overall, Mr Kotze says ‘we are optimistic about the cost restructuring efforts at EasyJet, their ability to gain share, and while the valuation offers a decent margin of safety in our opinion to compensate for some of the risks that are currently facing the industry.’

EasyJet shares closed today (4 Feb) at 796.8p compared with 1536.5p a year ago

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