A Simple Model for Why Airline Stocks Have Fallen Despite Record Profits — And What Could Change That

Airline stocks have fallen even though airlines are making record profits. Delta’s and American’s shares are down about 10% year-over-year. United is down about 15%. JetBlue has fallen even more than United. And it’s actually easy to understand why that is.

Ted Reed has a piece, “How Wall Street’s Unit Revenue Police Took Control of the Airline Industry” which — beyond just having a great title — offers a simple model for the disconnect between airline executives and Wall Street.

airline stocks
Copyright: rido / 123RF Stock Photo

Airline executives are frustrated that they’re producing record profits and yet their stocks get hammered or at least don’t go up in value.

But their share prices already factor in the profits that airlines are making today — and an expectation of what future profits will look like.

Airline stocks will go up — on more than a short-term trading basis — if investors believe that higher profits are more likely in the future.

  • That airlines will be making more in the future than they are today

  • Or, if investors are discounting the likelihood that current profits are sustainable, that conditions change to make sustaining profits more realistic.

Why Wall Street Looks to Seat Revenue — and Not Costs or Profits — to Value Airline Stocks

In every investor presentation and earnings call, airlines lead with their profits. Wall Street analysts ask about unit revenue in the form of PRASM or Passenger Revenue per Available Seat Mile — how much money airlines are earning from passengers for every mile flown by each seat.

But the question is whether those profits will (1) be sustained and (2) whether they’ll grow. That’s what’s going to drive increases in share price.

Investors want to see pricing power if they’re going to bet that things will improve and thus airlines will be worth more going forward.

There don’t appear to be opportunities for the largest airlines to take on more planes than they have today, fly more routes, to earn more money.

They don’t have the ability to sell more seats on their existing planes. Load factors are already about 85%, so there just aren’t that many more existing seats to sell.

So the question for airlines is how they’re going to generate more revenue for each seat. But seat revenue is falling.

That’s very much behind the drive to get customers to buy up to first class; to buy up to extra legroom seats; to buy up for seat assignments; to pay for more checked bags; to pay more to change tickets. There are a limited number of things airlines can do to generate incremental revenue from existing butts in seats.

Airlines Keep Pushing Back on Passenger Revenue as the Key Metric

Reed highlights this exchange from the Alaska Airlines earnings call.

Keay’s question [about PRASM] was a long one, slightly rambling, and it led Alaska Chief Financial Officer Brandon Pederson to respond to what he thought he heard.

So Pederson responded, “I agree with you. I don’t know why there is so much focus on PRASM. What I would do if I were an investor is I would focus on profit.

…it’s really {cost} that matters and profit on the bottom line and actual cash that goes into your checking account that you can use to de-lever the balance sheet and pay back debt and return capital to shareholders.”

It seems that Pederson spoke the unacceptable truth, that PRASM is not quite so important as it has come to seem. Retribution came swiftly.

First, Keay responded to Pederson, “I am sorry to interrupt you but I think you misheard me. I am saying the exact opposite to be clear. I think PRASM matters a lot because it’s a proxy for pricing power.”

Then Alaska CEO Brad Tilden spoke up. Tilden addressed Keay. He said that Keay was “making a great point,” that “I think Brandon does agree with you,” and that the airline industry has shifted its focus over the years, from cost per available seat mile, to return on invested capital, and now to PRASM.

American Airlines indicated in their second quarter earnings call that they want to give guidance on RASM or just Revenue per Available Seat Mile rather than passenger revenue per seat mile going forward, because non-passenger revenue like from their co-brand credit card partners gets captured in the former not the latter.

With bank payments for American for their co-brand credit card deals going up, American wants this to be reflected. But it will also tend to mask declines in revenue for each airplane seat.

Meanwhile, American’s President Scott Kirby points out that their passenger revenue per seat goes down when the airline adds seats to aircraft. They assume that an incremental seat added earns just half the revenue of existing seats, but comes at very low cost. So it’s good for the airline’s revenue overall, and good for profit, but reduces passenger revenue per available seat mile.

Analysts know this of course, and can adjust for it. And it doesn’t change the point that investors don’t believe airlines are in a position to sustain or grow their profits when ticket prices are falling.

Stock Buybacks Signal Airlines Aren’t Growth Companies

Airlines have been buying back billions of dollars worth of their own stock. That can increase share price, because it increases demand for shares. More importantly, the value of the airline is split up across fewer shares. Each share should be worth more. As a short-term trading play Wall Street loves stock buybacks.

Share buybacks are a tax-efficient way of returning excess cash to shareholders. Dividends are going to be taxable events, but higher share prices won’t trigger taxes until shares are sold.

An airline also gets to improve some financial metrics (without actually improving the underlying business) – they move cash off the balance sheet, they have fewer assets, thus return on assets is higher. With fewer outstanding shares, earnings per share will go up.

Share buybacks are also good for executives being compensated in stock. American’s CEO Doug Parker is getting paid entirely in stock. Those stock awards are more valuable as a result of fewer total outstanding shares.

But buybacks are a one shot deal, and using cash for buybacks trades off with investments an airline could make with the cash. Declaring the highest valued use of cash is returning it to shareholders is also saying that there’s no better use of the cash to grow future profits — things which should boost share price even more.

The volume of share repurchases signals that airlines aren’t growth companies with big opportunities to invest in ways that will drive more profit in the future. And that’s probably true. So contra airline executives who argue that markets aren’t properly valuing their stocks as ‘high quality industrials’ which would fetch bigger price-earnings ratios, markets are likely valuing airline stocks appropriately based on current conditions and available information.

Passenger Revenue May Be an Imperfect Metric — But It’s Directionally Correct

Reed seems more sympathetic to the airlines, and skeptical of analysts, about the importance of passenger revenue per available seat mile as a metric. But the real point here is about growth, or at a minimum likelihood of continued profits, and what they’re looking for is an ability to sustain if not grow the price of tickets (plus ancillary fees).

Delta argued in 2013, in 2015, and continues to argue today that investors should consider them a ‘high quality industrial’ and value them with a higher multiple as a result.

American’s CEO asks investors to ‘take a leap of faith’ that the airline business has changed.

But even if bust cycles aren’t on the horizon to follow the current boom, investors are asking where future profits are going to come from, where growth is going to come from?

Right now profits are arguably coming largely from lower fuel prices and lower cost of capital (low interest rates). Labor costs are going up — employees are getting new contracts that pay higher wages, and profit sharing is layering on top of that.

In the past higher costs have meant higher ticket prices. If that relationship won’t hold in the future, there’s the potential for things to get worse rather than better.

As of yet airlines haven’t demonstrated an ability to grow seat revenue or articulate a path towards future profits through some other means. Higher prices have been the focus because there haven’t been other ways to profit shown by the airlines, and their buybacks suggest they don’t have ideas for those either. Airline stocks then are likely to become more than short-term trading plays when airlines show they can grow revenue over time, something that’s seemed unlikely.

Disclosure: I have no positions in individual airline stocks. This isn’t meant to be investment advice, but rather an attempt to explain ongoing pull and push between airlines and the investment community.

About Gary Leff

Gary Leff is one of the foremost experts in the field of miles, points, and frequent business travel - a topic he has covered since 2002. Co-founder of frequent flyer community Milepoint.com, emcee of the Freddie Awards, and named one of the "World's Top Travel Experts" by Conde' Nast Traveler (2010-Present) Gary has been a guest on most major news media, profiled in several top print publications, and published broadly on the topic of consumer loyalty. More About Gary »

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Comments

  1. Though I have to admit that I’m pretty unschooled in such matters, I appreciate this interesting analysis, Gary. But don’t the airlines have the pricing power to raise fares, at least for domestic routes, and particularly for the many cities where there is relatively little competition? And even in those cities where there is a modicum of competition, can’t the airlines collude (though they would never call it that) to raise fares?

  2. “There don’t appear to be opportunities for the largest airlines to take on more planes than they have today, fly more routes, to earn more money.”

    Which is why AA just delayed the delivery of their previously ordered A350s by several years.

  3. @Steve: in regards to your second question, the airlines don’t publicly collude, but sometimes one airline will raise fares by say $25 across the board, and then the other airlines can then decide to follow suit. If the other airlines don’t, then the original airline will roll back the price increase.

  4. PRASM does seem like an outdated metric. A few years ago, an airline would sell bargain-basement seats to fill the plane. This allows a customer to fly who otherwise wouldn’t at a higher price, and requires the traveler to be pretty savvy/lucky to purchase the ticket at the right moment. Today, the low-cost flyer will typically settle for a ULCC who has cheap fares more readily available.

    Bargain-basement seats on legacy airlines are currently harder to find than they were a few years ago; it seems legacy airlines are more willing to fly with empty seats. I don’t know why this is exactly, but I suspect ULCCs are a factor.

  5. @Steve the frustration of the Wall Street community is precisely that airline fares have been falling, airlines have been powerless to increase the revenue they’re extracting from seats, those have been declining.

  6. @Pat bargain basement seats have been pretty prevalent, average fares are certainly lower than a year ago, and legacy carriers have been matching price of the ultra low cost carriers. there aren’t that many empty seats on legacy carriers with load factors north of 80%.

  7. Gary: By going through consolidation and capacity control US airlines have chosen to put themselves in a position when only PRASM metrics is important. Airline travel is not a growing industry in USA any longer and everyone is flying the same Boeing and Airbus airplanes. There is no differentiation between the products. Right now there is no prospect to increase number of seats and passengers in US and none of the big player will be taking any drastic steps soon. Regardless what the executives are saying the airlines are selling a commodity product that has no value once plane is departed or a passenger would step out of a plane. As any commodity, it is a subject to large fluctuation in price. Do you choose BP vs. Mobil gas because of the brand name or just fill up at the most convenient gas station or the one that costs 1 cent less per gallon? It is getting the same when choosing between AA, DL, and UA.
    The only thing that could happen is a newcomer that would shake up the industry by offering a cheaper and not necessary better product to attract new travelers. With oil prices low, this would happen sooner or later. Then the big airlines will loose again. We are already seeing low cost carriers entering long-haul market. Gulf carriers made significant gains including premium travel. Chinese companies are taking over transpacific flights. What if AirAsia would be allowed for entering US and paying crews their wages?
    Currently, US airlines have no long term strategy for growth. Their only hope is to hold to their monopoly and execute capacity control. But this will not last long as one cannot play defense forever. Hence, their stocks are dropping.

  8. It always amazes me when the airlines “raise” their prices. Raise from what? On any flight their must be 10-15 different fare basis – from coach to first. Do they raise the entire price list or just the lower tiers? Also, I still think all airlines should have “refundable” tickets like Southwest. Yes SW stock has gone down as well, but at least SW flyers aren’t nickel and dimed for every little thing!

  9. Gary, was any lip service paid to the pension liability issue? Given the nature of lower returns going forward due to current interest rates and sluggish equity markets, this might be playing into analysts concerns.

  10. @Alex77 : Are you saying Chevron with Techron isn’t worth 30 cents per gallon more?
    Damn.

    The idea airlines should be valued like industrials MIGHT be relevant if their credit ratings were as good as industrials and they actually WERE industrials.
    As it stands, airlines, like financials , have some degree of “jump to default” risk. Crash a few planes in a short period and see how many people flee your carrier and what scrutiny you attract from regulators.
    Granted, financials have the greatest JTD risk.
    The comparison is somewhat weak, but both these business types are highly susceptible to fear: one to fear of losing one’s money and the other to loss of life.

  11. Airlines (like many industries) would be smart to ignore Wall Street minions and focus on operations and long term objectives. Delta has done this for years and as a result has good operational performance and higher profits than other legacy carriers. Customers pay more for reliability. Wall Street clearly doesn’t understand the value of the credit card points Ponzi scheme. On the flip side the airlines always seem to be one external event (oil price hike, terrorism, economic downturn) away from losing money, so it is understandable that nobody is paying a premium for airline stocks.

  12. Businesses that tailor their operations to produce data that thrill Wall Street are missing the boat, of course, and sealing their own long-run doom. It’s hard to imagine a climate better for airline profits than right now. The industry is benefiting from about two decades of falling unit labor costs, recently plunging fuel costs, an industry M&A frenzy that seems momentarily in remission, and developed world capital costs lower than at any time since the Industrial Revolution. Couple all that with record passenger volume, and it’s hard to see how things could get any better. Hence, the relatively pessimistic views of some stock analysts.

  13. I actually read an article in a major newspaper that the legacys were complaining that they did not have good seat revenue/mile and were LOSING MONEY! and yet in the same article one if not all of the legacys made
    over $20 million more than the same quarter last year. When an airlines annual profit is $850,000 that is nearing $1 BILLION dollars. If you watch tickets prices the flights to mid size cities are high, some breaks on coast to coast but generally domestic tickets are high. Be careful how they are interpreting their sorry stories- they are doing abfab! And these LOW TICKETS to Europe and Asia is just temporary so they can make some money during low season when it is absolutelly freezing in winter and Asia is typhoon season. I pay for my own tickets now that I am retired and love the treatment and low fares on our non-legacy domestic carriers and middle east, Turkish and Norwegian. A 13YR flight attendant for a legacy carrier makes a minimum $65,000/YR. The average for a registered nurse is $60,000/YR. A 15GR LEGACY Captain makes $250,000/yr with great benefits/retirement. Very few MD’S make that, maybe an Orthopedic or Plastic Surgeon. Remember, the plane flies the pilot, the pilot does not fly the plane anymore- he just puts in the correct co-ordinates and watches the instruments for possible mechanical issues. I flew internationally for 10 years and loved it and the high paycheck, I got out when there was a shortage of pharmacists and made great money but let me tell you, the stress is huge and was at twice if not more stressful than being a F.A. I think the legacys and their employees are going to have to be reasonable about greedy profits and salaries.

  14. To add to my above commentary- Southwest Flight Attendants always make $5,000 MORE than the legacys. That’s right- $70,000/yr- that is why they are dancing thru the isles! And now they have a few new cities in the Caribbean and Mexico so has to be less boring. So, I am sure they did not neglect the cockpit. This only goes to show you don’t have to charge an arm and a leg to make great profits.It may not be a godess job like when I flew, but it sure ranks up there with the pay and benefits. This means JetBlue and the other non-legs could share the wealth more with their employees and still have a good profit. Greed to make people live on less than $35,000 being away from home so much. IN OTHER WORDS- THE FARES COULD BE CHEAPER AND STILL MAKE A GOOD PROFIT! WHY DOES EVERY ONE WANT TO MAKE A KILLING!

  15. PRASM by itself doesn’t mean much. The problem is with the unbundling of services to try and drive up PRASM. What unbundling has done is to give the power to consumers to drop services for which they would have been paying in the past. Bundled services are considered anti-competitive for a reason – they allow the bundler to push low demand items (early boarding for example) with high demand ones (seats). If anything, PRASM should (and usually does) have an inverse relationship with bundling.

    The exceptions, and this is where Alaska’s CFO is correct, would be models where costs are structured to make low demand services a truly incremental gain. Therefore, LCCs will always win on PRASM and legacies will always lose since their costs are not structured in the same way. For legacy carriers, revenue per seat mile and net income are definitely better indicators of performance.

    At the same time, no argument that share value is meant to demonstrate growth potential, which airlines are not generally considered to be. But that’s ignoring that revenue per se can continue to grow on account of greater volumes. In what is becoming pretty typical of investment fund strategies, the focus is on the short term growth metric (PRASM) than on longer term metrics, like aircrafts on order, interest payment growth and cash on hand.

  16. While I find your analysis interesting, I would submit that the issue is far less complex than you — and some Wall Street analysts — have painted. The obvious reason why unit revenue (PRASM) has been down in the airline industry since 2014 is that costs have collapsed. The price of jet fuel during that period has fallen by something like $2.00.

    I would submit that any industry — even one with few players and oligopolistic tendencies — could not raise its prices in an environment where its costs were cratering. This would be particularly true in the airline industry, where there would be an obvious tendency to add additional seats when they can be flown at much lower cost. For instance, a route to Asia might not be profitable at $3 fuel, but is highly profitable at $1.50 fuel. This is, of course, why the airline industry has recorded record profits at the same time as unit revenue has fallen.

    When airline costs increase — say because fuel prices rebound — I have little doubt that unit revenue will also rebound in the industry.

    Wall Street’s unwillingness to appreciate profits derived from lower costs has resulted in very strange market conditions. Airlines like American are using their record profits and low share prices to buy back remarkable quantities. AA just bought back something like 9% of their outstanding shares in the last quarter alone! If the gravy train doesn’t end soon, I suspect this anomaly will be corrected.

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