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“Aviation is the business of freedom,” according to International Air Transport Association (IATA), the trade association of the worlds’ airlines. And business was booming: free movement measured in passenger journeys grew from 1.5 billion in 1998 to 4.3 billion in 2018. Now, however, to help contain the COVID-19 spread, most flights are grounded. Governments have imposed severe travel restrictions on countries that cover over 98% of global passenger revenues. IATA recently forecast a 38% fall in passenger traffic this year (compare this to the worst year on record, 2009, which experienced a 3.5% contraction) and a 44% decline in passenger revenue. Every additional week of lockdown worsens this “aeromegeddon.” Despite the frightening IATA forecasts, we believe investors should look ahead. We discuss below what shareholders could expect after the end of flight restrictions and an economic recession.
Key insights
- We believe investors should look beyond frightening near-term declines in passenger traffic and revenue and estimate the recovery potential for aviation and aerospace stocks.
- Companies that can manage through the near-term challenges may emerge more efficient, with better pricing power, and poised to take capacity from weaker rivals.
- Based on a recovery in earnings by 2022, global aviation and aerospace equities are trading at historically low valuation multiples with the potential, in our view, to deliver the greatest outperformance relative to equity markets we have seen in decades.
Clearly, aviation and aerospace industries are of strategic importance, facilitating billions of passenger journeys and transporting billions of dollars worth of cargo, not to mention their military applications. Most governments are extending a financial lifeline to their respective national aviation and aerospace industries. Generally, companies in these industries have high fixed costs, intensifying the challenge of meeting their financial obligations. Yet all that cost translates to a very wide moat.
The strong players in aviation and aerospace have networks and franchises that are difficult and expensive to replicate.
World class aerospace companies boast expertly engineered products/equipment/software, global manufacturing facilities and massive and efficient supply chains. Airlines hold the limited availability of airport landing and departure slots. The strong players in aviation and aerospace have networks and franchises that are difficult and expensive to replicate. We know that planes must eventually return to the skies as they enable free movement of people and goods globally. For long-haul travel in particular, there are no viable alternatives.
With testing and vaccines, plus perhaps some type of health certification, passenger demand will rise again. In the next several years, the expanding middle class in emerging countries will likely increase their demand for travel. We believe medical breakthroughs needed for society to jettison “social distancing” are within a two-year investment horizon. With renewed air traffic, we expect airlines to re-accelerate their fleet modernization programs for greater fuel efficiency, segment their airfare classes to maximize revenue, and increase their use of data analytics to become more sophisticated retailers of ancillary services. Those with weak balance sheets and uncompetitive offerings could disappear.
Several well-managed airlines are poised to take capacity from their weaker rivals.
Consolidation usually brings pricing power to the survivors. Only two giant companies manufacture the majority of short- and long-haul aircraft that the world demands. In aircraft engines, four companies dominate the global market and service the bulk of the installed engine fleet. Several well-managed airlines are poised to take capacity from their weaker rivals. The aviation ecosystem of catering, airport retail and the like have also seen revenues collapse—and yet many have valuable franchises. Publicly traded aviation and aerospace companies—normally profitable and highly cash flow generating businesses—performed miserably in global equity markets in March and early April. Based on a recovery in earnings by 2022, global aviation and aerospace equities are trading at historically low valuation multiples. Many of these stocks could double and would just return to prices seen only last January. Those we favor in this environment have the potential, in our view, to deliver the greatest outperformance relative to equity markets we have seen in decades. In order to achieve these prospective returns, we believe these stocks must be bought now, not after the inevitable recovery becomes apparent.
This market commentary expresses Causeway’s views as of April 7, 2020 and should not be relied on as research or investment advice regarding any stock. These views and any portfolio holdings and characteristics are subject to change. There is no guarantee that any forecasts made will come to pass. Forecasts are subject to numerous assumptions, risks, and uncertainties, which change over time, and Causeway undertakes no duty to update any such forecasts. Information and data presented have been developed internally and/or obtained from sources believed to be reliable; however, Causeway does not guarantee the accuracy, adequacy, or completeness of such information. International investing may involve risk of capital loss from unfavorable fluctuations in currency values, from differences in generally accepted accounting principles, or from economic or political instability in other nations.
