Investing in the Airlines Industry
The coronavirus and subsequent drying up of travel and tourism demand put airlines in a stress environment worse than the September 11, 2001 attacks. Even then, the industry as a whole is in more resilient shape than it was in 2001 due to consolidation, cheaper fuel costs, and improved management.
The main challenges
Recovery in certain pockets of the economy like tourism and hospitality is more likely to see a “Nike swoosh” type of recovery over a “V” shaped recovery.
In the interim, airlines will be most concerned about matters of preservation – ensuring adequate liquidity to ride out an extraordinarily soft patch in demand.
The main issue isn’t so much whether there will be a permanent loss of demand. The industry can have confidence that people will want to fly again and resume travel when the public health matter is resolved. Demand in China picked up once its cases had gone down. It’s really a matter of being able to cut costs and avoid seeing the short-run losses from erode their liquidity buffers.
Governments around the world provided more than $100 billion in aid to the airline sector. Saving some essential services is deemed necessary by many, as the cost to not rescuing them – i.e., more unemployed, investment losses, service losses – is higher than the overall cost to saving them. To avoid the burden on the taxpayer, many governments have encouraged the industry to supplement their assistance with capital from the private sector.
The airline industry’s trade association, the International Air Transport Association, estimated about $300 billion in operating losses from declines in passenger traffic over the next 6-12 months.
That means airlines will need to tap various sources of capital to help them ride out the combination of revenue losses and large fixed costs. That can be government support, private market demand in the traditional forms (i.e., equity and debt issuance), or alternative financing schemes by pledging different types of collateral.
Debt, equity, or equity-linked securities are typical capital raising activities. Those types of issuances have still gone on during the Covid-19 pandemic.
However, in crisis circumstances, a debt or equity offering may not be enough to provide an adequate capital cushion to ride out a period of very large operating losses.
So, multiple different channels and securities have to be tapped and executed to provide confidence that the issuer will be able to maintain adequate liquidity.
Different forms of financing have to be coordinated in conjunction with each other. For example, it’s common for rescue financing to include equity and high yield debt together. A common stock offering will often be paired with convertible bonds. “Converts” (as they’re often called) allow for lower coupon than traditional debt and a delay in dilution if/when they are converted into common stock. Each financing product is dependent on each other and executed at the same time.
Cruise line operators were among the first forms of service to see a huge collapse in income from the virus. Rescue financings for major cruise ship operators preceded airlines.
These types of transactions, executed predominantly by bulge bracket investment banks, were simply migrated over to other sectors in similar straits, namely the lodging, leisure, gaming, and travel sectors, which are highly cyclical due to the reliance on discretionary consumer spending.
Airlines are squeezing liquidity out of practically any asset available. Frequent flier programs are a stable source of cash flow for airlines.
United Airlines raised $5 billion, using its mileage program as collateral for the loan. It was the largest-ever capital markets offering in the airline sector.
Investors’ appetite for these financings
When operating losses go into the hundreds of billions of dollars and private sector demand isn’t sufficient, the government will step in as the market maker should it choose to. Policymakers can also let them continue on their own accord if, in their judgment, they aren’t systemically important enough to save.
Private sector interest in these offerings is still broad. The demand for airline debt, equity, and structured finance offerings has seen interest from large assets managers, hedge funds, pension funds, credit groups (i.e., of private equity firms or credit-focused funds), as well as more niche players, such of those that focus on collateralized loan obligations or investors who exclusively deal in structured finance and asset-backed securities.
For some, the overall package plays a key role in deciding whether to invest. If the offering is large enough and successfully executed, more will be onboard because it materially reduces the risk of bankruptcy. So while equity offerings are dilutive and more debt brings increased credit risk, they still need to be of a certain size to attract demand.
Investors are also prudent about what deals they invest in, so the entire financing package has to be thoughtful and carefully crafted.
Short-run versus long-run
The operating environment will remain weak for airlines going forward. The psychology regarding the virus will keep demand for air travel weak for a while.
At the same time, airlines are similar to public utilities. Their intrinsic cyclicality and dependence on discretionary flows belies their broader social utility. They provide an essential service that’s critical for the economy, with important business and leisure components over the long-run.
Accordingly, throughout their now-100+ year history, airlines have seen large government backing to help atone for the reality that they are difficult businesses to operate in a purely free market given their capital intensity and consumers’ intense focus on price.
Airline investors are probably not making a bet that the short-term will be rosy. From the perspective of the pure mathematical reality of their business (i.e., current revenue, expenses, and balance sheet concerns), practically all airlines look insolvent.
But governments also recognize the value of airlines to the economy as a whole. A lot of capital is invested in them (i.e., somebody else’s future income), they employ a lot of people, and they provide a vital service.
While the government may deem it acceptable to let certain airlines fail (and it has readily allowed smaller ones to go under), just as it let certain banks fail in 2008, it is unlikely to allow many of the larger carriers to go under.
Some countries will keep large government equity stakes to effectively socialize airlines. This is more common in countries with anywhere from just one to a few carriers (e.g., Italy) where the failure of one would represent a huge dent in the country’s consumer aviation industry.
Others will provide a certain level of government support while letting them otherwise remain under private ownership, like the United States, though seeing some level of public ownership is not out of the range of possibility. This type of scheme was considered with Boeing, given its unique market structure (high barrier to entry) and strategic importance to the US for national security purposes.
Airline skeptics are more likely to cite the short-run environment and/or the reality that many airlines have negative retained earnings over their life. (In other words, the industry has cumulatively lost money.)
Airline investors are more likely to cite implicit or explicit government support (i.e., the “too big to fail” status of many), their importance to the broader function of the economy, and longer term outlook when demand eventually returns.