Terrorist scares, high oil prices, growing concern about the environment – 2006 should have been a bad year for aviation. But three years of solid global economic growth have helped airlines to fill their seats, in part due to the cuts in capacity in 2001 that followed the September 11th terrorist attacks. The UK’s flagship carrier, British Airways (LON:BA), has seen its share price rise 61% in the past year alone.
A growing middle class that can afford to fly has led to the launch of new airlines and new plane orders in developing markets in particular. China already has 134 airports and plans to increase that figure to 200 over the next ten years as regional services expand. Air India recently took delivery of its first new planes for ten years; the 18 Boeing 737-800s are part of an $11bn order placed a year ago for a 68-strong fleet. All this means business is currently booming for the likes of Airbus and Boeing – aircraft deliveries look set to rise from 668 in 2005 to 1,000 by 2009.
But can the good times continue for this notoriously cyclical industry?
Dan McCrum of Investors Chronicle is sceptical. Deliveries are a lagging indicator, whereas the book-to-bill ratio, which shows current orders against current deliveries, looks “worrying”. A rising ratio means growth is picking up, while a falling one suggests weakness ahead. According to some analysts, this ratio peaked at the end of 2005 and is now in sharp decline. Not even developing market demand will help – the Asia-Pacific region “already accounts for almost a third of the combined Airbus and Boeing backlog”. What’s more, says McCrum, higher fuel costs have swallowed much of airlines’ higher revenues, making order deferrals or cancellations more likely. This is bad news for stocks exposed to civil aerospace work, such as Rolls-Royce (see below).
So what of the airlines themselves? There has been much excitement over sector consolidation in recent months. In November, US Airways announced an $8bn hostile approach for bankrupt rival Delta Airlines and last month Qantas agreed an $8.6bn bid from a consortium backed by Macquarie and US private-equity group Texas Pacific. The hope is “that consolidation will keep the good times rolling and put a lid on capacity”, says Nils Pratley in The Guardian. But the deals won’t change the industry’s semi-permanent problems: “volatile fuel costs, illegal subsidies, strikes, pension liabilities and high fixed costs”. In the US, for example, most main players “have been in and out of bankruptcy protection”, emerging restructured and “ready to undercut successful operators”, which sustains excess capacity.
And the same headwinds airlines braved in 2006 are still here in 2007 – terrorism fears remain high, the threat of higher oil prices hangs over the market, and in the UK, the chancellor has exploited ‘green’ worries as a way to push through a doubling in air-passenger duty from February. Meanwhile, budget carriers are starting to push into the long-haul market, with operators promising fares as low as £75 for a one-way ticket from London to Hong Kong, for example.
Life will get tougher for the airline sector in 2007, but that doesn’t mean there aren’t interesting investments to be found. In the box on the right, we take a look at two developing market carriers that should benefit from rising local demand.
The aviation stocks to buy… and what to avoid
Rolls-Royce (LON:RR, 453p), “the key stock within UK civil aerospace”, says Investors Chronicle, has done well in recent years as aircraft orders picked up, with half its revenues coming from the ‘aftermarket’ – supplying replacement parts and servicing – rather than new equipment. However, it has been losing market share to American rival GE since 1995, and given concerns that the aerospace cycle is turning, and the weakness of the dollar, Investors Chronicle reckons the stock is a sell. Broker Panmure Gordon feels the shares are “expensive”, on a trailing p/e of 19, and notes that directors have been “significant net sellers” during 2006.
Among the airlines, while the more established players look unattractive for the reasons outlined on the left, developing market carriers may be worth a look. These include two Latin American operators. MoneyWeek wrote about Copa Holdings SA (NYSE:CPA, $46.6), owner of Copa Airlines, three months ago when we said its service to Havana would thrive in the post-Castro era. Helped by bumper November figures for both passenger and cargo traffic, the shares are now around a third higher, but still look promising.
Another attractive prospect could be Brazil’s Gol Linhas Aereas Inteligentes SA (NYSE:GOL, $28.7), which, together with bigger rival TAM, commands 87% of the domestic market. Strike action and overbooking has seen delays at Brazilian airports in recent months, but Gol is a prime candidate to attract foreign investment if Brazil’s government raises the limit on the stake foreign investors can hold in a firm – it is considering a hike from the current 20% to between 40% and 49%.