Brian Gaynor: Travel boom has airlines flying high

Kiwis preferred carrier is Air New Zealand. Photo / 123RF

Airlines are on a roll, with long-term critics of the industry, including Warren Buffett, now investing in the sector.

The International Air Transport Association (Iata) recently reported that global passenger traffic grew by 7.9 per cent in the first half of this year, on a revenue passenger kilometres (RPKs) basis, compared with the same period last year. This was the highest January-June growth rate since 2005.

The strong start to the year has been driven by a positive global economic backdrop and lower airfares.

The Asia-Pacific region, which has a 32.8 per cent share of global passenger traffic, had a January-June 2017 growth rate of 10.6 per cent, the highest of any region. The two major Australasian carriers, Air New Zealand and Qantas, have benefited from the travel boom, albeit that they are operating in a competitive environment.

Air New Zealand reported a net profit after tax of $382 million for the year to June 30, 2017. This was 17.5 per cent below the $463m for the 2016 year, an exceptionally good year.

The June 2016 year benefited from a non-recurring $112m foreign exchange hedging gain, low fuel prices and a less competitive environment.

This year, chairman Tony Carter wrote: "A significant increase in industry capacity was the main driver of the reduction, as a number of new international competitors entered the New Zealand market. However, towards the end of the year, conditions stabilised and we saw positive revenue momentum emerge".

Chief executive Christopher Luxon added: "In the beginning of 2017, the volatility from new capacity in the market required us to set a wide range for our initial full year guidance. As the second half of the year progressed, we saw the market dynamics improve beyond our expectations, which resulted in a subsequent upgrade to our earnings guidance that we ultimately delivered at the end of the year. As I look ahead to the coming year, the positive momentum continues in many of our key markets." Some 8500 Air New Zealand staff will receive a bonus of $1700 each, at a total cost of $14.5m.

Air New Zealand had an excellent operating year, carrying 16 million passengers compared with 15.2 million in the 2015-16 year, while its RPKs increased by 4.8 per cent compared with a capacity increase - in terms of available seat kilometres - of 6.3 per cent.

The airline had 10.4 million domestic passengers compared with 8.5 million five years ago, and 5.6 million international passengers compared with 4.6 million in 2011-12.

Kiwis are flying far and wide and their preferred carrier is Air New Zealand.

Qantas reported a net profit after tax of A$853m for the June 2017 year compared with A$1,029m for the previous year. The latter figure included a A$201m net gain from selling Sydney Airport Terminal Three.

Chief executive Alan Joyce was quoted as saying: "The result marked completion of a turnaround plan that has repositioned Qantas as one of the most profitable airline groups in the world. We operate in a very competitive environment, so continuous improvement is crucial".

He went on to say, "We have a plan to keep delivering sustainable returns well into the future. We're investing in lounges, Wi-Fi and cabin upgrades; looking at new aircraft to evolve our network; and diversifying into new businesses like insurance and financial services".

The carrier also announced that its 25,000 employees will receive a bonus of A$2500 for each full-time worker and A$2000 for part-timers. This will cost A$55m for non-executive employees compared with Air New Zealand's total bonus of $14.5m.

One of the more distinctive features of the two carriers is their massive operating cash flows, with Air New Zealand reporting net cash from operating activities of $904m for the year, while Qantas reported a A$2,704m figure.

Consequently, Air New Zealand had bank and short-term deposits of $1,369m as at June 30, while Qantas had A$1,775m.

Joyce claims that Qantas is "one of the most profitable airline groups in the world" but Air New Zealand could make a similar claim as its 10.6 per cent Ebit/revenue margin is higher than the industry average and higher than Qantas.

There has been a remarkable change in sentiment towards airline stocks, particularly by Warren Buffett and Berkshire Hathaway.

Buffett has been a consistent critic of the airline sector, for many reasons including:

Airline companies have low profitability and regularly operate at a loss

Low-fare entrants can be extremely disruptive

Airline companies have little price discipline and slash fares when they face competitive pressure.

Airline earnings are difficult to predict because they are influenced by several factors including oil prices, currency movements, economic conditions, capacity issues and fare price pressures

However, in the past 12 months Buffett has completely reversed his view of the industry and Berkshire Hathaway now owns 9.6 per cent of American Airlines, 7.2 per cent of Delta Air Lines, 8.0 per cent of Southwest Airlines and 9.3 per cent of United Continental Holdings. These are the four largest global airlines in terms of sharemarket capitalisation.

This investment strategy has had rather mixed results, as American Airlines' stock price is down 4.2 per cent since the end of 2016, Delta is off 4.1 per cent, Southwest is up 4.6 per cent, while United Continental's share price has declined 15 per cent.

These figures compare with a 10.4 per cent appreciation in the US S&P500 Index over the same eight-month period.

By comparison, Air New Zealand's share price has appreciated 62.6 per cent since the end of 2016 and the Qantas share price by 71.8 per cent.

Buffett should have invested in the two main Australasian carriers, but he is a US-centric investor.

The Oracle of Omaha told CNBC, that "it's true that the airlines had a bad 20th century. They are like the Chicago Cubs. And they got the bad century out of the way. The hope is they will keep [aircraft] orders in reasonable relationship to potential demand".

The Cubs won baseball's 2016 World Series, the team's first title since 1908.

Meanwhile, short- and long-term forecasts for the industry are positive.

Iata recently released its global mid-year 2017 update, which revised its 2017 revenue passenger kilometre growth forecast from 5.1 per cent to 7.4 per cent. Iata also raised its freight tonnes growth rate from 3.3 per cent to 7.3 per cent and the industry's Ebit margin forecast from 6.6 per cent to 7.7 per cent.

The Asia-Pacific will experience the strongest RPK growth and is predicted to have a higher load factor than any other region.

Iata's 20-year forecast concludes that global passenger numbers will nearly double from 3.8 billion passengers in 2016 to 7.2 billion in 2035. More than 50 per cent of the growth will occur in the Asia-Pacific region, with China expected to displace the US as the world's largest aviation market around 2024 and India displacing the UK in third place the following year. Indonesia is predicted to be the world's fifth largest aviation market in 2035.

These growth projections will put huge pressure on airports and safety requirements, as well as having a major environmental impact. New carriers will enter the market, particularly in the Asia-Pacific, and aircraft orders may be too aggressive at times. That could lead to surplus capacity and fare price pressures.

Only time will tell whether Buffett has made the right decision to change his view on the sector, but at this stage, the four largest non-US listed airline companies - Ryanair, China Eastern Airlines, Air China and UK based International Airlines Group - have substantially outperformed Buffet's US carriers, in terms of sharemarket performance.

Buffett should be paying far more attention to Asia-Pacific because it offers the most exciting growth prospects.

•Brian Gaynor is an executive director of Milford Asset Management, which holds shares in Air NZ and Qantas on behalf of clients.