Airline Round-Up In Coronavirus

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Summary

Let us begin with what should be an obvious conclusion: Airlines are an incredibly volatile investment option at this point. An industry that has (through massive consolidation over the past two decades) developed capacity discipline, which led to the most profitable decade in the history of aviation, brought to its lowest point over the course of a turbulent few weeks.

You can forgive airline CEOs for the feeling that the era of bankruptcies, every economic downturn, was a thing of the past: profits had become stupendous, enticing even longstanding aviation-nadir Warren Buffett to lay down a massive bet on the future of the airlines. No one foresaw a worldwide pandemic shuttering the entire transportation industry.

A once-in-a century catastrophe is a hard thing to see coming and impossible to plan for fiscally. So it is that an entire industry was brought to its knees in a matter of a few weeks. There are plenty of Monday morning quarterbacks to question every move that the airlines have made with FCF over the past decade of profitability, but none of that is useful to an investor now. The question is one of future prospects: we already know that the airlines have been decimated by COVID-19, now we need an effective crystal ball to figure out what comes next.

Furloughs, early out options, reduction in headcount

Employment for network and low-cost carriers stood at 534,767 in July 2001.But 4 years later, in July 2005, employment had fallen 28 percent to 383,859. This drop was driven by a decline in employment by the network carriers compared to increased hiring by low-cost carriers. Network carrier employment fell by 34 percent, from 465,198 in July 2001 to 308,714 in July 2005.

During the early days of coronavirus, the immediate response from airline executives was that the sudden drop in passenger demand was a short-term problem: passengers - the thinking went - were not afraid of flying like after 9/11. There would be a snap-back return in demand as soon as the impact of the virus waned. In hindsight, this was hopeless optimism: referring to a nearly empty glass as half-full.

It took a month before full acceptance of the situation was realized: this was worse than 9/11. People were not afraid of flying per se, they were afraid of being in close proximity to total strangers. Social distancing is simply impossible in commercial aviation. Even though no current outbreaks have been traced back to a particular flight, there is little question that the velocity of worldwide spread was the result of the rapid global movement produced by aviation.

There is little question that airline demand will be off for several years. Historical examples are nonexistent as it relates to demand curves following a worldwide economic shutdown, so the slope of the curve is a guessing game. Still, though there is no perfect predictor, a combination of the demand effects of 9/11 and the Great Recession provides the cleanest comparison for future predictions.

Less than Half Empty

Boeing CEO Dave Calhoun recently predicted a major airline will go bankrupt as a result of his assertion that passenger traffic will be below 25% of 2019 enplanements through September. Further, Calhoun expressed skepticism that traffic levels would exceed 50% by the end of the year. There is, perhaps, a bit of schadenfreude to Calhoun’s nihilism: Boeing was already in the midst of one of the most turbulent years in its existence. Misery loves company. The complete shutdown of capital expenditures in aviation does not bode well for Boeing, who suddenly has all the time in the world to get the 737 MAX recertified.

There is no precedent for the sustained decrease in demand for air travel that Calhoun proposes, but there is also no precedent for a virus that shuts down massive parts of the economy worldwide. Maybe Calhoun is correct, but without a firm basis for his assumption it remains a wild guess - and one that does not appear to have any basis except that of current lousy conditions. For some context, within three months of 9/11, domestic and international flying had returned to better than three quarters of pre-9/11 numbers. Within six months, both stood around 90%.

Of course, this is a different situation: not only is there a broad social reluctance to travel in close proximity to strangers, the economy is all but certain to reach the depths of the Great Recession, if not touch unemployment numbers not seen since the Great Depression. The present situation likely represents a combination of the adverse impacts of 9/11 and the Great Recession rolled together. The one-two punch feeds into the skepticism of Calhoun for a V-shaped recovery. Calhoun is not alone: Warren Buffett’s Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) clearly came to the same conclusion when they divested all of their airline holdings at a sizable loss.

Delta Air Lines (DAL) recently sent a communication to their pilot group announcing that the carrier was anticipating a surplus of 7,000 pilots through the end of the year. This number falls more or less in line with Calhoun’s 50% year-end scenario. Due to the complexities of first furloughing and then retraining pilots once they return, Delta noted that their furlough plans were predicated on demand projections for summer of 2021: in this case, they anticipated between 2,500 and 3,500 excess pilots. This represents around a third of their staffing at the pilot position, which in theory should equate to their expectation of passenger demand: around 67% by next summer.

United Airlines (UAL) has begun the furlough process through a displacement of their pilot group (no one can be furloughed under the terms of the CARES act until October 1st, but this does not prevent the airlines from preparing for such a furlough). The displacement produces the potential for a draw-down of 3,000 to 4,000 pilots. This is a bit more pessimistic than Delta’s numbers, but not by much.

Preserve Cash, No Matter What

If this seems (from a historical perspective) a bit pessimistic, it is. The low point during the Great Recession saw domestic air travel at 90% of 2006 enplanements. The average during the multi-year recessionary dip was 94%. Interestingly, international travel during the Great Recession was (for the most part) at or above pre-recession demand levels: the average for international travel was 104% from 2008 through 2012. Only four months total recorded 3% or more below peak values. (Click here for documentation of pre-9/11 and Great Recession airline demand levels).

If you combined the effects of 9/11 with the Great Recession, mathematically you would wind up around 85% of pre-crisis capacity by the end of the year. That is a difficult number to envision given the recent single-digit numbers being posted daily by the TSA, but it provides a hint at a critical question as it relates to the return of demand: how essential is air travel to businesses and individuals? Are the economic and personal incentives to travel so slight that demand levels below 25% can persist for several months?

Social Conditioning

There is little question that social distancing and nervousness surrounding coronavirus have produced strong incentives for individuals to avoid unnecessary travel, yet there are also many strong incentives that prompt individuals and companies to travel in the first place. There are no iron-clad numbers to sort out how much business travel can be replaced (albeit imperfectly) with video conferencing apps such as Zoom (ZM), or simply put off altogether. Yet, it should be clear that a good portion of business travel reflects the economic necessity of continued profitability. With nearly all businesses feeling the pressure of a couple months of restricted cash flows, there will be a strong financial incentive to do what it takes to return to productive business activity. For some businesses, this requires air travel.

In reality, these numbers will be highly influenced by the development of treatments and vaccines to COVID-19. Still, 25% by September seems far too low: the low point measured by TSA screening was 3.6% of 2019 numbers on April 16th; a month later, on May 16th, that had increased to 9.3%. That is a 260% improvement in a month. By May 22nd, it was 12.5%, already half of Calhoun’s 25% forecast: in a bit over a month there has been a 347% rebound in demand. It is impossible to believe that the remaining three-plus months until September will fail to do more than another 100%. States have just barely begun the process of limited reopening; it is difficult to believe that the growth trajectory of airline enplanements will flatten out as more and more states open up.

The downside for airlines is obvious here: relaxing restrictions at the state level has the potential to result in a resurgence of COVID-19 cases, though there is an implied consensus among epidemiologists that COVID-19 will wane over the warmer summer months. It will not completely go away, and a resurgence in winter is all but a given, but summer has the earmarking of a temporary reprieve to total social isolation.

If anything, September may represent the high point for the rest of the year. I would not be surprised to see travel over 60% going into September. But, like pretty much everyone else taking a stab at it right now, that amounts to a wild guess. Still, color me shocked if it is 25% or less.

With a vaccine well within the realm of possibilities by next summer, I would expect something much more like Great Recession demand at that point: better than 90% demand of pre-coronavirus levels. Perhaps people will still be hesitant to travel due to the lingering effects of a year’s worth of social distancing, but this should largely be offset by those who are anxious to escape their shut-in confinement. From this regard, betting on the airlines may be something like betting on oil companies: the extreme imbalance between supply and demand is going to result in a huge rebalance on the supply side. Neither industry can simply flip a switch to turn supply back on after it has pulled back sharply - not the least because of debt overhang and a likely paucity of investment dollars.

Expect a supply-demand imbalance to be in place this time next year - this time with a serious deficit of available seat miles. The airlines are in cash flow preservation mode, which means that they will likely undershoot on their demand forecasts for next year: with little leverage in the debt markets, they simply cannot afford to carry excess capacity. The long pole at that point will be retraining pilots and recertifying aircraft: it is not a simple or short process to return a pilot or airplane to revenue flying, following an extended absence. With several airlines hinting towards 30%-plus reductions in capacity, the airlines could be sharply back in the black by as early as Q2 2021.

Oil prices may be a bigger factor in 2021, offsetting some of the supply advantage for airline pricing. Still, with massive cash inflows from the federal government, most of the airlines should be able to make it through the winter to the relatively fat months of post-COVID-19 life. And while the grants recently awarded to the airlines only covered roughly 70% of payroll costs until October 1st (the earliest that airlines can furlough under the CARES act), every airline has instituted voluntary leave and separation packages. A significant percentage of employees for several airlines have taken leaves, significantly reducing payroll costs. The continued return of flying over this summer has the possibility of covering some more of those variable costs. Payroll, in other words, has a good shot to be fully covered by the grants by October 1st. With labor representing the number one cost for an airline, this is significant as it relates to liquidity.

You can view my video detailing my analysis of the predicted demand effects on air travel caused by COVID-19 here. Follow me on Seeking Alpha for updates on aviation and the rest of the market.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.