Thin profit margins and huge debt levels are standard practice in the airline industry – just think how much it costs for fuel, planes, staff, maintenance and infrastructure.
For investors, airline stocks usually come cheap due to the inherent risks of their businesses. Many of us are not willing to take the risk on a fragile business model where yearly profits (and losses) can swing wildly due to intense competition and regulatory changes.
However, despite the potential for losses, many investors still search for value in the industry. So let's take a look at some top names on the ASX.
Qantas Airways Limited (ASX: QAN) is the name which is synonymous with Australian airlines. People right around the world recognise the flying kangaroo as Australia's first-class airline. Unfortunately, the airline has faced huge amounts of competition and gone nowhere slowly. In a decade the stock has fallen from $3.50 to $1.10. It has a return on equity of 3.7%, return on capital of 4% and an operating margin of 11.8%. In the past 10 years profit has fallen from $650 million to an expected loss of $200 million to $300 million in 2014. From here on, investors are hoping for a turnaround story.
The reason Qantas is facing intense pressure on its margins is largely thanks to its main rival, Virgin Australia Holdings Ltd (ASX: VAH). Like Qantas, Virgin has huge amounts of debt and its share price has rapidly descended. In the past 10 years, it has issued 1.4 million shares whilst earnings have swung from red to black year-in year-out. It has an operating margin of only 5.4%, return on capital of -1% and return on equity of -7%.
The number one issue faced by Australian airlines comes from international competition. From across the pond, Air New Zealand (ASX: AIZ) was one stock I held throughout 2013. At the time it was well below $1.00 and offered a huge dividend yield – the only major airline which offers a payout. Air New Zealand is backed by the New Zealand government who are the major shareholder, although it's total ownership has reduced in recent months. It has an operating margin of 15.6%, return on capital of 7% and return on equity of 10%. Despite its ability to leverage more profits than its rivals, in this Fool's opinion the stock is more than fully valued.
Regional airlines are a different breed altogether. They usually offer less demanding percentages of debt and have higher profit margins. For example in FY12, Regional Express Holdings (ASX: REX) or Rex, had an operating margin of 18.3% and return on equity and capital of 13%. In more recent times, Rex's margins have been put under pressure by a slowdown in the mining sector and domestic tourism.
Fellow small-cap regional airline Alliance Aviation Services (ASX: AQZ) is in a similar position to Rex, although its contracts are long term with miners such as Newcrest Mining Limited (ASX: NCM) and BHP Billiton Limited (ASX: BHP). Despite higher gearing levels (thanks to the purchase of new aircraft) and a subdued mining sector outlook, in FY13 profits grew 13% and management declared a substantial dividend – currently it yields a trailing payout of 7.2% fully franked. It has an operating margin of 26%, return on capital of 12% and a return on equity of 16.2%.
Foolish takeaway
The Australian airline industry is in a period of transition, for both large and small players. Larger players face unprecedented competition and smaller ones have to deal with a slowdown in the resources sector. In my opinion, none of these stocks are a standout buy. But investors should look for strong margins and maintenance capabilities. On paper Alliance appears to be the most competitive airline and boasts some longer contracts, which offer stability for long-term shareholders.
