FlyBoeingJets
YES, that's NICE
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This measure cannot fall too close to $0 without airlines become insolvent, but we think real yields are approaching some non-zero asymptote. Basically, we see little--short of reregulation--that might precipitate permanently higher ticket prices. Sure, yields were up substantially in 2005 as bankruptcies and stratospheric fuel prices helped reduce industry capacity. Others will be quick to remind of yields on international flights, where low-cost competition is noticeably absent. And what if we see further consolidation like the merger of America West and http://im.morningstar.com/im/premIcon.gif US Airways
To these optimists, we would point out the long history of new and existing airlines picking up capacity that has been dropped by others. We would also warn of proliferating "open skies" agreements that are bound, eventually, to invite lower-cost competitors into international skies. For these reasons, we expect real pricing yields to remain basically flat over the long term.
On top of its commodity pricing environment, the airline industry is deeply cyclical. Because of their bloated cost structures, legacy players typically lose money in economic downturns, and P/E multiples become meaningless by definition. When times are good, P/E multiples can start to look very attractive. Investors should recognize that this does not mean that a major airline's intrinsic value varies over the course of the business cycle.
In 1999, Delta Air Linestraded as high as $70, implying a trailing P/E of just under 10. In 2005, about a year after we assigned the firm a $0 fair value estimate, Delta filed for Chapter 11 bankruptcy. Without question, 9/11, SARS, and record fuel costs expedited this decline. But aggressive low-cost carriers were in plain view in 1999, and a downturn was to be expected in the coming years based on the history of that cycle. So, did Delta's intrinsic value fall from $70 to $0 in those six years, or was it never anywhere near $70?
http://im.morningstar.com/im/DALRQ10year.png
Intrinsic Value vs. Price Targets
Unlike sell-side analysts, who try to predict what stock prices will do in the next 12 months, we here at Morningstar are attempting to estimate the intrinsic value of businesses. Had we covered Delta in 1999 when the stock's P/E was attractive by most standards, our discounted cash-flow model would not have included the impact of the largely unexpected factors we noted above. However, our cash-flow forecasts would have incorporated an industry downturn, which, because it was more than a year out, was not considered by Delta's P/E multiples at that time. For differences like this, investors should expect to see stock prices--and Wall Street price targets--of airlines and other cyclical companies vary around our fair value estimate at different points in their respective cycles. Now that the current airline cycle is well into an upswing, for instance, these stocks are trading at 3-6 times our fair value estimates and 9-10 times next year's earnings forecasts.
Yet despite massive restructuring efforts and positive industrywide trends, we simply expect the legacy airlines to produce weak cash flows because their business model remains less efficient in a highly commodified pricing environment. The effect is particularly harsh through cyclical downturns, for which we account in our models. As we noted above, forward P/E ratios do not capture these more distant struggles, and such earnings multiples may admittedly be better suited to the game in which short-term investors and speculators participate. But for the investor who is thinking about buying and holding a stock longer than a year or two, the method is severely limited.
The bottom line is simple: We do not recommend legacy airlines to long-term investors who seek stable price appreciation throughout economic cycles. For those who want to gamble, please do so at your own risk.
To these optimists, we would point out the long history of new and existing airlines picking up capacity that has been dropped by others. We would also warn of proliferating "open skies" agreements that are bound, eventually, to invite lower-cost competitors into international skies. For these reasons, we expect real pricing yields to remain basically flat over the long term.
On top of its commodity pricing environment, the airline industry is deeply cyclical. Because of their bloated cost structures, legacy players typically lose money in economic downturns, and P/E multiples become meaningless by definition. When times are good, P/E multiples can start to look very attractive. Investors should recognize that this does not mean that a major airline's intrinsic value varies over the course of the business cycle.
In 1999, Delta Air Linestraded as high as $70, implying a trailing P/E of just under 10. In 2005, about a year after we assigned the firm a $0 fair value estimate, Delta filed for Chapter 11 bankruptcy. Without question, 9/11, SARS, and record fuel costs expedited this decline. But aggressive low-cost carriers were in plain view in 1999, and a downturn was to be expected in the coming years based on the history of that cycle. So, did Delta's intrinsic value fall from $70 to $0 in those six years, or was it never anywhere near $70?
http://im.morningstar.com/im/DALRQ10year.png
Intrinsic Value vs. Price Targets
Unlike sell-side analysts, who try to predict what stock prices will do in the next 12 months, we here at Morningstar are attempting to estimate the intrinsic value of businesses. Had we covered Delta in 1999 when the stock's P/E was attractive by most standards, our discounted cash-flow model would not have included the impact of the largely unexpected factors we noted above. However, our cash-flow forecasts would have incorporated an industry downturn, which, because it was more than a year out, was not considered by Delta's P/E multiples at that time. For differences like this, investors should expect to see stock prices--and Wall Street price targets--of airlines and other cyclical companies vary around our fair value estimate at different points in their respective cycles. Now that the current airline cycle is well into an upswing, for instance, these stocks are trading at 3-6 times our fair value estimates and 9-10 times next year's earnings forecasts.
Yet despite massive restructuring efforts and positive industrywide trends, we simply expect the legacy airlines to produce weak cash flows because their business model remains less efficient in a highly commodified pricing environment. The effect is particularly harsh through cyclical downturns, for which we account in our models. As we noted above, forward P/E ratios do not capture these more distant struggles, and such earnings multiples may admittedly be better suited to the game in which short-term investors and speculators participate. But for the investor who is thinking about buying and holding a stock longer than a year or two, the method is severely limited.
The bottom line is simple: We do not recommend legacy airlines to long-term investors who seek stable price appreciation throughout economic cycles. For those who want to gamble, please do so at your own risk.
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