A Technical Analysis on Airlines

As a traveller you might be familiar to the prices Airlines charge for their services. You might, like me sit, in front of your computer during several days to able to get the most opportune price. This has often proven too big a gamble. Not such a gamble is an investment in the Airlines Industry and in this post we will elaborate why.

 

Financial Performances of Airlines have been linked to one weighty exogenous factor. The resource we are referring to is Oil. Oil prices have been in a constant downturn for the last two years. Below we graphed Crude Oil Prices over the last 3 years, peaking at 93$ and hitting rock deep at 29$. Even though Oil was considered to be a safe bet, as supposedly it was a scarce resource, tables have flipped. This is due to the recent chain of events, markets have been flooded with oil, making it extremely cheap.

The movement on the oil spot prices are shocking but should be no surprise to anyone anymore. The chart below depicts the crude oil prices since 1861 up to now. The red line being adjusted for inflation, the blue being not adjusted. If we consider the inflation adjusted rate, determining the representative purchasing power, we can tell that fluctuations and high volatility are no rare event.

 

 

After this short insight into Oil Price we will loop back to Airlines. All the data we will be referring to has been aggregated from the SEC Fillings. You will be able to download the full Excel file under this link. We will take a closer look at American Airlines (NASDAQ:AAL) and Delta Air Lines (NYSE:DAL) To have a broader view of the whole Industry we will also point out the Airline Index (ALX).

 

The Airline Index is composed of shares of the following issues:

 

1. Alaska Air Group
2. KLM Royal Dutch Airlines NV
3. America West Holdings Corporation CL
4. Northwest Airlines Corp.
5. AMR Corporation Southwest Airlines Co.
6. Continental Airlines, Inc.
7. B UAL Corporation
8. Delta Air Lines Inc.
9. US Airways Group, Inc.

 

Oil has been the main expense in the past years for Airlines. In 2012 and 2013 Fuel made up for about 36% of all expenses for both Delta Air Lines and American Airlines. American Airlines stated that a 1 Cent increase in Oil Prices would increase Expenses by 44 Million. This goes without saying that a decrease in Oil Prices will decrease Expenses by 44 Million. These Expenses are so fatal that both companies have dedicated hedging-programs to the Oil prices.

 

The fuel hedging activities are intended to reduce the financial impact from changes in the price of jet fuel. AAL and DAL actively manage fuel price risks through these hedging programs intended to reduce the financial impact from changes in the price of jet fuel. These fuel hedging program utilize several different contract and commodity types. Market volatility of oil prices greatly impacts fuel costs. Fuel costs are managed through two primary methods: purchase agreements and fuel hedging.

 

The American Airlines hedging-portfolio has continuously outperformed the Delta Air Lines hedging-portfolio. American Airlines was able to hedge the Price per Gallon down to 2.91$ in 2014, whereas Delta Air Lines had to spend 3.47$ per Gallon.

 

American Airlines was able to reduce its “Fuel and related Taxes Expenses” from 10’592 Million to 6’226 Million which corresponds to a decrease of 41%. As the amount of Gallons purchased has decreased by only one percent. The percentage decrease of the Average Price per Gallon is the exact same as the percentage decrease in their Fuel Expenses. Which lets us make the assumption that the decrease is majorly due to the volatility on the financial markets and the hedging-efforts made by American-Airline

 

AAL Total Expenses have decreased by 10% in the last year. Based on the Total Revenues generated by commercial flights and the amount of boarded passengers we will generate the approximate average ticket price. Several Fees and Surcharges are added to the Total Revenues generated by commercial flight. The average price paid is not an exact representation of the real average price paid, as it includes surcharges and fees that most people might avoid. Nonetheless it will still give us a blurred idea of reality.

 

In 2014, 197 Million Passengers boarded AAL flights generating Total Revenues of 37’124 Million. The average price per Ticket was 188,45$. In 2015, 201 Million Passengers boarded AAL flights generating Total Revenues of 35’512 Million. According to our calculations the average price per Ticket was 176,68$. So as the price of Oil Expenses has decreased by 41% and as Total Expenses have decreased by 10% the Average Ticket Price has only decreased by 6%. This lets us assume that travellers have not been usurping from Oil Price decreases.

 

American Airlines Official Statement is as follows:

 

“Fuel prices have fluctuated substantially over the past several years. We cannot predict the future availability, price volatility or cost of aircraft fuel. Natural disasters, political disruptions or wars involving oil-producing countries, changes in fuel-related governmental policy, the strength of the U.S. dollar against foreign currencies, changes in access to petroleum product pipelines and terminals, speculation in the energy futures markets, changes in aircraft fuel production capacity, environmental concerns and other unpredictable events may result in fuel supply shortages, additional fuel price volatility and cost increases in the future.”

 

This is a plausible explanation if it wasn’t for the Fuel Surcharges, that have in some cases been rising and fail to adjust to the low Oil prices (Oil Is Cheap — Why Are Airlines Still Imposing Fuel Surcharges?). It’s hard to get someone’s hand out of your pocket once it gets in.

 

At this point we will turn our attention to the investment side of things. The Graph below plots the percentage changes of Crude Oil, the Airline Index, American Airlines and Delta Air Lines.

 

 

As Oil Prices have fallen, Airline stocks and the Airline Index have been growing. There is a negative correlation between oil prices and Airline Stocks. Which means that both move in opposite direction. Analysts have been saying that the decrease in Oil Prices would have diminishing impacts on Airline Stocks, which has not happened yet, quite the contrary has been occurring  as seen in the Graph below. As Oil Prices have fallen, correlation has increased.

 

As Oil Prices and Total Expenses have been decreasing Average Ticket Prices have not decreased accordingly. This has created an extra Profit cushion. These Earnings will most likely be retained or used to create adequate provisions.

 

These measures will have a positive impact on Airlines, allowing some financial restructuring. This has lead ratings agencies to upgrade Airlines. The improvement of those Ratings will dilute the cost of debt, allowing the industry to take on more and cheaper debt while keeping their tax shield up. So what can be expected in the future? Possibly share repurchases and higher dividends. American companies tend to take on debt to pay dividends. This makes the outlook for the Airlines very positive which reflects on their shares and makes them a must-have in every Portfolio.

What Pokémon taught me about Portfolio-Management

If you don’t know Pokémon by now you must have been living under a rock. Pokémon is one of the biggest franchises to ever have existed. It has fascinated old and young for 20 years now. The basic Concept of Pokémon is having a team of up to 6 Pokémon and fight other Pokémon-Trainers to become the best Trainer there has ever been. You might be wondering where the link between Pokémon and Portfolio-Management is.

 

To Answer this question, and maybe prove you that I’m not completely crazy, we will go more in depth about how Pokémon works. The Pokémon Universe contains more than 1000 Pokémon and keeps growing steadily. Whenever I started playing the Pokémon count was at 151. There are various Types of Pokémon, Fire, Grass, Water, Fly, Ghost and much more. The particularity about the diffrent Types is are their strengths and weaknesses. So for example a Fire Pokémon, will be really strong against a Grass Pokémon but will rarely succeed to win against a Water-Type.

 

A common mistake is that people tend to setup up their Team in a really unbalanced way. An “unbalanced team” is a team consisting of Fire-Types only. The Idea of having a team overexposed to any kind of Types might sound like a good Idea, but it is a common mistake made by beginners. Even though the Fire-Types are really strong, a Team only composed off Fire Pokémon is a poor Idea. The Team will obviously excel against Grass-Types, but get demolished by Water Types. 1 or 2 Water Pokémon that are the same or lower level then your Fire Pokémon will be enough to finish you. So obviously as a Fire-Type trainer, running into a Water trainer, that you have to beat to advance in the story, is pretty frustrating. Same applies to having a team composed of only one Pokémon, that has a really high level.

 

In all the other cases it will be more efficient having a diversified Team. Fire is not strong again any other Type, it just deals normal damage. So if you are fighting against a trainer having Rock-Type Pokémon your task will be much easier if you have a Team with one Water-Type Pokémon, as Rock Pokémon’s are weak to Water attacks.

 

By now it might be clear what the parallel between Pokémon and Portfolio-Management is. If not let me refer to the novel “Don Quixote”. Out of this novel surged one of the pillars of Finance. The line I’m referring to is the following: “It is the part of a wise man to keep himself today for tomorrow, and not venture all his eggs in one basket.”. As crazy as Don Quixote seemed to be, he knew that you should never put all your Eggs in one basket. This is a piece of advice goes to say that one should not concentrate all efforts and resources in one area as one could lose everything.

 

If you are still wondering, why you shouldn’t put all your Eggs in one basket I will try to explain it. Obviously you might be thinking if the market, industry or company does really good I might get a really high return. This might be true, but at this point you are not investing anymore but you’re gambling. In one scenario you might beat the market, but in the other case you might lose a lot of money if the company you invested in defaults. In this case you might lose all your money. Psychologically speaking the loss of a certain amount will hurt you more than a monetary increase of the same amount.

 

In Finance this phenomenon is referred to as diversification. The benefits of diversification are various, a simple explanation was delivered by Markowitz and Tobin. They explain the concepts of correlation, minimum-variance portfolio and of the tangential portfolio which I will not go into detail much more. I’ll present you an example my Finance Professor used to introduce us to the concept of correlation.

 

To explain diversification, we are going to make some little assumptions. We will be in a stock market that is composed of only one country. So imagine that in the little Republic of Finance there are only four stocks:

 

1. Umbrella Corp ( NOT the Resident Evil military organization)
2. Rubber Boots Corp
3. Sun Cream Corp
4. Ice Cream Corp

 

If you could make portfolios of up to two stocks you would have the possibility to make up to 6 different Portfolios. Let’s compare three possible Portfolios:

 

1. Portfolio A (Umbrella, Rubber Boots)
2. Portfolio B (Sun Cream, Ice Cream)
3. Portfolio C (Umbrella, Ice Cream)

 

Portfolio A and B are really seasonal and have therefore both a positive correlation. If the sales off Umbrella increase, the sales of Rubber Boots will increase as well, as we might be in a bad weather period. This is referred to as correlation. A positive correlation indicates that if the amount of Umbrella sales increases the amount of rubber boots increases by a smaller or bigger amount. This does not mean that an increase in sales off Umbrellas is due to an increase in sales of rubber boots. And vice-versa. In most cases the reason for the increase in sales is an externality, in our case for example announcement of a rain period or a rain period itself.

 

Portfolio C is not dependant on seasons as it has one asset of Umbrella Corp and one asset of Ice Cream Corp. These assets combined have a negative correlation. This means that if the sales of Ice Cream increase, the sales of Umbrella Corp will decrease and vice-versa. Portfolio C will be generating steadier incomes and cash flows. Due to its negative correlation it will be much less volatile then Portfolio A and B. Volatility is the measurement of risk, which an investor will always want to keep at a minimum.

 

So an Investor will always seek to diversify its portfolio and keep his income less volatile. Diversification is the Alpha and Omega across Sectors. You will never want to have a too big exposure to a certain company industry or even asset class. This is what Pokémon has taught me about Portfolio Management.