Airlines' Overcapacity Fears Dampen Joy from Low Oil Prices
Valuation metrics
For a capital-intensive industry such as the airline industry, we use the EV/EBITDAR (or enterprise value divided by earnings before interest, tax, depreciation, amortization, and rent). This is because in a capital-intensive business, companies often end up taking varying levels of debt. EV/EBITDAR is a capital-structure-neutral ratio that takes both equity and debt capital into account, so it allows us to compare companies with different debt levels.
For airlines, we go a step further. Airlines often use operating leases to buy aircraft, which results in a huge amount of rent. To neutralize this, we use the forward EV + Op. leases-to-EBITDAR ratio (enterprise value plus operating leases to earnings before interest, tax, depreciation, amortization, and rent) to value airline companies. A forward multiple uses estimates for the next 12 months.
Airline industry valuation
In October, the forward EV + Op. leases-to-EBITDAR multiple for the industry stood at 5.5. This is the highest valuation the airline industry has had in 2015 but lower than the peak in 2014. The high valuations in 2014 were supported by the declining fuel costs, so increased profitability resulted. The industry multiple had increased to 5.7 by the end of December 2014.
Airlines then started investing in capacity growth to earn higher revenues. However, throughout the year, the airline industry has seen a decline in both capacity utilization and passenger yields. Thus, overcapacity fears loom large.
Airline industry valuation has remained almost constant since January 2015, even though airlines continue to report increased profits. To avoid the risk of investing in a single stock, investors can get exposure to airlines by investing in the iShares Transportation Average ETF (IYT), which invests 5.7% of its holdings in Alaska (ALK), 4.7% of its holdings in United Continental (UAL), 4.2% of its holdings in Delta (DAL), 4.0% of its holdings in Southwest (LUV), 3.5% of its holdings in American Airlines (AAL), and 2.2% of its holdings in JetBlue (JBLU).
Browse this series on Market Realist: