Warren Buffett’s famous aversion to airline shares as bottomless pits where shareholder capital goes to die has come from a lifetime of experience. However, Buffett is known to make the wrong call every now and then. Is he missing out on good investments by ignoring BA parent International Consolidated Airlines Group (LSE: IAG), easyJet (LSE: EZJ) and Wizz Air (LSE: WIZZ)?
After several years of stunning returns, shares of discount carrier easyJet have stagnated recently as meteoric growth has slowed considerably. More than any other discounter, easyJet’s great performance has turned it into a mature, dividend-paying company. This is certainly no bad thing with a 3.5% yielding dividend, very low debt levels and predicted revenue growth of 7% to 8% per year over the near term. But its shares aren’t cheap, trading at 11 times earnings with little prospect for a return to runaway growth as budget airlines already account for 40% of European passengers. easyJet is a well-run company with industry-leading financial metrics. But future growth will necessarily involve the company moving out of its comfort zone, either through interlining agreements with traditional carriers or increased long-haul flights.
Little room for error
Shares of IAG, which was formed out of the British Airways and Iberia merger, have also seen a huge run-up in price as drastic restructuring has seen a return to profitability and the first dividend payments since being formed four years ago. While easyJet has focused on optimising its core business, IAG is attempting to fight both the American and Middle Eastern national carriers on transatlantic routes, and discount competitors in Europe through its own low-cost subsidiary, Vueling.
This gamble may pay off as long as restructuring plans at legacy carriers such as Iberia and Aer Lingus continue apace, but with €7bn in net debt, IAG management has little room for error. IAG’s expansive geographic coverage may be a point of pride for the company but I remain sceptical that the model of sprawling airlines with global operations will prove more lucrative now than it has in the past. This is especially true for IAG, whose inflexible labour contracts and significant debt restrain it from adapting as fast as more focused discounters and high-end carriers to changing market conditions.
Hungary-based Wizz Air has been well-received by investors since going public last February with the shares up 53% from their IPO price. The company’s focus on relatively under-served Central and Eastern Europe has worked well, with third quarter year-on-year revenue increasing 17.3% while operating expenses rose only 13.5%. Profits for the period were up nearly 400% as revenue gains were matched by increased margins across operations. The growth for Wizz Air shouldn’t slow down either, as each quarter sees the addition of routes in the low double-digits. Concentrating on Central and Eastern Europe has proven a boon for the airline thus far, but a relative lack of geographic concentration could be extremely harmful if economic growth in the region slows considerably.
Although Wizz Air’s growth appears set to continue for the time being, the airline industry remains a highly cyclical, capital-intensive one with relatively little moat to entry. When fuel prices inevitably rise and the macroeconomic environment turns for the worse, airlines will once again find themselves saddled with expensive planes to pay for and plummeting margins as excess capacity filters down to lower ticket prices.
Ian Pierce has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.