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By Jeremy Glaser and Basili Alukos, CPA, CFA | 05-07-2012 03:00 PM

Airlines Gaining Pricing Power

Capacity cuts and industry consolidation have given airlines the power to raise prices in the face of higher fuel costs, says Basili Alukos.

Jeremy Glaser: For Morningstar, I am Jeremy Glaser. The Wall Street Journal recently named six Morningstar equity analysts Best on the Street, including Basili Alukos in the airline sector. I'm here today with Basili to discuss some trends of the industry and his favorite pack. Basili, thanks for joining me.

Basili Alukos: Thank you for having me, Jeremy.

Glaser: So let's talk a little bit about your outlook for airlines in 2012. What are some of the big trends that you think are going to be affecting investors in this space?

Alukos: The biggest trend will be oil prices. Oil prices are extremely high. This is the first time that I've really ever seen the airlines actually have pricing power that has been able to offset the rising fuel prices. And I think that's a combination of all the capacity cuts that occurred during the recession and thereafter, as well as the consolidation and now most recently with the AMR bankruptcy. So now you have capacity tight, you have oil prices high, and airlines are actually able to get some pricing power. As a result profitability has done relatively well considering how much oil has increased from last year.

Glaser: Now let's talk a little bit about consolidation. U.S. Airways is trying to buy AMR out of bankruptcy. You know is that a deal that you think is going to go through, and if it does what would be the impact across the entire industry?

Alukos: As I think about the potential deal, to me it makes the more sense. U.S. Airways was a company I thought would run into trouble; it's actually done a phenomenal job cutting costs. But it's primarily a domestic airline, and I think it runs against tough competition with Southwest. So if U.S. Airways were to pair up with AMR, that gives the firm a strong international presence. It allows U.S. Airways to focus primarily on the domestic route, and I think it does create a formidable carrier.

At the end of the day, capacity needs to come out of the system, but there needs to be the elimination of redundant costs, such as management costs and overhead costs. Then hopefully for the airlines' sake, once all of these costs have been removed, they may actually get close to earning their costs of capital.

Glaser: It certainly sounds like management's focus on return on capital and actual return on capital numbers are getting a little bit better for the airlines, which is a bit of a change. Which airline do you think looks the most attractive today? Where would you put money to work?

Alukos: Well, the one airline that historically actually did earn returns above its cost of capital is Southwest. As I look at the firm today, I still think it is attractive. It is trading [lower than my fair value estimate right now]. I think the main disconnect between where I think the company is worth versus what the Street thinks is the expectations for the merger with AirTran.

It's taken a bit longer to actually integrate the two carriers. Southwest always flies Boeing 737s, and now you have AirTran which flies Boeing 717s. So it's bringing two airlines together. Mergers are complicated tasks, but the revenue opportunities at [Atlanta's Hartsfield-Jackson International Airport] alone I think are enough to generate the $400 million in synergies. When you combine that with potential cost cuts, Southwest will eventually start flying internationally. I think there is a lot of opportunity for Southwest.

Glaser: It sounds like you love Southwest there. Basili, thanks for so much for joining me. Congratulations on the award.

Alukos: You're welcome. Thanks for having me.

Glaser: For Morningstar, I am Jeremy Glaser.

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