Episode Transcript

 

>> This film, taken in 1903, recalls the first flight of this primitive [inaudible] plane, making aviation history. As the two brothers prepare to attempt the first catapulted takeoff, man's age-old dream of flight becomes a reality.

 

>> That first flight, near Kitty Hawk, North Carolina, was hundreds of years in the making. Engineers, physicists, mathematicians, and machinists around the globe contributed to the epic achievement of mechanical flight. Eleven years later, in 1914, the first commercial airline was founded. With a fleet of two primitive seaplanes, the Saint Petersburg-Tampa Airboat Line ran daily flights between St. Pete's and Tampa, charging $5 for a one-way ticket or 100 pounds of freight. The airline operated for four months, shutting down operations before it turned a profit. Today's airlines benefit from advanced technology, more diverse revenue streams, and high demand. But they also face high fixed costs and extreme sensitive to macroeconomic changes. As Warren Buffet famously joked, if a far-sighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down. The airline industry is an integral part of the global economy. But what does the risk-reward tradeoff look like for the airlines over the longer term? Will loyalty programs continue to boost profits? Will sustainability pressures further weigh on cost management? And will tariffs bring fleet upgrades to a ground stop?

 

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To understand today's investment landscape, it's important to know how we got here. This is the OUTThinking Investor, a podcast from PGIM that examines the past, the present-day opportunities, and the future possibilities across global capital markets. Three experts will discuss how the airline industry has evolved and where it sits today.

 

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Oscar Munoz is former CEO and chairman of United Airlines and author of the book Turnaround Time: Uniting an Airline and its Employees in the Friendly Skies. Jack Fitzsimmons is a credit analyst on the US-leveraged Finance Credit Research Team at PGIM Fixed Income. Shawn Goodyear is a credit analyst for PGIM Fixed Income's European Investment Grade Credit Research Team. The airline industry contributes about 4% to global GDP directly. Supports close to 100 million jobs around the world, and transports nearly a third of all global trade. But as investments, the airlines' track record has had its ups and downs. Oscar Munoz has witnessed this firsthand.

 

>> Over the past 50 years, the industry has evolved like every other business, mightily. There's been lots of consolidation. Regulation has allowed airlines to operate in the free market economy in a very competitive space, as opposed to being controlled by a lot of regulatory aspects. So all of those things have happened to many modes of transpiration. And then of course, aircraft have evolved. They've gotten bigger and better and more fuel-efficient. And with the expansion of so many different airline around the world, a broader global [inaudible] truly has made the world a smaller place. So it's an exciting industry. It's also fraught with financial difficulties, because these are long-lived, expensive assets. And so from an investment perspective, everybody looks at the past. And probably the most pressing concern that I see with regards to the investible quality of our industry is that it's so, so tied to fuel price. You go back on any regression [inaudible] and you'll see that as fuel prices rise, our stocks go down, and vice versa. And again, those are uncertainties that create a beta that is just very difficult for people to [inaudible] through. But we have seen sustained periods of growth. Over the last decade, a few of the airlines have done very well.

 

>> In fact, airline profit soared into 2025 with strong earnings and record revenue. What's less certain is how revenue and profits will hold up longer term. In the US, macroeconomic uncertainty around inflation, interest rates, and tariffs triggered some to withdraw forward guidance on earnings. It's a similar picture in Europe, as Shawn Goodyear explains.

 

>> Coming into earnings, there was a lot of concern over demand weakness, and particularly on the transatlantic. This was a course driven by expectations for a week the US economy off the back of all the tariff uncertainty we've seen. So some equity analysts lowered their forecasts and airline stocks and bonds sold off. For context, the transatlantic has been an extremely strong market for the European airlines who have all seen double-digit yield increases over the past couple of years. And this has actually helped to fuel the post-pandemic recovery. All their non-disclose margins. This is widely assumed to be their most profitable major routes with estimates that it accounts for over half of operating profit for some of the airlines. So this means any weakness could therefore materially change the [inaudible] outlook for the network airlines. So back in March, Virgin Atlantic, the UK's second largest airline on the transatlantic, sounded the alarm when it said it started to see signals US demand had been slowing. And since then, we've had all the big three network airlines in Europe say namely IAG, Lufthansa, and Air France KLM reports, and they all report transatlantic softness in forward bookings. IAG [inaudible] British Airways, and the Spanish national carrier, Iberia. Interestingly Lufthansa, Air France KLM said that this was coming from outbound European to US bookings, but IAG claimed it was US to UK bookings. For all of them, weakness in the economy has been the driver, and to varying degrees this has been offset by strength in premium leisure, which continues to be extremely robust. The airline business is complex, with lots of dependencies that vary within and across countries. A key challenge in the US is the outdated air traffic control system, which is actually making air traffic worse.

 

>> This is the moment when air traffic controllers working a busy airport in Newark, New Jersey suddenly lost radar and communication, leaving those air traffic controllers essentially flying blind with planes in the air.

 

[ Radio transmission ]

 

>> Lost our radar, and it's not working correctly.

 

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If you could call the towers, we're approaching.

 

>> Fortunately, all flights continued their routes and landed safely. But this 90-second malfunction off the air traffic control system caused backups and delays at Newark for days. Newark is one of the busiest airports.

 

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>> There are 60 developed countries outside of the United States that have more modern technology. That technology exists. We actually build it in the United States. But because of a lot of different regulatory, legal, and sort of opposition from various people in the country, we've never been able to evolve to what is a more modern air traffic control system that would take many years, probably over a couple of administrations from the federal government perspective, and would have to override the congressional budgeting process, because this sins't a process you can start and stop, and only fund from year-to-year. It has to be something that we are committed. We are going to do this for the next 10 years. We're going to hire the best people in the nation. We're going to pay them appropriately, which is difficult given the tech world that you know. So you know, the good things are great. It's getting better. We have great reach, but that air traffic control mechanism is still a go issue.

 

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>> Loyalty program s have become a critical strategic asset for the airlines. Although there's little transparency into how much they contribute to profitability, these programs add a great deal of stickiness to the airlines' customer retention. According to Jack Fitzsimmons, that's especially true for the premium airlines.

 

>> I think the real game for airlines is to win brand-loyal customers, and these customers care firstly about schedules. So if you're a customer that's based in Dallas, you'll likely be an American AAdvantage loyalty member. And that's because American's hub is in Dallas, and that's where American's schedule is more robust than competitors. If you're in Atlanta, you'll likely be Delta. Most smart kids though are pretty competitive, and customers will start to care about which airline then has the best service, the best lounges, the most comfortable spacious airplanes, the more reliable Wi-Fi. And once an airline attracts those customers in that competitive market, get them signed up for a co-brand credit card, and they start swiping that card and accumulating your airline's points by spending on even non-airline travel related goods and services. That customer becomes pretty sticky. So airlines talk a lot about how their loyalty members are willing to pay much more for a flight with an airline where they have loyalty status than with an airline that they don't. I've heard average ranges of 10 to 40% premium that loyalty customers will pay to fly with an airline on their co-brand credit card. I've also heard from American Airlines, they've said that their loyalty members bring in about 10% of additional flights revenue on average.

 

>> Take American Airlines co-branded credit card for example. They're extending and expanding the program for an addition 10 years, and the potential impact on their earnings before interest and taxes, or EBIT, is huge.

 

>> They expect cash remuneration from their co-branded credit card to grow about 10% annually. Annually in 2025, cash remuneration was about 5.6 billion. And American expects this number to reach 10 billion. They expect an incremental 1.5 billion of EBIT contribution from that incremental revenue. So if you just look at the margin on the airline remuneration, that's about a 35% margin. They are the crown jewel assets essentially. They continue to drive margin and they continue to hold up pretty steadily especially in the current backdrop.

 

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>> Loyalty programs offset lower margins from increased competition, which has forced airlines to innovate and evolve to stay profitable. They've also found other ways to boost profitability.

 

>> These include ancillary fees. So fees for checked bags, seat selection, priority boarding, and then also in-flight services. And then just other streams as well. Transporting other companies' cargo is a revenue stream for airlines. And then partnerships between different airlines where they can revenue-share. And then finally, the other way the airline industry has changed over the last 50 years is pretty obvious, but technological advancements. So online booking systems, they've allowed for the transition from travel agent bookings to online platforms, increasing direct sales, and then thus decreasing costs for the airlines. Another is new revenue management systems. So systems with dynamic placing. And these were sophisticated algorithms that adjust ticket price based off demand and allows airlines to maximize revenue. Another technological advancement is just new next-generation aircraft that has higher gauge, or more seats per flight. And then these aircraft are thought to be anywhere from 20 to 25% more fuel efficient. So that also helps the airlines save on the cost side.

 

>> Jet fuel is typically the biggest cost of operating an airline. So the price of fuel is a decent indicator of the industry's profitability. Lower prices over the past couple of years have acted as a tailwind for the airlines.

 

>> European airlines hedge most of their fuel, so about 70 to 80%, but still benefit from big declines. And we can see a large drop in their fuel bill this year, which would potentially offset any of that demand weakness we might see. Cross-pressures have actually eased substantially for the European airlines. And this is after they spiked in 2022 and 2023 when global inflation reached multi-decade highs. The staff [inaudible] increases are still higher than before the pandemic, as then labor force remains tight and many European countries. Fuel is by far the largest cost for airlines. This represents about 30% of their total cost base. I would say and imagine fuel-related cost pressure is carbon costs. This is quite unique to Europe. These could actually impact margins in the medium term. All European airlines are captured in the EU's emissions trading scheme and have to pay for carbon credits. The cost is currently quite small, so it's about 2 to 6% total costs for the low-cost carrier, and about 1% for the network airlines.

 

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>> European airlines face much greater sustainability pressures related to net-zero carbon emissions than those in other countries and regions, especially compared with US airlines. In the US, the goal is for about 10% of jet fuel to be SAF by 2030, aiming for net-zero carbon emissions by 2050. Another higher-cost hurdle for European airlines are the airport fees. The slot system in Europe varies by airport, with the highest costs at the busiest airports. Slots at Heathrow for example, are so example that British Airways' parent, IAG, used its slots to collateralize debt during the pandemic. Managing costs, cash flows, and day-to-day operations for the airlines is complicated. Engineering a path for growth is even more so. Particularly given the sensitivity of the global economic cycle and macroeconomic shocks.

 

>> The conventional wisdom was always yo have to grow at a certain rate of growth, otherwise you're going to get too much capacity into the market, and prices are going to drop. And when you're a big player like United, you really had to constrain your growth, because 50 basis points of growth for you could take the entire country. What's the conventional wisdom? When I got there. again back to the strategic angle of this, you could see that we were being sort of the industry's watchdog and police on capacity, but all our competitors, they would say the right thing. Oh we're only going to grow x percent. When the report card was done, they had grown double that. And so slowly our market share was being eroded. So we had to figure out a way to promote profitable growth, which no one believed. Growth is going to drop profit was the attitude. In early 2018, when we released our three-year plan, we released a growth rate of 4 to 6% and the market reacted horribly. But our team had done so much work around this. We knew where we had to grow. For us, in the center of the United States, Chicago, Houston, and Denver were not growing as much, and we thought there was more profit there. So we're going to put capacity in there without affecting the bottom line.

 

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That was in January 2018. Time was on United's side, and it didn't take long for the market to buy into the company's turnaround.

 

>> By Thanksgiving, our stock had risen by $40, which is unheard of, because we deliver first quarter, second quarter, and third quarter earnings, where we grew our top line in the places that we said, and our earning grew as well. not by cutting people, not by slashing and burning, but just flying more people with a more effective pricing dynamic and mechanism, flying to places people want to fly at the times they want to fly, and on the aircraft they want to fly.

 

>> The industry as a whole has battled higher labor cots and airport fees since the pandemic. Pilots for example account for around 40% off labor costs. And their wages rose nearly 50% over the past vie years. This drove higher costs for all airlines. But low-cost carriers were hurt the most. In the US, it was a similar picture on the revenue side.

 

>> The full-service carriers were able to generate higher-unit revenues to help offset these unit cost increases in a much more effective manner than the ultra low-cost carriers. And the reason for this is because the full-service carriers really have revenue diversity. The low-cost carrier business model is pretty strange right now. They're now kind of then low-margin carriers, and in order to kind of become competitive again, it would make sense for them to combine and streamline operations, which is cost, and become more competitive with the legacy carriers. So I don't really envision an acquisition in the near future with the big three airlines. I think that would be a higher hurdle. The low-cost carriers are really going to have to change their strategy, which we've actually been observing recently as some of the lower-cost carriers are exploring a premium offering. And there are two reasons why they're doing this. One, preferences seem to have changed, and consumers are paying up for premium travel. And two, having premium features makes your loyalty programs much more desirable and attractive. It does seem like the higher cohort, the higher income level Americans are still doing well and still spending and willing to spend on premium travel.

 

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>> It's the reverse in Europe, where the low-cost, short-haul carriers have had the strongest balance sheets, even before the pandemic.

 

>> The local carrier business model remains superior in Europe. It has historically enjoyed faster growth, higher margins, more resilient earnings, and superior cash flow generations than the normal network airlines. Across the industry, even for the weaker names in Europe, balance sheets have generally recovered to their pre-pandemic positions with deleveraging largely complete. And for most, the primary use for capital will be now for fleet expansion and replacement. Almost all the airlines have big order books with delivery stepping up over then coming years. And for many, fleet replacement is critical to reduce unit costs and achieve emissions reduction targets. That said, most airlines will still be returning cash to shareholders with dividends having resumed for the majority of European airlines at least. Although at relatively low payout ratios. And I'd say the two standout airlines, which have generate significant [inaudible] pre-cash flow even after [inaudible] are Ryanair and IAG. And these guys have actually introduced share buyback programs too.

 

>> A real concern weighing on the industry is the impact that tariffs might have, as airlines need to update or expand their feet. Two manufacturers control their industry: US-based Boeing and Europe-based Airbus.

 

>> So there is still a risk that the EU would retaliate by slapping a 20% tariff rate on aircraft exports from Boeing. This is not something that the EU airlines could withstand. It would simply not be economical to pay an extra 20% on their Boeing fleet orders. Ryanair is by far the most airline at risk, with an all-Boeing fleet and an [inaudible] with hundreds of going 737s. Similarly the CEO of Lufthansa getting a pretty similar message, insisting that youn would not see airlines paying an additional 20% and take delivery as planned. Ultimately any delivery delays would disrupt fleet [inaudible] leading to inefficient and higher unit costs. Interestingly, BA announced a new order, and this was for 32 wide-body Boeing aircraft. And this was actually in May, after the US and UK signed a trade agreement.

 

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>>Boeing is the largest exporter in the US, and holds around 50% of global market share, while Airbus's Europe's largest exporter, and holds around 60% of market share. Might this be an opportunity for Airbus to further expand its market share?

 

>> Unfortunately, they are not in a great position to take advantage of this, because their order book is pretty much completely full for then next decade. So even when you saw Boeing had its particular issues with production, having to kind of ground planes, Airbus couldn't take advantage of that because its order book was so full, and it could not speed that up. And again, it's been struggling to ramp up its own deliveries.

 

>> Jets are capital-intensive and long-dated assets, with the average lifespan of a plane around 20 to 30 years. That's in addition to significant maintenance costs, even for the newer planes.

 

>> The mechanical instruments that don't always work no matter how much we maintain them, something's going to break at a certain point in time. And so I have to say that in spite of all of that, every time I see an aircraft take off in the air, I throw my arms in the air and celebrate, because yes! We got another one up there, because it is quite the process to get a flight out in time, and yes, the general customer doesn't have to know any of this sort of thing, but it is a complicated, logistical dance to get all of these moving parts together and aligned to make your flight not only safe, but on time.

 

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>> Thanks to Oscar Munoz, Jack Fitzsimmons, and Shawn Goodyear for their insights on the airline industry. The OUTThinking Investor is a podcast from PGIM. Follow, subscribe, and if you like what you hear, go ahead and give us a review. If you enjoyed this episode, and want to hear more from PGIM, tune in to our Speaking of Alternatives podcast. See the link in the show notes for more information.

 

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