How Should Airlines Use Their Potential Windfalls from Fuel Savings?

By Markets Fool.com

With jet fuel prices down about 50% since oil prices began to slide, airlines are now seeing a windfall of profits from this major reduction in expense. But with airlines now dealing with this sudden improvement in fortune, investors are wondering what should and what will the companies do with the extra profits?

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Share buybacks
Due to the growth of airline industry profits even before the recent slide in oil prices, share buybacks began to take hold at many airlines. Alaska Air Group , Southwest Airlines , and Delta Air Lines were the first major carriers to run stock buyback programs in recent airline history.

source: American Airlines Group

But since then, American Airlines Group and United Continental Holdings have climbed on board as well.

For airlines, buybacks have been a particularly attractive option and it's no surprise that they have found supporters at all major U.S. airlines. Shares of these airlines traded at and continue to trade at valuations well below the market average with some carrying single digit price to earnings ratios.

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Additionally, buybacks lend themselves to more cyclical industries like airlines. Since buyback programs have defined limits to them, companies can shut down buybacks to preserve capital during tough times without raising the same red flags as if they slashed a dividend.

With airline shares still trading at fairly low valuations, I think directing a modest amount of fuel savings into share buybacks would be a good way to build shareholder value while retaining the flexibility to cut back on capital returns if fuel prices begin to rise again.

Dividends
While dividends can be a great way to reward shareholders, I would expect airlines to approach higher dividends with a note of caution. Unlike share buybacks, investors expect dividends to keep getting paid and a dividend cut can cause the Street to panic. Because of this, dividends require a longer term of capital commitment and offer less flexibility than buybacks. In the case of using savings from cheaper fuel, it would be unwise for an airline to commit to paying out a large portion of these savings as dividends since a rebound in fuel costs would then force a dividend cutback.

This is not to say I'm completely against airline dividends. The initiation of Delta's and Alaska's dividends in 2013 and American Airlines' dividend in 2014 quite likely helped to bring dividend-only investors and funds on board bringing in new buyers for their shares. Southwest Airlines used dividends to remind investors of the greater security of its stock and, although it only paid a penny per quarter dividend until 2013, it was the only major airline dividend in town before that.

At this point, United Continental remains the only major airline without a dividend but the airline may take the fuel savings as a chance to initiate a small dividend. If United Continental follows in the path of other recent airline dividend launches, its annual dividend yield will likely be around 1%.

For current dividend paying airlines, I would expect small dividend increases at most. Since much of these profits are coming from a downturn in a traditionally volatile commodity, I doubt many airlines would want to commit themselves to a longer term payout of these current higher profits.

New aircraft
Many people have wondered whether the savings from lower fuel costs will result in more aircraft orders now that airlines have more money to spare.While the idea makes sense, there's a limit to how many new aircraft airlines want to order at this point. Airlines have already been seeing record profits over the past couple years resulting in a boom of aircraft orders that already hasBoeingandAirbuswith near record backlogs.

source: United Continental

Some airlines may decide to order sooner than they otherwise would have but there's a limit to how many still working aircraft the airlines will retire early.

Terminal renovations
Aircraft orders tend to get more attention but some of the most important qualities of an airline are what's available on the ground. To compete in this arena, airport terminals are being renovated by some airlines to offer more features and increase airline operational efficiency.

Delta JFK Airport map source: Delta Air Lines

In the past few years, Delta Air Lines has spent about $1.4 billion to renovate two of its terminal at New York JFK International while Southwest Airlines is getting going on a $508 million renovation to its terminal at Los Angeles International.If airlines want to reinvest in their businesses but not through new aircraft alone, more carriers may use some fuel savings to renovate their terminals.

Debt reduction
One of the criticisms of airlines as investments has been their high debt levels which make airline investments above average in risk, keeping away more conservative investors. That being said, fuel savings could be just the key for accelerated debt reduction. Delta Air Lines has become the poster child for this since launching an aggressive debt reduction plan that since 2009 has seen the airline slash its net debt from $17 billion to $7.3 billion.

Debt reduction may not get the same attention as share buybacks and dividends but it too can boost valuations. With the airline industry trading at 12.5 times earnings compared to the S&P 500 at 18.5 times earnings, there is a lot of room for multiple expansion if airlines can reduce their debt and prove they are stable companies around for the long-term rather than speculative indebted companies.

Lower fares
Many passengers have been calling for airlines to lower their fares with fuel prices so much lower. But since airlines are profit-seeking entities like any other corporation, they will charge what the market will bear. Currently, the market seems to be able to bear a lot. Planes are still pretty full without much evidence of industry price cutting and with the airline industry consolidated into fewer players than in the past, it's less likely that fare wars will erupt between airlines.

Barring a change in airline industry strategies, fares look likely to remain near current levels with the airlines collecting the savings.

Using the savings
With future oil prices always remaining an unknown, no one knows how long the airlines will be able to continue benefiting from reduced fuel costs. In the meantime, they have plenty of options available to choose from including share buybacks, dividends, reinvestment in planes or terminals, and debt reduction.

At this point, I would favor a combination of buybacks, terminal upgrades, and debt reduction. All three of these carry long-term shareholder benefits and leave airlines the flexibility to cut back if fuel prices rise or industry conditions worsen.

The article How Should Airlines Use Their Potential Windfalls from Fuel Savings? originally appeared on Fool.com.

Alexander MacLennan owns shares of American Airlines Group and Delta Air Lines,. Alexander MacLennan has the following options: long January 2017 $25 calls on American Airlines Group and long January 2016 $60 calls on American Airlines Group. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.