A 10-Point Checklist for Investing in Airlines (Part 1)

By Markets Fool.com

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Buying airline stocks can be one of the more vexing exercises a stock investor undertakes. Commercial aviation is a complicated industry that rewards investors who use a structured plan when researching portfolio candidates. In this two-part series, we break down a checklist that covers a number of key areas to consider before clicking "buy" on a carrier's symbol in your brokerage account. The full checklist follows; let's begin by diving into the first five areas.

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1. Put operating income margin in context

This may come as a surprise, but despite drastically different economic models and operating characteristics between low-cost carriers (LCCs), ultra-low-cost carriers (ULCCs), and network carriers, most airlines tend to have very similar profit profiles.

Why would this be the case? It's simple: The basic economics of running an airline haven't changed in years. For most airlines you'll analyze, labor expense and fuel expense together will equal between 45% and 55% of a carrier's total operating cost.

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During periods of higher fuel prices and wage inflation, these combined costs can take up an even bigger slice of the total expense pie. Because of these two outsize line items, and because the amount airlines can charge for each seat is governed by competition, there's not a huge amount of operating leverage available to any given airline to improve profitability very much beyond its peers.

I've collected recent trailing-12-month operating margins for a wide variety of carriers. When we remove two outliers, Allegiant Travel andUnited Continental Holdings, we can see that operating income falls in a pretty tight range, from 15% to just over 24%.

Data source: YCharts.

If you buy into an airline with operating income much below the 10-percentage-point spread in which most airline profits tend to cluster, be sure to understand why the margin is depressed, and ascertain if a plan exists to bring the airline closer to benchmark level. And if you acquire stock in an airline which exceeds the top of the operating margin band above, check on its valuation relative to peers, to make sure you're not paying too dearly for the profit. We'll return to valuation in Part 2.

2. Gauge existing leverage

The extent to which an airline is a capital-intensive business is hard to appreciate, unless perhaps you run a rail company. Ample debt is the norm in this industry. In periods of high inflation and low economic growth, many airlines have historically been caught in a cycle of declining passenger miles sold alongside higher financing costs, leading to the serial bankruptcies for which the industry is famous.

The past few years of economic recovery and sustained low interest rates have provided airlines with opportunities to clean up their balance sheets. Three U.S. carriers -- Southwest Airlines (NYSE: LUV),Alaska Airlines, and Delta Airlines (NYSE: DAL) -- have even reduced debt enough over the past few years to enjoy "investment grade" status, the highest debt rating granted by major credit rating agencies.

Still, seeing substantial borrowings on an airline's balance sheet isn't necessarily bad. Airlines need efficient fleets to serve capacity. But how much is too much debt? Running a standard debt-to-equity ratio might not be very helpful in answering this question.

Rather, compare net property and equipment (i.e., a carrier's planes and other fixed assets) to long-term debt. In most cases, net property and equipment should exceed long-term borrowings. If you're looking at a network (also loosely referred to as "legacy") carrier such as American Airlines, I'd also recommend adding pension liabilities to long-term debt in this comparison.

Couple this with a ratio such as "times interest earned" to get a sense of how current cash flow covers debt obligations. This may seem like a lot of work, but it's your best way to protect your investment dollars in an industry that tends to move in boom and bust cycles.

3. Scan the major statistics

Aviation is a statistics-driven industry. You should be familiar with the major statistics airlines use to describe their operations, but beware -- it's easy to get into the weeds and focus too heavily on these. Keep them in context of your existing knowledge of a carrier. Nearly every airline publishes its major statistics, which you can find in quarterly and annual reports, as well as news articles that cover airline earnings.

Two important metrics that serve as excellent signposts to a carrier's recent health are PRASM, or passenger revenue per available seat mile, and CASM, or operating cost per available seat mile. Both of these figures are expressed in cents. Most airlines also provide a CASM "ex-fuel" statistic, which shows operating costs without the effect of fuel pricing.

Checking in on major statistics allows you to see an airline's performance expressed in all-important parameters like passengers and miles. Once you get comfortable reviewing these numbers, it's helpful to compare the stats of your investment with similarly configured airlines.

4. Find the average fleet age

Understanding fleet age and fleet plans is crucial to grasping a carrier's long-term business strategy. You can quickly find fleet age on sites such as planespotters.net, along with detailed descriptions of the types of planes that make up an airline's fleet. Delta's average fleet age, for example, is one of the oldest among both network carriers and LCC/ULCC airlines, at nearly 17 years. Compare this with Southwest Airlines, which has a calculated fleet age of roughly 12 years.

Delta's time-honored strategy has been to focus on repair and maintenance over buying new planes, thus pushing up long-term debt. Recently, however, the airline has turned its attention to fleet modernization.Committed Delta investors should check fleet age every few quarters, looking for an aggregate reduction in line with management's current plans.

You can see that the general idea is pretty simple: Find the fleet age and grasp what it tells you about a particular carrier's asset strategy, and then monitor changes on a regular basis.

5. Familiarize yourself with route strategy

Like fleet age, an airline's changing routes point to its larger ambitions. While network carriers' routes cover the globe and take time for the average investor to absorb, it can be relatively easy to understand how route additions and deletions affect regional airlines and LCCs.

For example, Hawaiian Holdings (NASDAQ: HA) subsidiary Hawaiian Airlines is currently waiting for fulfillment on an order for six Boeing A320 neo units, which will allow it future route expansion opportunities. Mark Dunkerley, the airline's CEO, recently acknowledged that routes to Europe, and specifically London, are a possibility in the near future. To the investor who pays attention, this type of route enhancement signals revenue opportunity ahead.

Rounding out the checklist

Are the skies looking friendlier yet? In the second part of this series, we touch on some crucial topics, including fuel costs, competition, and valuation. To understand the investment strategy underlying these areas, click here to read on.

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Asit Sharma has no position in any stocks mentioned. The Motley Fool recommends Spirit Airlines. 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.