Flying the (Un) Friendly Skies

The jokes at the expense of United Continental (NYSE: UAL) are proliferating on social media, which is never a good sign for a company’s stock. One particularly brutal gag is a fake ad for Southwest Airlines (NYSE: LUV) that reads: We beat the competition, not you.

Shares of UAL plunged this week after video of a bloodied passenger being dragged off a United flight from Chicago to Louisville, Kentucky went viral. United CEO Oscar Munoz, contradicting witness statements, described the passenger as “disruptive and belligerent.” That passenger, Dr. David Dao, was being bumped from the flight not because it was overbooked, but because it was full and the airline needed to move staff to Louisville.

After the media got a hold of the video and the story spread, indignant investors shaved more than 4% off United Continental Holdings stock, wiping nearly $1 billion off its value.

On a positive note: Personal Finance Growth Portfolio holding Delta Air Lines (NYSE: DAL) recently spiked on solid earnings plus the expectation of benefiting from UAL’s woes.

One would hope Mr. Munoz learned his lesson, since it brought unwelcome scrutiny to the entire airline industry and its policy of overbooking. The scandal has weighed on almost every airline stock, but it’s also instructive about how airlines make their profits.

Back in the days of even more tightly regulated air travel, there was a complex system of subsidies in place paid for by the traveler and investors. To win profitable routes, airlines also had to take on unprofitable routes as a public service, increasing the cost for passengers. That also meant that airlines were dependent on generous investors, especially bond buyers, hopeful for passenger and revenue growth.

But since the industry has seen those rules removed, the average U.S. domestic round-trip airfare has dropped in half even as the industry has dramatically consolidated. At the same time, airlines that were once derided as horrible investments have started to turn a profit. Benefiting from deregulation, low oil prices and steady economic growth, airline stocks have risen almost 90% since 2014. And they’re likely to go higher still.

They’re so profitable, Warren Buffett’s Berkshire Hathaway (NYSE: BRK.A) recently doubled its stake in American Airlines Group (NYSE: AAL), increased its holdings of United Continental by more than 600% and boosted its position in Delta Air Lines by nearly 1,500%. All told, the Oracle of Omaha plunked down nearly $5.5 billion on airline stocks.

Analysts predict that when the next recession hits, U.S.-based airlines will be in their best positions ever, likely to go into the economic downturn with a cash cushion.

Assuming the next recession doesn’t hit this year, 2017 could be particularly profitable for airlines. Most of the major carriers are planning on capacity increases of up to 2%, well off the 5% clip we’ve seen over the past few years.

As capacity growth slows even as demand for air travel continues to grow, airlines can charge more per ticket, boosting their revenue per available seat mile (RASM), a key measure of airline revenue growth. As airlines boost their surcharges to cover the higher cost of fuel, RASM is expected to rise in coming quarters.

The skies might not be quite so friendly any more, but they’re going to be a lot more profitable.