The outbreak of COVID-19 has caused panic in equity markets worldwide, with travel and leisure stocks particularly affected. The SVM UK Opportunity Fund’s overweight position in aviation stocks has been a significant negative contributor to performance over the past week. While the volatility of the sector is well-known and can be hugely frustrating at times like this, we remain convinced of its longer-term attractions and believe our holdings are well placed to outperform over upcoming years.
In the short-term, however, things are difficult to forecast. IAG and Easyjet have both withdrawn earnings forecasts for the current fiscal year. Much will depend on whether containment of the virus proves possible and the response of national governments. In the long-run, however, we do not expect this to have any significant effect on demand for air travel. One area we are monitoring closely is the impact on corporate travel demand, as this may accelerate moves towards videoconferencing. This would be more of a concern for flag carriers though than the low-cost carriers.
The funds three airline stocks (Ryanair; Wizz Air; and IAG) all have different geographic exposures and business models, but do share some similarities. All three have solid balance sheets and will be long-term winners in a consolidating European airline market. The largest five European airlines (IAG; Air France/KLM; Lufthansa; Easyjet; and Ryanair) accounted for 43% of intra-European capacity in 2008; today that figure is 63%*. Those five airlines plus Wizz Air will account for c.96% of all operating profits generated by European airlines in 2019**. There remains a long tail of sub-scale, poorly managed, unprofitable airlines in the European aviation market. These airlines are typically more levered, have older fleets, and will be the ones that suffer most during any downturn in demand.
As a consequence, we believe there is a very high likelihood that the current COVID-19 inspired drop in demand for air travel will accelerate the pace of industry failure and also industry consolidation. Data from the US market, which is a number of years ahead of Europe in its consolidation journey, shows that net profit per passenger is significantly higher in more consolidated markets**. As demand for air travel normalises, the best airlines will emerge in a stronger position than they entered the crisis. Obviously this has been a painful event for both us and investors in the fund, but once the current panic subsides and investors realise that the impact on 2020 earnings should be assigned a PE of 1x, we expect focus to shift towards the long-term winners in the sector. Ryanair, Wizz Air and IAG will be at the head of that list.
*Source: IAG CMD19