The logic behind the 737 MAX

I found this to be an interesting read.........hope you do too.

 

(Michael Carter - APF Editor)

We all know about the 787 by now -- Boeing's (NYSE: BA) proof of concept that aircraft designed around energy efficiency can translate into better profits for airlines. That's great, but we also know that the 787 only flies long-range -- what about the huge market for domestic routes?

Enter the 737 MAX. You've got to see this thing. This is a work of art in the the sky that shareholders can appreciate more than a Monet.

Have you ever seen wingtips like that? Did you notice the tapered tail section? To say the least, the plane gets excellent fuel economy ... but more on that later. The question now: how can airline investors benefit?

The rationale

The answer to this question starts with a look at Southwest Airlines' (NYSE: LUV) 2012 annual report, where CEO Gary Kelly gives early and specific mention to fleet modernization as a way of driving increased profits. Central to his commentary: acquisition of a whopping 150 737 MAX aircraft for delivery into operation during 2017.

Competitor United Airlines' (NYSE: UAL) 2012 report similarly touts advances in energy efficiency as a vital way to counter rising fuel costs, and along these lines, United has committed to an order of 100 737 MAX units for delivery in the same time frame.

Orders of such large quantity infer that execs at Southwest and United have got their strategic thinking caps on, and if I had to guess, I'd say that their strategy centers around asset efficiency and cost-cutting.

Buying so many expensive airplanes seems a bit counter-intuitive to that end, but LUV and UAL have learned where new planes cost less than maintaining the old birds that guzzle fuel. Why else the emphatic focus on fleet modernization in the annual reports?

Speaking of assets

Considering all this talk about changes in airline fleet composition, let's take a look at some return on asset figures, an important metric considering the asset-intensive nature of the industry.

At a bird's-eye view, Southwest and United's share prices do seem to trace a positive correlation with their respective Return on Asset (ROA) figures. Drilling down a bit further, Southwest's ROA suffered its biggest decline from mid-2008 to mid-2009 -- and so did its share price.

As ROA improved from -1% in its 2009 trough to an average of 2% for the majority of 2010-2012, its share price tripled and maintained this level until a third quarter (Q3) 2012 drop in ROA. So far in 2013, the upward trajectory has resumed, coinciding with a move back above the 2% ROA mark.

Data from United shows a similar relationship: a terrible -25% collapse in ROA in late 2009, including an equally horrendous 5-year low in equity value. ROA subsequently rebounded and stabilized to positive levels, and has remained remarkably consistent at around 0.2% in recent years; the share price also bounced back in the same pattern.

When I look for similar movements in other industries, from telecom to tech, I generally don't see such a strong relationship between ROA and stock price as in the airline industry. That said, a move into more efficient assets can bolster net income to a degree where ROA stabilizes or rises, with the expectation that stock price will follow.

Strategic impact

To say that improved asset utilization leads to more shareholder value may be a bit obvious, but I'd feel worse about making this point if the 737 MAX wasn't already so poised to change the game.

First, and this bears repeating, major airlines have placed big orders for the aircraft -- 100 at United and 150 at Southwest. Considering that United currently operates about 700 mainline jets and that Southwest has around 600 (all 737s, might I add, which is good for maintenance costs), the MAX will have a significant impact on raising the average fuel economy of both aircraft fleets.

Boeing says on its web site: "When compared to a fleet of 100 of today's most fuel-efficient airplanes, this new model will emit 286,000 fewer tons of CO2 and save nearly 200 million pounds of fuel per year, which translates into more than $100 million in cost savings."

This leads to the important point of environmental sustainability: a value increasingly relevant to corporate performance metrics and to the modern consumer. Because this aircraft update will put Southwest and United on the forefront of sustainability relative to competitors, a more eco-friendly approach could amount to an important distinguishing factor in a fiercely competitive industry.

In this vein, LUV and UAL's commitment to bleeding-edge technology differs from the asset management strategies of other major airlines that have not adopted the 737 MAX at all or as extensively.

Therefore, in the event that the MAX delivers significant savings over older aircraft and over competing products (Boeing cites an 8% per-seat advantage over Airbus's newest A320), Southwest and United investors will likely come out on top.

Considering that the 737 MAX draws on extensive R&D already pioneered in 787 development -- the first application of this technology to domestic-range jets -- I like the MAX's chances to make good on the advantages that Boeing promises.

The Foolish takeaway

If nothing else, the ever-present reality of increasing oil prices has exposed the airline industry to more fuel expense pressure than ever. Personally, I like the idea of an airline that maintains a younger, more productive fleet as opposed to those that gamble on fuel prices and operate older aircraft.

Southwest has employed this strategy for years and has a great track record of earnings to show for it, so perhaps United has made a smart move to commit more to a similar strategy. For investors who value companies that take a proactive response to industry challenges, LUV and UAL could be great choices due to their forward-thinking investment in the 737 MAX.

(Andrew Gill - The Motley Fool)