It has been a banner week for U.S. airlines and their shareholders as blockbuster earnings across the board bolstered a sector that had been left for dead for more than a decade. But despite the well-deserved euphoria of monster short-term gains, investors should keep an eye on longer-term headwinds that may constrain future earnings.
But first things first: airline stocks deserve this party. All four of the largest U.S. airlines — Delta Air Lines (DAL), American Airlines (AAL), United Continental (UAL) and Southwest Airlines (LUV) rocked their second-quarter earnings. Let’s recap:
- Delta: DAL’s operating revenue increased 9.4% in the second quarter to $10.62 billion; with earnings of $801 million ($1.04 per share) — 17% above the prior year. Analysts had expected EPS of $1.03 on $10.59 billion in revenue.
- American Airlines: The airline behemoth birthed by the merger of US Airways and American Airlines stole the earnings show this week, reporting historic net profits of $1.5 billion ($1.98 per share) on $11.4 billion in sales. Wall Street had expected $1.95 on revenue of $11.3 billion. AAL Chairman Doug Parker also announced a 10-cent aper share dividend — American’s first dividend since 1980 — and a $1 billion share repurchase program.
- United Continental: UAL reported second-quarter earnings of $919 million ($2.34 per share) on $10.3 billion in revenue; analysts had expected EPS of $2.19 on $10.3 billion in revenue. UAL, the only U.S. carrier to post a first quarter loss, increased profits by 50% compared to a year ago.
- Southwest: LUV also beat the Street in the second quarter, with earnings of $485 million (70 cents per share) on $5 billion in revenue. Analysts had expected EPS of 61 cents on $4.94 billion. The record second-quarter earnings illustrate the progress LUV has made to integrate AirTran.
It’s no surprise that airline stocks have been on a tear, gaining an average of 100% in the past 52 weeks. Can airline stocks continue to gain altitude? Here are some short-term tailwinds and longer-term headwinds to consider:
Strong Traffic Growth: Passenger air traffic grew by 5.5% last year and is on track to grow 6% per year through 2016, according to new forecasts by the International Civil Aviation Organization (ICAO). In North America, ICAO expects passenger traffic to grow by 2.7% in 2014, in large part due to the rebound in the U.S. economy and lower unemployment rate.
Benefits of Consolidation: The benefits of consolidation among U.S. airlines has been a key driver of efficiency and profitability. The mergers of US Airways and American, United and Continental, Delta and Northwest as well as Southwest and AirTran — all of which occurred within the past five years — are delivering substantial economies of scale. That having been said, the devil is in the details when it comes to airline mergers — particularly when combining computer systems and sorting out flights and seniority lists.
Ancillary Fee Income: Passengers may hate getting dinged for multiple fees, but airline stocks are soaring as a result. Ancillary revenue (fees associated with everything from baggage to priority boarding to inflight sales) accounted for $31.5 billion in airline revenue last year, according to a new report by IdeaWorks. Expect this trend to accelerate in the coming years, driven by advanced inflight entertainment options like Wi-Fi. A stronger U.S. economy is boosting the fortunes of North American airlines.
Unfortunately, the long-term outlook isn’t quite as rosy.