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Airline Stocks Soar on Strong Earnings, Near-Term Tailwinds

Despite solid earnings, long-term challenges loom over the horizon

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Longer-Term Headwinds

Slim Margins: While record profits are continuing to drive airline stocks higher, it remains a notoriously tough business for making money. With massive fixed costs and inherent vulnerability to the global economy’s fits and starts, there is little margin for error when carriers hit turbulence. Consider that IATA forecasts the world’s airlines to generate $746 billion in revenue this year — and bring in only $18 billion in total profit. That breaks down to a margin of just 2.4% — if all goes well with the economy and operating costs remain stable.

Geopolitical Risk: Commercial air carriers have been far from complacent about the threat of terrorism since 9/11, but a new wave of weapons and combatants may raise the risks of flying at altitude over conflict zones. The downing of a Malaysian Airlines 777 near the Russia-Ukraine boarder and the FAA’s temporary ban on flights to Tel Aviv after a Hamas rocket landed near Ben Gurion Airport are grim reminders that what airline pilots can’t see can hurt them. As airlines and governments seek solutions, a new type of “no fly” zone is be likely to be widened over hot zones like Syria, Eastern Ukraine, Israel, North Korea, Somalia and the Crimean peninsula.

Fuel Prices: Since fuel can account for up to 30% of an airline’s operating expenses, even an increase of a few pennies a gallon can eat away at air carriers’ profits. Jet fuel prices been at high levels for the past three years, and U.S. airlines have employed different strategies such as hedging to limit vulnerability. Delta actually bought a refinery to gain its own supply of jet petrol — and DAL is making a small profit in the oil business. Nevertheless, fuel price volatility remains a considerable risk for airline stocks in the future.

Bottom Line

Airline stocks have outperformed as the industry has become leaner, managed capacity more aggressively and increased economies of scale through consolidation. They are also trading at low multiples and many have attractive price-to-earnings -growth ratios of less than 1, suggesting that they are still undervalued.

That said, I think airline stocks are in a bit of a bubble now because of their Phoenix-like resurgence, lower fuel costs and strong passenger traffic trends. With such slim margins, airlines are still a very tough place to make money over the long term.

As of this writing, Susan J. Aluise did not hold a position in any of the aforementioned securities.

Article printed from InvestorPlace Media,

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