After the latest decline in oil prices, the airlines are sitting pretty. But the positive outlooks haven’t been reflected in airline stocks as much as they should have. You know what that means — buying opportunity!
While all the major U.S. airlines look attractive at current levels, American Airlines Group Inc (AAL) and Alaska Air Group, Inc. (ALK) appear to be the best choices for investors because they have the least risk from potential labor strife.
Despite the huge drop in oil prices last year, fuel still accounted for around 20% of major U.S. airlines costs in 2015. So the recent steep decline in jet fuel prices is going to have a significant positive impact on the airlines’ bottom lines.
It’s possible to roughly estimate the tailwind that airline stocks will receive from the decline in jet fuel prices over the past few months. Since October 2015 (the last time that many airlines reported their results), jet fuel prices have tumbled by about 30%. Because fuel accounts for about 20% of airlines costs, the reduction in fuel costs should provide a tailwind of about 6% for airline profits.
One might think that the airlines would respond to the huge decline in fuel prices by lowering airfares, but the opposite is true. The price of one way U.S. domestic fares increased by $3 recently at American Airlines, United Continental Holdings Inc (UAL), Delta Air Lines, Inc. (DAL), Southwest Airlines Co (LUV) and JetBlue Airways Corporation (JBLU).
Making the Case for the Airline Stocks
Meanwhile, most airline stocks have actually dropped significantly over the last few months: AAL is down 10% over the last three months, UAL has retreated 16% during that period, while DAL has dropped 5% and ALK has given back nearly 6%.
In the wake of these declines, the valuation of airlines stocks is really quite attractive, with most of them trading below ten times analysts’ consensus 2016 EPS estimates. AAL is trading at 5.8 times analysts’ consensus 2016 estimates, ALK is at 9 times the consensus 2016 outlook, UAL is at a tiny 5.3 times the consensus 2016 outlook and DAL weighs in at 6.5 times forward earnings.
Industry traffic trends in December looked pretty healthy: ALK’s traffic jumped 9.9% in December vs. the same period a year earlier; AAL’s total revenue passenger miles rose 1.5% vs. December 2014; UAL’s December consolidated traffic rose 1.5%; and LUV’s revenue passenger miles surged 8.6% last month.
The only potential spoiler for the airlines is salary demands and labor strife. Last year, in a reversal from 2013, labor costs accounted for a bigger percentage of airlines total expenses than fuel, according to FactSet.
If history is any indication, unionized employees could react to the airlines’ success by increasing their salary demands. After the last industry upturn in the 1990s, “generous labor contracts led to rising wage expense that weighed heavily on industry profitability after the cycle turned in 2001,” the Associated Press quoted Credit Suisse as saying recently.
However, it’s possible that the unions may have learned their lesson from the last cycle and will restrain their salary demands going forward.
But just in case the unions decide to take a tough line, ALK and AAL look like the best choice for investors, since they have the fewest open labor contracts among major U.S. airlines, according to Credit Suisse. Not to mention ALK beat earnings by 6 cents and raised its dividend 38%, while AAL is set to report earnings on Jan. 29.
Given airlines’ low valuations, tailwind from jet fuel and decent growth rates, airline stocks are quite appealing. Investors should buy airline stocks, especially ALK and AAL, but they should keep a close eye on the status of airlines’ talks with their labor unions.
As of this writing, Larry Ramer did not hold a position in any of the aforementioned securities.
