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Airlines Face Turbulence as Fuel Costs Rise

Higher expenses appear just as carriers were bouncing back

As the airline industry struggles to get up off the mat after being hammered by a two-year recession and global financial turmoil, rising fuel prices are again threatening to put carriers’ profitability on the ropes.

Since fuel prices account for at least one-third of airline operating expenses, even comparatively small price shifts can have a serious impact on profits. Indeed, the price of fuel was a key talking point for senior executives at two carriers that released earnings this week — Delta Air Lines (NYSE:DAL) and AMR’s American Airlines (NYSE:AMR).

While both airlines reported increased revenue for the quarter, it didn’t rise quickly enough to offset an average 13% increase in fuel prices.  And with oil prices trending even higher, Delta and American each say fuel costs could rise by $1 billion this year.

Airline stocks had tumbled by midweek — and were down again early Thursday — on the Delta and American numbers. Delta reported in-line revenue of $7.8 billion but its operating profit missed Wall Street estimates. AMR, meanwhile, beat earnings estimates but its revenue was merely what Wall Street was looking for.

Airlines are scrambling for a formula to protect their profits from fuel price volatility. In a memo to Delta employees, CFO Hank Halter cited the recent runup in fuel prices as the biggest challenge his airline faces. In a conference call with investors on Wednesday, American CEO Gerard Arpey characterized the trend as “the most worrisome trend we see.” He pointed out that in the face of dramatic fuel price increases, the most “logical” first step would be to “raise your ticket prices.”

 That’s bad news for deal-seeking air travelers because higher fares and fees for everything from baggage to blankets are a sure thing in 2011 — crude oil prices have moved 20% higher since last June into the $90/barrel range.

So far, fare and other fee increases haven’t had a major effect on load factors, which measure how much of an airline’s passenger carrying capacity is being used.  In fact, sales are on the rise, driven by the rebound in business travel.   Business travel is key to airline profitability because while this market segment comprises just 20% of all air travelers, it accounts for some 50% of airline revenue.

However, fuel price swings — high or low — can trigger the dreaded Law of Unintended Consequences.  Ray Neidl, senior aerospace specialist at Maxim Group, said in a recent interview that airlines might be able to cope with fuel prices in the $75-$100/barrel range by making capacity adjustments. However, if prices exceed $100/barrel, it will be much harder to pass increased costs on to customers. 

Conversely, if fuel prices dip below $75, airlines could be motivated to increase capacity by bringing big, fuel-guzzling planes back into service.

Because of this, airlines should be able to continue to boost profitability if fuel prices hold in the $85-$95/barrel range. Hedging strategies will be a valuable tool to help airlines guard against sudden spikes. Some carriers also are looking to add more fuel-efficient aircraft to their fleets. And even though fuel prices are rising, today’s $90/barrel average for crude oil is still a far cry from the $145/barrel airlines struggled with in mid-2008.

Bottom Line: The outlook for fuel prices may be hazy, but there are bright lights on the runway for the airline sector in general.  Air carriers have begun to bounce back from two years of recession-driven turbulence to turn a profit.

Fourth-quarter results for major U.S. airlines should look better than they have in years.  In addition to Delta and American, United Continental (NYSE:UAL), Southwest Airlines (NYSE:LUV), US Airways (NYSE:LCC), JetBlue (NYSE:JBLU), AirTran (NYSE:AAI) and Alaska Air (NYSE:ALK) all are expected to show a return to profitability when they release numbers over the next two weeks. 

But rising fuel prices are a major threat. Major U.S. airlines are meeting that challenge with resolve, with most having rolled out three waves of fare increases since Thanksgiving.  They also are focused on increasing efficiency and lowering operating costs.  The airlines that do the best job of holding the line on costs — particularly fuel — have the best chance to reward investors in 2011.

At the time of publication, Susan J. Aluise did not hold a position in any of the stocks named here.

Article printed from InvestorPlace Media,

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