Airline Stocks Soar on Strong Earnings, Near-Term Tailwinds

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.

airline stocks, delta, southwest, american airlines

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:

Short-Term Tailwinds

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.

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.

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