Investors bullish on airline stocks at the beginning of 2014 have made oodles of money. Each of the following — American Airlines Group Inc (AAL), Delta Air Lines, Inc. (DAL), United Continental Holdings Inc (UAL) and Southwest Airlines Co (LUV) stock — have soared more than 60% year-to-date.
While the best year of job creation since 1999 has helped keep travel demand high, the major boon to airlines has been the precipitous decline in crude oil prices.
With oil prices now in the mid-$50 per barrel range, the market pressures on energy prices aren’t abating, and there are multiple factors threatening to send oil all the way down to $50 a barrel soon.
With that in mind, airline stocks are still in a great position going into 2015. But AAL stock in particular is poised to blow competitors out of the water, all because it made an unbelievably gutsy strategic move earlier this year.
American Airlines Doesn’t Hedge Fuel Costs
Fuel is the single largest input cost for airlines, so like any responsible corporate citizen, AAL and other airlines constantly look to minimize that cost. Of course, energy costs are hardly the most stable thing on earth, and companies and investors enjoy some degree of predictability.
The way the airline industry tries to achieve these two goals simultaneously is through hedging — basically, airlines place bets that fuel prices will increase, so if they do, the company’s higher fuel costs are offset by gains in their contracts. Conversely, when oil prices fall, they lose money on their bets but enjoy huge cost decreases.
Southwest Airlines arguably owes a big portion of its relevancy today to the strong hedging strategy it employed in the decade or so after the September 11 attacks. Energy prices were historically high for a sizable portion of that 10-year period, and Southwest reaped the rewards. Dallas Morning News writer Terry Maxon cites some alarming statistics on the success of that strategy:
“In 2005, Southwest’s price per gallon averaged $1.13, compared with $1.72 at American, $1.77 at US Airways, $1.71 at Delta and $1.79 at United. In 2008, as all other carriers paid more than $3 per gallon, Southwest averaged $2.12 per gallon.”
The thing that makes AAL stock a screaming buy in a time of plummeting fuel costs is that the company simply doesn’t hedge against rising oil prices. At all.
This outside-the-box, borderline absurd strategy will doubtlessly give American Airlines a leg up on the competition in the current environment. And each and every day that oil prices fall or remain at depressed levels, AAL stock looks like a bigger and bigger buy.
Management expects to save more than $2 billion on fuel costs in 2015. To give you an idea of how meaningfully this could impact AAL’s bottom line, consider that the company’s net income through the first nine months of 2014 was just under $2.3 billion. Point being, the latest Wall Street estimates calling for FY 2015 EPS to come in 45% above FY 2014 EPS could easily be considered conservative if oil prices remain depressed.
I think AAL stock is a strong buy in light of this bold strategic move and the pressures on oil. But investors should remember: American is equally exposed to downside risk if oil prices rebound dramatically.
Considering its decision to shun hedging, investors taking a position in AAL are indirectly taking a position on oil prices, too. If you don’t feel strongly about which way oil will go, think twice about American. But if you expect lower energy prices for an extended period of time, AAL stock is a screaming buy.
As of this writing John Divine held no positions in any of the stocks mentioned. You can follow him on Twitter at @divinebizkid.
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