The fourth-quarter 2016 earnings season is over as far as the airline space is concerned. Stocks in the space, which seem to be back in favor after being grounded for most of 2016, fared quite impressively on the earnings front.
Quite a few key segment participants like United Continental Holdings Inc (UAL), JetBlue Airways Corporation (JBLU) and Spirit Airlines Incorporated (SAVE) reported better-than-expected earnings in the quarter.
Lowered Bar Helped Earnings Beats
The string of positive surprises was no doubt facilitated by reduced expectations. The lowered bar made it easier for companies to beat the Zacks Consensus Estimate. For example, the Zacks Consensus Estimate for United Continental in the fourth quarter was $1.65, much lower than the year-ago figure of $2.59 per share.
Although things look rosy on the surface, a deeper analysis of the airline results in the quarter tells a different story. Despite a number of companies beating earnings in the quarter, year-over-year growth in the bottom-line front was hard to come by.
High Labor Costs Distorted Earnings Picture
The primary factor which made bottom-line growth almost non-existent was escalated labor costs. Many companies are inking deals with various labor groups, hence costs pertaining to the factor are spiking.
For example, at Delta Air Lines, Inc. (DAL), earnings declined almost 30% year over year due to higher costs. Consolidated unit cost or cost per available seat mile (CASM), including profit sharing, increased 10.6%, mainly due to the agreement with pilots that was ratified in December. Also, at Spirit Airlines, earnings per share declined 24.5% on a year-over-year basis. Increased labor costs contributed to the decline.Additionally, the rise in fuel costs in the quarter also hurt the bottom-line.
Return of Capacity Woes?
Another factor to hurt airlines in the recent past is capacity overexpansion. The fears were re-ignited when American Airlines Group AAL, in its fourth quarter conference call hinted at increasing domestic capacity but reducing the same internationally in 2017.
The January traffic reports of most carriers also hint at capacity expansion outweighing traffic growth, thereby leading to a fall in load factor (percentage of seats filled with passengers). Generally, carriers are forced to reduce fares as unit revenues decline at the face of capacity outpacing demand growth.
Revenue Picture Brighter
With carriers struggling to come up with earnings growth due to higher costs, the top-line picture was quite encouraging. Unit revenues, which hurt airlines for quite some time, are on the mend. Carriers like American Airlines and Alaska Airlines Group, Inc. (ALK) displayed positive unit revenues in the quarter.
Moreover, other carriers too came up with bullish projections with respect to the metric. The improved top-line scenario contributed to many airline heavyweights like American Airlines Group Inc (AAL) and Delta Air Lines reporting better-than-expected revenues, despite failing to beat earnings estimates.
Given this bullish backdrop, more and more carriers are expected to return to unit revenue growth in 2017. Moreover, the scenario of rising oil prices in 2017 provides airlines the scope to raise air fares, thereby boosting revenues.
Our Choices for Airline Stocks to Buy
In a season where bottom-line growth was dull, airline stocks which managed to achieve the same should be considered as creditable options for investing. Apart from registering earnings growth, the stocks that we have considered have also expanded on the top-line front. We have pruned the list further by considering companies which have reported better-than-expected revenues and earnings.
Naturally, a stock that satisfies all the above criteria is likely to be highly sought after by investors. In addition to a favorable Zacks Rank the stocks have a sound VGM Score. Here V stands for Value, G for Growth and M for Momentum and the score is a weighted combination of these three scores.
Such a score allows you to eliminate the negative aspects of stocks and select winners. However, it is important to keep in mind that each Style Score will carry a different weight while arriving at a VGM score. Our research shows that stocks with a VGM Score of ‘A’ or ‘B’ when combined with a Zacks Rank #1 (Strong Buy) or #2 (Buy) offer the best upside potential.
SkyWest, Inc. (SKYW), through its subsidiaries, operates a regional airline in the U.S. The company has a Zacks Rank #2 and a VGM score of “A.” The St. George, UT-based carrier’s earnings (on an adjusted basis) of 54 cents per share were 3 cents above the Zacks Consensus Estimate. Earnings also improved 10.2% from the year-ago figure. Quarterly revenues of $758 million beat the Zacks Consensus Estimate of $753 million and also increased marginally on a year-over-year basis.
Alaska Air Group has a Zacks Rank #2 and a VGM score of “A.” The carrier’s fourth quarter earnings of $1.56 per share were 15 cents above the Zacks Consensus Estimate.
Moreover, the bottom line expanded 6.85% on a year-over-year basis. Revenues came in at $1.52 billion, beating the Zacks Consensus Estimate of $1.43 billion. The top line grew 11% on a year-over-year basis.
Both the stocks have outperformed the Zacks- categorized Transportation- Airline industry over the last one year. SkyWest and Alaska Air Group have returned 98.9% and 32.4%, respectively over the last one year, compared with the industry’s gain of 20% in the period.
What’s Ahead for the Sector?
Adding the above-mentioned stocks to one’s portfolio is expected to result in healthy returns as the airline space in general is in for good times.
This is augmented by its attractive valuation. Going by the EV-to-EBITDA (enterprise value to earnings before interest, tax, depreciation, and amortization) ratio, which is often used to value airline stocks, given their significant debt levels and fixed costs,the industry appears anything but expensive currently.
The industry currently has a trailing 12-month EV/EBITDA ratio of 5.54, which is favorable compared to what the industry saw in the last three years. The ratio is almost near the low end of 4.6 during the period.
Additionally, this compares favorably with the market at large, as the current EV/EBITDA for the S&P 500 is at 10.62 and the median level is 9.7. The industry’s favorable positioning compared to the overall market certainly hints at more upside going forward. Also, the fact Warren Buffett – one of the most revered investors of all times – is rooting for airline stocks after quite a long time highlights the rosy future for stocks in the space.
The improving scenario for the airline industry can be well gauged from the fact that the Zacks Industry Rank for the Transportation- Airline space is a bullish 59. The favorable rank places the industry in the top 26% of the 250+ groups enlisted. The improving scenario for the airline industry can be well gauged from the fact that the Zacks Industry Rank for the space has improved immensely, given the industry’s 200+ rank only a few months ago.
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