Is a solid earnings report from a competitor really enough to justify a big gain from American Airlines Group Inc (NASDAQ:AAL)? Investors certainly thought it was, as they sent American Airlines stock up 4% on Wednesday after rival United Continental Holdings Inc (NYSE:UAL) posted rock-solid first quarter numbers.
And yet, even with Wednesday’s pop, AAL stock has been noticeably weak of late. What gives? Investors are still concerned that a nasty price war could be brewing. They may be right, but that concern isn’t even the half of it.
An Increasingly Expensive Business
In the most superficial sense, United Continental’s first quarter report bodes well for American Airlines stock. United turned $9.032 billion worth of revenue last quarter into a per-share profit 50 cents. Both were better than expected, and both were higher than the prior year’s comps — earnings in particular.
Delta did well last quarter, too, although arguably not quite as well as United. Net income fell just a bit, from $561 million to $547 million despite record revenues of $9.76 billion. And, that top line still missed the estimate of $9.85 billion, though per-share earnings of 74 cents beat by a penny.
The one common element of Delta’s and United’s reports that’s sure to be a well-watched factor when American Airlines dishes out its first quarter numbers on Apr. 26? Rising costs. Namely, increases in fuel and labor costs, which are the second-largest and largest expenses, respectively, for almost all airlines.
Fuel expenditures were up 26% for United Continental last quarter, while payroll spending grew 3%. Delta saw its jet fuel expenses grow 20% year-over-year.
None of the three major U.S. airlines hedge their fuel costs any longer, as they found it too expensive and too unfruitful to do so.
Digesting higher fuel costs isn’t as one-dimensional or as black-and-white as it may seem on the surface; it’s not just a simple matter of charging fliers a little more.
One of those nuances is, as Delta CEO Ed Bastian pointed out following Delta’s quarterly report, the six-to-nine-month lag between rising fuel prices being passed along to consumers in the form of higher ticket prices.
He explained, “It forces discipline,” adding, “When you think about fuel at $70 a barrel you’ve got think about the long-term implications of the supply you’re putting into the market.”
In other words, an airline doesn’t want to expand by adding new routes unless it knows it can pay for that growth by selling those tickets. Ticket prices need to be affordable for consumers but also profitable for airlines, which is a fine line sometimes.
The X-factor: Knowing your competition may expand or open a new route (or new routes) with a willingness to lose money for a short while in doing so. “Being there” first is a key part of the airline battle.
And that may well be exactly what’s happening right now.
You’ll recall that United Continental put all the industry’s stocks into a tailspin in January, announcing its intent to increase its capacity at a pace of between 4% and 6% per year through 2020.
This was coupled with the comment, “The best way to compete with low-cost carriers is to match their prices. We can’t let low-cost carriers have price advantages in our hubs,” from one of its executives during its Q3 conference call. It’s difficult to think a price war isn’t on the horizon.
United has since backed off a bit on its expansion plans, and rhetoric, but the proverbial cat is out of the bag.
Bad news for airline investors? Not so fast. Demand for air travel in the United States is expected to grow at an annual pace of 3% through 2036, with global demand projected to grow at a 4.7% clip for the same time frame. If those projections do indeed pan out, a price war may not be so brutal.
The matter of expensive fuel and costly labor would linger, though.
Looking Ahead for American Airlines Stock
It’s a lot — perhaps too much — for the average investor to think about heading into American Airlines’ Apr. 26 earnings report. AAL shareholders can more or less expect their company to mimic the quarterly numbers Delta and United Continental just posted, but the dynamic is bigger than any one quarter.
A bet on American Airlines stock is a bet on persistent demand growth and a bet on tame fuel prices. Further muddying the waters is the fact that the former depends on the latter factor.
The really frustrating nuance? For demand for air travel to remain brisk, the global economy must remain reasonably firm. The firmer the global economy is, the more bullish pressure gets applied to oil, and jet fuel, prices, thus making air travel progressively unaffordable. That’s the complicated worry Delta’s chief Ed Bastian was describing just a few days ago.
Throw in political posturing that could turn into an outright trade war that will surely create a ripple effect, and there’s far more uncertainty than certainty right now. That’s the biggest part of the reason American Airlines stock is down 19% since its January peak.
Investors certainly have much to think about before, during and after Thursday’s earnings report. This isn’t just about last quarter’s numbers.
As of this writing, James Brumley did not hold a position in any of the aforementioned securities. You can follow him on Twitter, at @jbrumley.