Airline Industry Outlook - October 2016

Airline stocks, which were investor favorites not so long ago, have somewhat lost their appeal, thanks to the number of issues the sector is currently grappling with. The latest challenge has come in the form of Hurricane Matthew, which has disrupted travel plans and caused many carriers to cancel flights/offer refunds for the security of passengers.

The Headwinds at a Glance

The surge in terror attacks across the globe has hurt demand for air travel. Moreover, the Brexit vote in June this year has added to the uncertainty. In fact, German carrier Lufthansa (DLAKY) has trimmed its earnings per share outlook for 2016 in view of waning travel demand to Europe due to multiple terrorism-related incidents and the uncertainty following the Brexit.

The carrier said that advance bookings, especially on long-haul Europe bound routes, have been hurt by the above-mentioned headwinds. The German carrier now expects 2016 adjusted earnings before interest and taxes to be below the 2015 level (the previous guidance had hinted at the bottom line being slightly above the 2015 figure).

Foreign currency pressures, declining air fares and technological glitches have also hurt airlines recently. Over the past few months, technological problems have adversely affected the operations at airlines majors like Delta Air Lines (NYSE:DAL) (DAL), United Continental Holdings (UAL) and Southwest Airlines Co. (LUV). The severity of the power outage at Delta Air Lines can be gauged by the fact that the disruption hurt the top line of the carrier in the third quarter to the tune of $100 million.

The ongoing uncertainty regarding Alaska Air Group’s (ALK) proposed takeover of Virgin America (VA) adds to the woes of the already beleaguered industry. The emergence and success of low-cost carriers like Spirit Airlines (SAVE) and JetBlue Airways (JBLU) have posed significant threats to legacy carriers.

Also, the Zika outbreak in Miami a couple of months ago naturally led to fears and declining travel demand to Florida, hurting carriers. The outbreak prompted the Centers for Disease Control and Prevention (CDC) to issue an advisory for pregnant women to avoid the Zika-affected Miami area. Moreover, disputes like the one involving major U.S. carriers and their Gulf counterparts pose challenges to stocks in the space.

Modest Q3 Results

Unit revenue issues have been plaguing the airline stocks for quite some time and the third quarter of 2016 was no exception.

We note that passenger unit revenues declined 6.8% year over year at Delta Air Lines in the third quarter. Consolidated passenger revenue per available seat mile (PRASM, or unit revenues) declined 5.8% in the third quarter at United Continental. Both these carriers registered a decrease in earnings as well as revenues in the third quarter. Though American Airlines Group (AAL) posted better-than-expected quarterly results, it recorded a year-over-year deterioration in the top line.

Declining air fares, which have been a major headwind for airline companies in recent times, was one of the factors hurting results. Increasing labor costs, as many carriers have been inking new labor deals, also hampered bottom-line growth. Investors should note that total operating expenses at American Airlines rose 5.2% in the third quarter to $9.2 billion mainly because of the 15.3% increase in salaries and benefits expenses. The recent labor deals inked by the company were one of the primary factors contributing to the increase in costs. JetBlue’s third quarter results were also hit by higher labor costs.

Moreover, the absence of any notable stock price appreciation for most companies in spite of their earnings beats can be attributed to prevailing headwinds in the space. The Transportation-Airline segment’s Zacks Industry rank of 241 (out of more than 260 industries) highlights the risks faced by the airline space. With the entire industry struggling as reflected by the disappointing Zacks Industry rank, it is of little surprise that Buy-rated stocks are hard to find in the airline space. In fact, Latin American carriers Copa Holdings (CPA) and GOL Linhas (GOL) are the only stocks to sport a Zacks Rank #1 (Strong Buy) in the space.

You can see the complete list of today’s Zacks #1 Rank stocks here.

According to our latest Earnings Trends report, the transportation sector (of which airlines are a part) is expected to end the third-quarter earnings season with a 14.3% year-over-year decrease in the bottom line. This is worse than the second-quarter performance when earnings declined 12.4%.

A Silver Lining

Despite the above-mentioned headwinds, the sector has had its share of positive developments. The decision of the U.S. Department of Transportation's decision -- rendered on Aug 31, to allow major U.S.-based carriers to operate flights to Havana -- is a major positive. Once operational, the top line of the concerned carriers will be benefitted immensely by the new route additions as Havana is a favorite tourist spot.

Although oil prices have recovered from the 12-year low of around $26 per barrel it slipped to this February, it is nowhere near the above $100 a barrel mark reached in mid-2014. Furthermore, since oil prices have been week for quite a long time, the benefit of cheap oil is on the wane as it has been priced in. Nonetheless, cheap oil remains a tailwind as evidenced by the fact that the International Air Transport Association’s (IATA) bullish forecast with respect to profitability for the airline sector is primarily based on low oil prices.

The organization expects the airline industry to profit by an estimated $39.4 billion in 2016. The comparable 2015 figure was $35.3 billion. In the event of the forecast coming true, the year 2016 would be the fifth successive year of improving profitability for the airline industry. Its fuel bill is projected to fall to $135 billion in 2016, which represents a significant decline from $226 billion recorded only two years ago. The bulk of the global profits ($22.9 billion) is expected to come from the North American region.

Moreover, bullish capacity-related forecasts from carriers like Delta and Southwest are encouraging. While releasing its third-quarter results, Delta mentioned that capacity is projected to expand merely 1%, which is in line with the projection for the fourth quarter. Southwest had stated at the 9th Annual Global Transportation Conference that its 2017 capacity is expected to expand less than 4% year over year.

The projection compares favorably with the view for 2016, wherein capacity is projected to increase in the range of 5% to 6%. The carrier further mentioned that most of the 2017 capacity growth (approximately 2 points) would come from domestic markets, while international expansion would account for 1–2 points.

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