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Industry Outlook

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The global airline industry continues to face challenges from the deepening of the European debt crisis that is wiping out the positive impacts of lower fuel prices, increasing air traffic and improved freight market. The scenario is unlikely to change for the remainder of the year.

The International Air Transport Association (IATA) still projects overall airline profits of $3.0 billion for 2012 with net profit margin of 0.5% on the back of healthy growth in North and South America. The profit outlook is less than $7.9 billion earned in 2011 and $16 billion earned in 2010. This steep decline in the industry’s profitability is a function of the overall unfavorable macro backdrop in which the industry has to operate this year.

Regional Forecast

North America: North American airlines are seeing improving growth prospects as the year progresses thanks to tight capacity, rising travel demand and a number of new and enhanced ancillary revenues. The carriers are performing at record levels when it comes to customer service including on-time arrivals, baggage handling, fewer customer complaints, lower cancellations and lower overbooked flights. As a result, these carriers are expected to generate $1.4 billion in profits this year, up from the previous expectation of $900 million.

Asia-Pacific: These carriers are expected to record a profit of $2.0 billion in 2012, down from the previous forecast of $2.3 billion. IATA made the downward revision on the heels of weak cargo performance and the slowdowns in Chinese and Indian economic growth. Notably, this is the highest profit-producing region in the industry outside the home market.

Middle East & Latin America: Per IATA, profits from the Middle East carriers are expected to grow to $400 million, down from the previous expectation of $500 million. Profit projection for Latin American carriers increased to $400 million from $100 million forecasted previously.

Africa: African air carriers are expected to incur a loss of $100 million due to weaker yields after touching the break-even point in 2011.

Europe: As for the European airlines, the IATA expects this year’s loss to widen to $1.1 billion given intensifying Eurozone woes, continued weakness in cargo and passenger businesses and higher taxes. The forecast is almost double the previous expectation of $600 million.

Underlying Factors for 2012 Profits

In the base-case scenario, there are several factors that will drive overall airline profits in 2012:

Cargo & Freight

Passenger markets are growing at a slower pace while freight has also been modestly weak since the beginning of the year. The cargo market has bottomed out, following a sharp fall in 2011 and we expect it to remain stable in the second half.

While the economic slowdown in several countries like Europe and U.S. will keep travel growth trends at check, markets in Asia, Latin America and the Middle East would continue to boost growth in the second half of the year. The IATA projects global airline passenger growth of 4.6% in 2012 versus 4.2% forecasted previously.

Coming to demand-supply balances, demand (measured in traffic) will outpace capacity (combined passenger and cargo) as the year advances. Capacity is expected to show an increase of 3.3% while air travel demand is expected to see a 4.8% pickup.

Fuel Price Rise: Boon or Bane?

The airline profit outlook depends on fuel prices, the major variable component in the industry.

Crude oil price has dropped about 15% in the recently concluded second quarter. Lower fuel price no doubt cuts airline operating expenses, but it also indicates a slowing economy and the consequent fall in global air travel demand. However, if pricing remains stable despite the questionable macroeconomic outlook, the carriers should experience better profitability solely on the back of falling fuel costs.

Even with the falling fuel prices, the Association projects fuel to account for 33% of the overall operating costs, which is at similar levels when oil prices spiked in 2008 but 13–14% higher than a decade ago.

High crude oil prices, largely a function of geostrategic forces, are beyond the control of the airlines. However, using Brent crude oil as the basis, IATA expects crude oil price will hover around $110 per barrel this year. We expect crude oil and jet fuel prices to increase further this year because of the political tension in the Persian Gulf, but forecasting this key variable with any level of accuracy has always been extremely challenging.

Given the weak macroeconomic data points, we believe the carriers are ready to accept the burden of rising fuel prices as they are well positioned to endure the current crisis. Successfully passing on the increased cost to customers in the form of fare hikes and efficient use of fuel-hedging strategies are helping them to combat the rising fuel prices (hedging strategies discussed below).

Getting Rid of Unprofitable Jets

Most of the air carriers are scrapping or cutting flights in many small airports that are unprofitable in order to reduce their fuel cost burden. North American carriers lead the way in capacity discipline.

Over the last two years, Delta Air Lines Inc. (DAL - Analyst Report), United Continental Holdings Inc. (UAL - Analyst Report), US Airways Group Inc. (LCC) and American Airlines, a subsidiary of AMR Corp. (AAMRQ) slashed their capacity by about 16.6%, 16.3%, 14.3% and 8.4%, respectively as per the Center for Aviation (CAPA).

Other international airlines like Air Canada, Air France (AFLYY), Qantas Airways, Korean Airlines and All Nippon Airways also reduced their capacities over the past two years.

Hedging Strategies

Hedging strategies provide a cushion to the rising fuel prices and are being used extensively. The carriers use a combination of calls, swaps and collars at varying WTI crude-equivalent price levels to hedge.

Rightsizing

Passengers are demanding high quality services with proper security. Airlines are using obsolete, old and less-fuel efficient aircraft, flying which are no longer feasible in a fuel-expensive environment. Hence, air carriers are also focusing on fleet rightsizing.

Though initially expensive, the new aircraft are more fuel efficient than the existing ones and have helped in lowering operating and maintenance costs. Global airlines are expected to invest $3.5 trillion to buy 27,800 new airplanes, having seating capacity of more than 100, over the next 2 decades (2011–2030). New airlines business, advanced technology and dynamic growth of air travel in emerging markets throughout the world are boosting demand for these airplanes.

About one-third of the demand is expected to come from Asia, which currently accounts for 28% of global air passengers. The demand in Europe and the U.S. is expected to fall to 23% and 20% by 2030, respectively, from the current 27% that each enjoy.

Airbus, the world's leading aircraft manufacturer, will deliver the largest number of aircraft to the airline companies, followed by The Boeing Co. (BA - Analyst Report). The U.S. air carriers have started buying new planes from these manufacturers in order to provide good customer service. The progress thus attained would help these companies to regain their lost profits.

U.S. Airlines: 20-Year Projection

The U.S. airline industry is expected to remain profitable over the next two decades given the improving worldwide trends in air travel. However, growth may be held back until 2015 due to increases in fuel costs and the ongoing economic difficulties in the U.S. and Europe.

Although U.S. airlines will likely see a small dip this year, the demand for air travel will double over the next 20 years, as predicted by the U.S. Federal Aviation Administration (FAA). Passenger demand is expected to grow 2% to $746 million in 2013 and about 3% in subsequent years, reaching $1 billion by 2024 and $1.2 billion by 2032.

The FAA projects air traffic, customarily measured in billions of revenue passenger miles -- a unit of one mile flown by one passenger -- to grow by more than 90% over the same period. Revenue passenger miles would jump from 815 billion reported last year to 1.57 trillion by 2032 at an average annual rate of 3.2%.

International traffic is expected to grow 4.2% per year, in contrast to domestic travel that will growth at a more modest clip of 2.7% annually through 2032. This projection assumes a steady economic recovery with no major calamities like a large rise in oil price, swings in macroeconomic policy or financial meltdowns. Further, major North American airlines would raise capacity (available seat miles) at an annual rate of 3.1%, reaching 1.89 trillion by 2032.

The 20-year trajectory is expected to stem from the implementation of NextGen, the satellite-based navigation system that aims to make air travel more efficient. The carriers are taking numerous steps to improve their profitability as described in the above sections.

Moreover, the growing demand for air travel and a relatively lesser number of planes will make future fare hikes possible over the next two decades. Airline mergers and consolidation will bring down the number of flights and reduce the number of cities served.

OPPORTUNITIES

We believe industry consolidation and various ancillary revenues will boost profitability and cost performance of most air carriers going forward. This is an opportune moment for companies to consolidate in order to regain their lost profits and operational efficiency.

Ancillary Revenue: A number of supplementary revenue streams helped the airline industry gain ground in 2010 and 2011 after two years of drought. Ancillary revenues shot up 66% over two years to $22.6 billion in 2011. Air carriers are adding novel features to their services and expanding new products to improve passenger satisfaction and experience. The IATA projects total revenue of $631 billion for 2012, down slightly from $633 million projected in March.

Carriers are going wireless with in-flight entertainment systems such as American Airlines' Gogo "Vision" wireless video-on-demand, Delta Air Lines' "Delta Connect," Lufthansa's "BoardConnect," Emirates’ “ice OnDemand” and Southwest’s “Live TV.” Other carriers such as Virgin America, Qantas and Virgin Australia will soon launch their in-flight entertainment systems.

Cathay Pacific, Malaysia Airlines, KLM, Delta, Qantas and British Airways have also made Apple Inc.'s (AAPL) iPad available to passengers in their lounges, rent them out in the air as well as use them as a self-service kiosk, customer survey tool and food ordering tool.

Further, major U.S. carriers remain focused on expanding their product and service offerings on board and on the ground for higher ancillary revenues. Delta Air Lines and United Continental are installing winglets, WiFi and flat-bed seats apart from expanding Economy Comfort or Economy Plus seats to their fleet. United Continental is also introducing streaming wireless video in its aircraft.

Southwest Airlines Co. (LUV - Analyst Report) is benefiting from EarlyBird check-in, unaccompanied minor travel and pet fees. The company is renovating in-flight cabins and redesigning interiors, and has labeled the new appearance as Evolve: the New Southwest Experience. These fleet modernization plans and the All-New Rapid Rewards program is contributing to revenue growth.

JetBlue Airways Corp. (JBLU - Analyst Report) is experiencing solid growth given continued success in the Getaway Vacations Division, as well as the Even More Space product.

Consolidation: Airline companies consolidate in order to restore lost profits. This is evident from the past three mega-mergers: Northwest Airlines and Delta Air Lines in 2008, United Airlines and Continental Airlines in 2010, and AirTran Holdings and Southwest Airlines in 2011. All the three companies -- Delta, United and Southwest -- are the long-term beneficiaries on both capacity and cost fronts.

Again, the airline industry is awaiting another major consolidation. The rumors about American Airlines merging with another airline have been heating up since the company filed for bankruptcy protection in November last year. American Airlines is evaluating its merger proposal with US Airways, JetBlue, Alaska Air Group (ALK), Frontier Airlines, a subsidiary of Republic Airways Holdings (RJET) and Virgin America.

We see American Airlines-US Airways as the hottest pair in the industry. Three months ago, the three labor unions of American Airlines supported a merger with US Airways. The combination would create an airline on par with the largest U.S. air carrier, United Continental, in terms of revenue and traffic, and bigger than the current second-largest airline, Delta. As a result, American Airlines should emerge as a successful candidate by balancing its debt level and lowering costs.

The consolidation of American Airlines, if successful, would be the fourth in the last three years. Nevertheless, any potential merger with AMR will take several months or a year to materialize, as American Airlines has yet to complete its court restructuring process and will undergo antitrust scrutiny.

Expansion: North American carriers are making continuous efforts to increase their domestic and international flights. Delta Air Lines is focusing on adding flights in New York, Latin America, Mexico and Brazil. Delta Air Lines is progressing well on the $1.2 billion expansion at New York-JFK, scheduled to open in 2013. Internationally, Delta's deal with a Chinese international airline, China Eastern, should prove profitable.

Southwest started new services in Atlanta and will introduce services to new and unexplored domestic markets including New York LaGuardia, Boston Logan, Milwaukee and Baltimore/Washington as well as many smaller domestic cities. Further, Southwest is looking to tap the opportunity in the international market with its debut in the Caribbean, Central America, Latin America and Mexican markets by 2015.

United Continental is benefiting and enhancing its access from each other's hubs and networks. JetBlue continues to successfully expand its network in two major growth regions: Boston to New York and the Caribbean.

Technology Upgrades: Air carriers are involved in numerous technology upgrades and system automation for various activities such as airline reservation system, flight operations system, website maintenance and in-flight entertainment systems. These upgrades enable companies to perform better, lower costs and enhance customer service.

The major outperformer is expected to be Republic Airways, which has a Zacks #1 (Strong Buy) Rank for the short term (1–3 months). We also recommend Spirit Airlines Inc. (SAVE), Allegiant Travel Company (ALGT), Hawaiian Holdings Inc. (HA), Skywest Inc. (SKYW), U.S. Airways and Air France that have a Zacks #2 (Buy) Rank.

We also like a few Zacks #3 (Hold) Rank stocks such as Alaska Air Group, AMR Corp., Delta, JetBlue, Southwest, United Continental and GOL Linhas (GOL).

WEAKNESSES

Of the many challenges facing the industry, the most important ones include volatile fuel prices, economic weakness, natural calamities, government regulation, unionization, airport infrastructure constraints and safety concerns.

Oil Price Volatility: Fuel price volatility continues to be one of the significant challenges, as the cost of fuel is largely unpredictable. Fuel prices remain well below the 2008 level of over $140 per barrel that had ravaged the airlines industry. The company's ability to pass along the increased costs of fuel to its customers is limited by the competitive nature of the airline industry. Thus, even a small change in fuel prices can significantly affect profitability.

Unionization: The airline business is labor-intensive. Most of the employees are unionized and depend on various U.S. labor organizations. The relation between airlines and labor unions are governed by the Railway Labor Act, which states that a collective bargaining agreement between an airline and a labor union does not expire. Instead it becomes amendable as of a stated date. Failure to amend terms and conditions suitably may lead to work stoppages or strikes, and thereby hamper operations.

Federal Regulations: The airline industry is highly regulated, in particular by the federal government. All companies engaged in air transportation in the U.S. are subject to the regulations implemented by the Department of Transportation (DOT). The DOT recently laid new pricing rules for air carriers, effective January 26, 2012. As per the new rules, airline companies have to include all taxes and fees while advertising fares for their flights. As passengers are switching to low fares, the new rules might weaken travel demand, thereby leading to lower profits for the industry.

Further, airlines are also regulated by the Federal Aviation Administration (FAA), a division of the DOT, primarily in areas of flight operations, maintenance and other safety and technical matters.

Capacity Creep: The airline industry has a poor record of capacity discipline, though it has largely been mindful of this issue in this cycle. It remains to be seen how long the current trends remain in place before old habits return.

Large Investments: The air carriers are investing a lot of money to enhance their products and services in order to make them competitive. The proper returns from these investments are uncertain or the timings are unknown. The carriers might also lose money invested in the business for the new developments.

We expect Ryanair Holdings plc (RYAAY), which has a Zacks #4 (Sell) Rank, to underperform the broader market.

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