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Industry Outlook

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Leaving behind the effects of an unstable oil price scenario and sluggish world trade, the global airline industry is expected to perk up through 2013 on improved passenger traffic and freight volumes. This improved backdrop is reflected in the International Air Transport Association's (IATA) projections for this year that show the industry generating $10.6 billion in profits this year, up from their earlier forecast of $8.4 billion.

Net profit margin is expected to be 1.6%, up slightly from the previously estimated 1.3%.

Regional Forecast

North America: North American airlines display strong growth prospects for the coming months courtesy of disciplined capacity, rising travel demand and a number of new and enhanced ancillary revenues. The carriers are performing impressively in terms of customer service including on-time arrivals, advanced baggage handling systems, fewer customer complaints, lower cancellations and overbooked flights.

As a result, these carriers are expected to generate $3.6 billion in profits in 2013, higher than $2.3 billion earned last year.

Asia-Pacific: These carriers are expected to record a profit of $4.2 billion in 2013, much more than $3.9 billion recorded in 2012. The expected boost in cargo performance will aid the profitability level. Notably, this is the sector’s highest profit-producing region outside the home market.

Middle East: Per IATA, profits from the Middle East carriers are expected to grow to $1.4 billion compared with $900 million in 2012. The region will likely witness strong traffic growth owing to expansion of connectivity to emerging markets.

Latin America: Profit projection for the Latin American carriers was pegged at $600 million, almost double the 2012 profit. Growing demand and capacity expansion initiatives will offset the volatility in the domestic scenario.

Africa: African air carriers are expected to post profits of $100 million this year, after a loss of $100 million in 2012. Over the last few quarters, this territory has attracted immense attention, owing to the untapped business opportunities it offers.

Europe: As for the European airlines, the IATA expects this year’s profit to reach $800 million versus $300 million in 2012. Although the Eurozone woes will continue to linger, airline activities are expected to improve based on robust services on long-haul routes to emerging markets.

Underlying Factors for 2013 Profits

In the base-case scenario, there are several dynamics that will act as driving factors for the overall airline profits in 2013. These include:

Passenger & Cargo: While economic instability in several regions like Europe and Latin America will keep travel growth at check, markets in Asia, the U.S. and the Middle East will continue to boost growth in the first half of 2013. The IATA projects global airline passenger growth of 5.4%, while cargo business will see expansion of 2.7%.

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 4.0% while air travel demand is expected to see a 4.7% pickup.

Fuel Price Effect: Airline profit outlook depends on fuel prices, the major variable component in the industry. Average crude oil prices remained relatively flat year over year at $94.05 per barrel in 2012. Lower fuel price no doubt cuts the airlines’ operating expenses, but it also indicates a slowing economy and the consequent fall in global air travel demand.

However, if pricing remains stable despite an uncertain macroeconomic outlook, the carriers will likely experience better profitability. The Association projects fuel cost of $216 billion in 2013, accounting for 33% of the overall operating costs.

Service and Fleet Restructuring: Most of the air carriers at large are scrapping or cutting flights in many small and unprofitable airports in order to reduce their fuel cost burden. The companies are also working on replacing old and depleted airplanes with new and upgraded ones. Though initially expensive, the new and improved aircraft are more fuel efficient than the existing ones and will help in lowering operating and maintenance costs.

In the coming two decades, global airlines are expected to invest nearly $3.5 trillion to buy about 27,800 new airplanes. For this, they are banking on top aircraft manufacturers such as The Boeing Company (BA - Analyst Report) and Airbus. Over the long run, the carriers aim to replace their old narrow-body jets -- A320’s/B757-200/300 -- with advanced narrow-body airplanes such as A320 Neo and the 737 Max, enabling better services to customers and maintaining equilibrium between demand and supply.

Recently, United Continental Holdings Inc. (UAL - Analyst Report) ordered eight Boeing 737-900ERs aircraft and Qantas Airways placed an order for five. Ryanair Holdings plc (RYAAY) inked a deal with Boeing to buy 175 new Next Generation 737-800 airplanes.

Hawaiian Airlines, Inc, a subsidiary of Hawaiian Holdings Inc. (HA), entered into an agreement with Airbus to purchase 16 new A321 Neo aircraft between 2017 and 2020. The deal also has the option of acquiring nine additional aircraft.

Jet Renovation: With flyers demanding comfortable and quality services along with proper security, airlines are focusing on aircraft redesigning by offering new and attractive products and services within the travel plan.

Delta Air Lines Inc. (DAL - Analyst Report) recently launched new Fly Delta application for iPad users. The company targets investing more than $2 billion through 2013 on improved products, services and airport facilities in the air and on the ground.

Dallas-based Southwest Airlines (LUV - Analyst Report) is upgrading its 737-700 fleet with the new Boeing Sky Interior, and renovating in-flight cabins and decorating interiors (known as Evolve) to improve customer satisfaction and experience. Additionally, the company is offering Row 44 WiFi technology-based facilities like Live Television. The company is also expanding seating capacities in Boeing 737-700s planes.

Hedging Strategies: Hedging strategies are used by airline companies to cope with the rising fuel prices. The carriers use a combination of calls, swaps and collars at varying WTI crude-equivalent price levels to hedge.

Longer-term Outlook

Although U.S. airlines experienced sluggish growth over the last few months, the demand for air travel is expected to nearly double over the next 20 years, as predicted by the U.S. Federal Aviation Administration (FAA). Passenger enplanements is expected to grow 2.8% to 757.2 million in 2014 and about 2.1% in the future years, reaching $1.0 billion by 2027 and nearly $1.15 billion by 2033.

The FAA projects air traffic, customarily measured in billions of revenue passenger miles (implying a unit of one mile flown by one passenger), to grow many folds over the same period. Revenue passenger miles will jump from 815 billion reported in 2011 to 1.46 trillion by 2033 at an average annual rate of 2.8%.

International traffic is forecasted to move up 4.0% per year, reaching 402.9 million in 2033. Domestic travel will grow at a more modest clip of 2.7% annually. This projection assumes a steady economic recovery with no major headwinds like a large rise in oil price, swings in macroeconomic policy or financial meltdowns. Further, major North American airlines will raise capacity (available seat miles) at an annual rate of 2.0%, reaching 1.06 trillion by 2033.

OPPORTUNITIES

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

Additional Revenue Gains: A number of supplementary revenue streams helped the airline industry gain ground in 2011 and 2012. 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 $671 billion for 2013.

With the aim of enhancing on-board entertainment choices for flyers, Southwest Airlines announced the offering of on-demand movies on flights. Additionally, the carrier is benefiting from the All-New Rapid Rewards program and increased ancillary product offerings such as EarlyBird check-in, unaccompanied minor travel and pet fees.

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.

Passenger air transportation services provider JetBlue Airways Corp. (JBLU - Analyst Report) is experiencing solid growth given continued success in the Getaways vacation package business, TrueBlue frequent-flier program and Even More product offerings.

Moreover, the airlines are also persistently concentrating on distinctive advertising and promotional activities with the help of popular social media outlets that create brand awareness and attract more passengers.

Mergers & Acquisitions: Airline companies unite in order to restore lost profits and broaden their perimeter. This was evident in the past three-mega mergers of Northwest Airlines and Delta Air Lines in 2008, United and Continental in 2010, and AirTran and Southwest in 2011. All three companies -- Delta, United and Southwest -- are the long-term beneficiaries on both capacity and cost fronts.

Currently, the biggest airline amalgamation that is creating waves is the merger of US Airways Group Inc. (LCC) and American Airlines Inc, a subsidiary of AMR Corporation (AAMRQ). In mid-February, the board of directors of both the carriers gave a nod to the pending merger agreement, paving the way for the largest global carrier. In early April, U.S. Bankruptcy Judge Sean Lane gave his green signal for the $11 billion unification, by turning down the application of a planned $19.9 million severance package for Tom Horton, the outgoing CEO of AMR.

We see American Airlines-US Airways as the hottest pairing in the industry, as it will be in the best interest of customers. This collaboration will dethrone United Continental Holdings from its current status of being the carrier of the highest number of passengers. As a result, the newly formed airline -- American Airlines Group Inc. -- will emerge as a successful candidate by balancing its debt level and lowering costs.

Delta is attempting to acquire a 49% stake in British carrier Virgin Atlantic for £224 million or $360 million from Singapore Airlines. With this acquisition, Delta Airlines will gain more control over one of the busiest air routes across the globe -- New York to London. The deal will also hugely benefit customers with a broader network of flights, enhanced connectivity and convenient booking options. The companies have submitted an antitrust immunity application with the U.S. Department of Transportation (DoT) for their proposed joint venture.

Apart from these major acquisitions, various airline partnerships and alliances are vital to the overall growth of the industry. JetBlue remains focused on growing partnerships (codeshare, interline, and baggage handling agreements) with both legacy and international carriers in order to enhance its services and take advantage of travel benefits.

The company has allied with several international companies, including Cathay Pacific, Air China, the LOT Polish Airlines, Turkish Airlines, Japan Airlines, Emirates, Hawaiian Airlines, Aer Lingus and recently, entered into an alliance with South Korea's prime carrier, Asiana Airlines.

Expansion: North American carriers are making continuous efforts to increase their domestic and international flights. Delta strengthened its position in New York City by gaining market share in LaGuardia airport. Moreover, the company along with Alaska Airlines, has agreed to increase international service in the West Coast. This move will take the airline closer to serving the key markets in Asia as well as benefit flyers in the Pacific Northwest circuit.

In 2013, Southwest targets to introduce services to new and unexplored domestic markets including Branson; Charlotte, Flint, Rochester, Portland, Wichita and Grand Rapids. Further, the company is looking to tap opportunities in the international market with its debut in the Caribbean, Central America, Latin America and Mexican markets by 2015.

While JetBlue continues to successfully expand its network in two major growth regions: Boston, and Caribbean and Latin America, Allegiant Travel Company (ALGT) is consistently introducing non-stop low-cost travel options between various spots domestically.

Technology Upgrades: Air carriers are opting for numerous technology upgrades and system automation for various activities such as airline reservations, flight operations and website maintenance. These upgrades allow the companies to function effectively and efficiently, minimize expenses and render better customer service.

The major outperformers are expected to be Alaska Air Group Inc. (ALK) and Allegiant Travel Company, which have a Zacks Rank # 2 (Buy). We also like a few Zacks #3 (Hold) Rank stocks such as Spirit Airlines Inc. (SAVE), Bristow Group Inc. (BRS), United Continental, Delta and Southwest.

CHALLENGES

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 fuel costs are largely unpredictable. Airline carriers’ ability to pass along the increased costs of fuel to its flyers is limited by the competitive nature of the industry. Thus, even a small change in fuel price 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. 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.

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

We expect GOL Linhas A (GOL) and SkyWest Inc. (SKYW), which have a Zacks Rank #4 (Sell), to underperform the broader market.

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