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Industry Outlook

Seven months into 2013, the outlook for the global airline industry looks bright for the balance of the year, owing to the economic recovery in North America, a steady rise in demand and effective cost-control measures.  

The International Air Transport Association (IATA) projects overall airline profits of $12.7 billion for 2013, with 3.13 billion passengers in total. The forecast is higher than the previous estimate of $10.6 billion. Net profit margin is expected at 1.8%, up slightly from 1.6% estimated previously.

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, and lower cancellations and overbooked flights. As a result, these carriers are expected to generate $4.4 billion in profits in 2013, up from $2.3 billion earned last year.

Asia-Pacific: These carriers are expected to record a profit of $4.6 billion in 2013, much more than $3.9 billion recorded in 2012. The boost is expected from China, Japan and long-haul markets on upbeat trade flows and business activities. This will partially balance the effects of the regional sluggish cargo markets.

Middle East: Per IATA, profits from the Middle East carriers are expected to grow to $1.5 billion compared with $900 million in 2012. The region will likely witness strong traffic growth owing to expanded connectivity to emerging markets.

Latin America: Profit projection for the Latin American carriers is pegged at $600 million, almost double the 2012 profit. Growing demand and capacity expansion stemming from increased trading and business flows with Asia and North America will offset the volatility in the domestic scenario.

Europe: As for the European airlines, the IATA expects this year’s profit to reach $1.6 billion versus $300 million in 2012. Lingering effects from the Euro-zone crisis are not expected to abate for quite some time, overall demand will likely stabilize due to better activities in North Atlantic market and certain European areas.

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.

Underlying Factors for 2013 Profits

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

Passenger & Cargo: While economic instability in several regions like Europe and Latin America will keep travel growth in check, markets in Asia, the U.S. and the Middle East will continue to boost growth in the second half of 2013. The IATA projects global airline passenger growth of 5.3%, while cargo business will see an expansion of 1.5%. The average industry load factor is expected at a record level of 80.3%.

Coming to demand-supply balances, demand (measured in traffic) will outpace capacity as the year advances. While the projected capacity increase is 4.3%, air travel demand will likely see a 5.3% pickup, resulting in a modest 0.3% growth in passenger yields this year.

Fuel Price Effect: Airline profit outlook depends on fuel prices, the major variable component in the industry. For 2013, average oil prices are expected to stay below last year’s level, primarily due to increased fuel supply in North America. 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 $214 billion in 2013, accounting for 31% of the overall operating costs.  

Service and Fleet Restructuring: Most of the air carriers at large are scrapping flights in many small and unprofitable airports in order to reduce their cost burden that has increased 55% over the period 2006–2013. The companies are also replacing old and depleted airplanes with new and upgraded ones. Though initially expensive, new and improved aircraft are more fuel efficient than the existing ones and will help in lowering operating and maintenance costs.

Leading passenger carrier Delta Air Lines (DAL) disclosed plans to shrink operations at the Memphis, TN hub due to low financial gains. This initiative falls under Delta’s strategy to trim its operating expenses and achieve the targeted $1 billion in cost savings over the next few years.

Over the next 20 years, global airlines are expected to invest nearly $4 trillion to $5 trillion for fleet development. For this, the airlines are banking on top aircraft manufactures such as The Boeing Company (BA), Embraer SA (ERJ) 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 B737 Max, for better service and demand-supply equilibrium.

In May, United Continental Holdings Inc. (UAL - Analyst Report) agreed to buy 30 Embraer 175 regional jets. The deal, estimated at about $4 billion, also has the option of 40 additional purchases. Additionally, the airline placed a purchase order for 35 jets with Airbus for an undisclosed amount. Per the agreement, Airbus will convert United's existing order of 25 A350-900s into A350-1000s as well as deliver 10 new A350-1000s starting 2018.

Ryanair Holdings plc (RYAAY - Snapshot Report) inked a deal with Boeing to buy 175 new Next Generation 737-800 airplanes for approximately $15.6 billion.

Hawaiian Airlines, Inc, a subsidiary of Hawaiian Holdings Inc. (HA - Snapshot Report) 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.

United Continental is aiming to increase the number of 180-degree flat-bed seats and a personal on-demand entertainment system for its premium cabin passengers of long-route international flights. This will provide flyers an added level of privacy and comfort along with multi-course meals and complimentary wine plus personal staff attention.

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.

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.

U.S. Airlines – 20-Year Projection

Very long-term projections are by their very nature uncertain, but the U.S. airline industry is expected to remain profitable over the next two decades given the improving worldwide aviation trends. However, growth may be held back until 2015 due to volatility in fuel prices and the ongoing economic headwinds, particularly in Europe.

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 are expected to grow 2.8% to 757.2 million in 2014 and about 2.1% in the future, 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 2.8% 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.

Zacks Industry Rank

Within the Zacks Industry classification, airlines are grouped into the Transportation sector (one of 16 Zacks sectors).

We rank all the 260-plus industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry. To learn more visit: About Zacks Industry Rank.

As a point of reference, the outlook for industries in the top one-third of the list (with Zacks Industry Rank #88 and lower) is ‘Positive,’ the mid one-third of the list (between #$89 and #176) is ‘Neutral,’ while the last one-third (from #177 and above) is ‘Negative.’

The Zacks Industry Rank for airline industry is currently #160, implying that it is in the mid-range of all industries ranked. This highlights a mixed outlook for the industry in the near term with a number of long-term positive factors offset by near-term challenges on the earnings front.

Earnings Trends

The airline industry falls under the broader transportation sector that displays stable growth in earnings. The first and second quarter results of 2013 were impressive for the sector in terms of both beat ratios (percentage of companies coming out with positive surprises) and growth.

The earnings "beat ratio" was 87.5%, while the revenue "beat ratio" was 37.5% in the first quarter. Total earnings for this sector increased 3.3% and total revenue grew 3.1%.

With some results for the second quarter still to be released, we expect earnings to register growth of 3.6% while there will be an improvement of 2.9% on the revenue front.

For the months ahead, earnings are expected to grow 11.0% in the third quarter of 2013 and 12.8% in the fourth quarter, thereby reaching full-year 2013 growth of 10.3%. For revenue, growth will likely be 4.6% in the September quarter, followed by 5.0% in the fourth quarter. Full-year revenue will likely increase 4.1%.

For more details about earnings for this sector and others, please read our ‘Earnings Trends’ report.

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 for higher profits and operational efficiency.

Additional Revenue Gains: A number of supplementary revenue streams helped the airline industry gain ground in 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 $711 billion for 2013.

United Continental introduced a new benefit program -- MileagePlus Small Business Network. This initiative is part of United’s award-winning loyalty program, MileagePlus. It is the first travel loyalty program in the U.S. that allows businesses to earn and redeem miles.

To bring in incremental revenue, Atlanta-based Delta Air Lines announced the launch of new nonstop seasonal flights between Fargo, ND and Atlanta every Saturday from Dec 21. The airline unveiled the service to tap growing demand in the northern part of the nation to connect with the warmer places in Southeast and Latin America during winter. This new flight system will give flyers in the North Dakota region easy access to numerous destinations all over the nation and overseas across Atlanta.

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 will be offering vitaminwater as an option to premium beverages.

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.

Moreover, the airlines continue to focus 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 mega mergers within the industry involving 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 long-term beneficiaries on 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). The merger will likely to be completed within the next few months, with the European Union’s (EU) approval expected in the coming days. In mid Feb, the board of directors of both the carriers gave their nod to the pending merger agreement, paving way for the largest global carrier.

We see American Airlines-US Airways as the hottest pair 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.

Another leading U.S. airline, Delta Air Lines successfully completed the acquisition of a 49% stake in British carrier Virgin Atlantic from Singapore Airlines. This partnership entitled Delta and Virgin Atlantic to gain 36% access to the New York-London travel route, second to the 51% control exercised by a partnership of AMR's American Airlines and British Airways.

The alliance will hugely benefit customers with a broader network of flights, enhanced connectivity and convenient booking options. Reaping advantages of the deal, Delta launched a daily nonstop service between Seattle and London, scheduled to commence from Mar 29, 2014.

Apart from these major acquisitions, various airline partnerships and alliances are vital to the overall growth of the industry. Low-cost airline JetBlue Airways Corporation (JBLU - Analyst Report) 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, Asiana Airlines, the LOT Polish Airlines, Turkish Airlines, Japan Airlines, Emirates, Hawaiian Airlines, Aer Lingus and recently, entered into an alliance with South African Airways.

Expansion: North American carriers continuously strive to increase domestic and international flights. Delta Air Lines 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 new and unexplored domestic markets including Branson; Charlotte, Flint, Rochester, Portland, Wichita and Grand Rapids. Further, the company is also 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 -- the Caribbean and Latin America -- as these comprise almost one-third of the company’s total network. Allegiant Travel Company (ALGT - Snapshot Report) 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 reservation, flight operations and website maintenance. These upgrades allow the companies to function effectively and efficiently, minimize expenses and render better customer service.

JetBlue Airways is set to introduce custom-equipped iPads for pilots on-board. This will replace the heavy paper manuals during flight phases, resulting in reduction of weight on the plane and in turn fuel saving as well as lower printing costs. Additionally, pilots will have more real-time capabilities in the cockpit plus better technological support.

This follows American Airlines that launched the Electronic Flight Bag program, whereby pilots will utilize tablets during flights.

The major outperformers will be Hawaiian Holdings Inc. ((HA - Snapshot Report) and US Airways Group, Inc. that have Zacks Rank #1 (Strong Buy). We also like a few Zacks #2 (Buy) Rank stocks such as Ryanair Holdings plc (RYAAY - Snapshot Report) and Spirit Airlines, Inc. (SAVE - Snapshot Report). United Continental, Delta Airways and Southwest carry a Zacks Rank #3 (Hold).

CHALLENGES

Of the many challenges facing the industry, the most crucial 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 (DoT). Further, airlines are also regulated by the Federal Aviation Administration, 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 to gain a competitive edge. However, returns from these investments are uncertain. In fact, the carriers investing in new developments could even end up losing money.

We expect GOL Linhas A (GOL - Analyst Report) and Republic Airways Holdings Inc. (RJET - Snapshot Report), which have a Zacks Rank #4 (Sell), to underperform the broader market.

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