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It is a well-established fact that some of the headwinds like declining unit revenues and depressed airfares, which had hit airlines in the last few years, are on the mend. Despite this optimism, one must be mindful of certain factors still hurting stocks in the space before investing in the sector. Let’s delve into the details.

High Costs Distorted Q1 Earnings Picture

With labor deals in vogue in the aviation space, labor costs have been on the rise. In the recently concluded Q1 earnings season, growth on the bottom-line front was hardly visible for airlines due to high costs. For example, Q1 earnings at Delta Air Lines (DAL - Free Report) contracted 41.7% on a year-over-year basis due to higher costs. At Southwest Airlines (LUV - Free Report) , the bottom line declined 30.7% year over year.

Apart from this, fuel costs increased and resulted in bottom-line contraction. For example, at American Airlines Group (AAL - Free Report) , total operating expenses climbed 11.4% year over year to $9 billion primarily due to the rise in fuel costs.

In fact, American Airlines’ shares fell on Apr 27, despite better-than-expected earnings and revenues in Q1, due to its announcement to hike wages of its pilots and flight attendants to match industry-leading standards. As a result, American Airlines is likely to see an increase of approximately $230 million in salary and benefit expenses in 2017, and $350 million in each of the following two years.

Repetition Likely in Q2

Increased costs are expected to hurt the bottom line of carriers in the second quarter too. United Continental Holdings (UAL - Free Report) expects unit costs to increase in the band of 4–5% from higher labor costs.

United Continental carries a Zacks Rank #2 (Buy). You can see the complete list of today’s Zacks #1 Rank stocks here.

Hawaiian Holdings (HA - Free Report) expects cost per available seat mile (CASM), excluding fuel and special items, to increase in the band of 4.5% to 7.5%, mainly due to the sixty-three month pay-related deal cleared by its pilots in Mar 2017. Fuel cost per gallon is expected in the band of $1.60 to $1.70, which is higher than $1.55 recorded in the second quarter of 2016.

Similarly, Allegiant Travel Company (ALGT - Free Report) expects CASM excluding fuel, to increase in the band of 13–15% in the second quarter of 2017, mainly due to the implementation of the new pilot agreement.

Higher Costs to Hurt Bottom Line

The International Air Transport Association (IATA) expects 2017 global net profit for the industry to decline 9.8% year over year to $31.4 billion. Average oil price for 2017 is expected to be $54 per barrel for Brent Crude (the comparable figure in 2016 was $44.6 per barrel). With most airlines, including heavyweights in the U.S. aviation space inking labor deals, it is of little surprise that labor costs are surging. IATA expects unit labor costs to increase approximately 3% in 2017.

The research firm has also predicted that airline companies will earn $7.69 per passenger in 2017 compared with $9.1 in 2016. Global net profit margin is expected to decline to 4.2% in 2017 from 4.9% a year ago.

Customer-Related Issues

The passenger-dragging incident at United Airlines, the wholly owned subsidiary of United Continental, on Apr 9, drew flak from across the globe, resulting in multiple apologies from the company.

As a fallout of the incident, United Airlines’ CEO Oscar Munoz is now no longer guaranteed to be the company’s chairman in 2018.

Another legacy carrier, American Airlines, also found itself in the middle of a passenger fiasco a few days later. Reportedly, a female passenger on one of American Airlines flights was seen crying in a video, uploaded on social media by a fellow passenger, following an ugly altercation with one of the flight attendants. The attendant reportedly hit her with her baby’s stroller. The female passenger was subsequently escorted off the flight. The errant male flight attendant was “removed from duty.”

Shares of low-cost carrier Spirit Airlines (SAVE - Free Report) were also hit recently by unfavorable customer-related issues.

Weather-Related Issues & Technological Glitches

The damage caused by winter storm Stella in March disrupted operations in a major way, causing leading carriers like Delta and American Airlines to cancel multiple flights. This is not the first time that sector participants have been laid low by a winter storm.

For example, Hurricane Matthew had caused extensive damage in the affected areas last year. Such acts of nature throw the schedules of carriers out of gear, causing multiple flight cancellations.

Technical glitches have been a great nuisance for carriers. Recently, British Airways, the largest carrier in the UK (in terms of on fleet size) encountered a major IT system failure resulting in cancellation of flights and untold miseries to concerned travelers. British Airways’counterparts in the US like Delta and United Continental too have suffered similar setbacks this year. Since expenditure on technological infrastructure is a major one for airlines, their profitability might be hurt in the event of such malfunctions.

Popularity of Low-Cost Carriers Ringing Alarm Bells?

The emergence and the subsequent growth and success of low-cost carriers like Spirit Airlines, and Southwest Airlines have raised concerns for legacy carriers like American Airlines and United Continental.

In a bid to combat the threat of low-cost carriers and attract budget-conscious travelers, both the above-mentioned legacy carriers have recently started to sell cheaper tickets (Basic Economy Fares). In a price-sensitive economy, it is not only the survival of the fittest but also of the cheapest.

In fact according to a Bloomberg report, American Airlines intends to curtail the legroom for passengers on its newest Boeing 737 planes. It is widely believed that the move is aimed at countering the challenges of low-cost carriers, as by trimming the space between rows more seats/passengers can be accommodated, thereby allowing them to sell more low-priced tickets.

Laptop Ban: What’s in Store?

In March, the U.S. Transportation Safety Administration imposed a ban (to promote security) on carrying electronic devices, larger than mobile phones, on U.S.-bound flights operated by some carriers like Egyptair and Etihad from 10 airports in seven Middle Eastern nations and Turkey.

However, according to media reports the ban may be expanded. John Kelly, Homeland Security Secretary, has reportedly spoken about tightening security on planes to counter terror attacks. In this context, the government might prevent laptops in all flights to/from the U.S. In the event of the wider ban materializing, demand for air travel may shrink thereby hurting the top line of carriers. However, a Politico report on May 30 stated that the U.S. had decided against banning laptops from the cabins of U.S.-bound planes from Europe as of now.

According to another report, the U.S. government is looking to ban laptops from the cabins of domestic-bound flights from 71 airports. With conflicting reports emerging, it is natural that focus will remain on the issue going forward.

Cuba Issue: What Lies Ahead?

According to various media reports, President Trump might reverse the decision of his predecessor Barack Obama on Cuba. In 2014, President Obama had called for the restoration of diplomatic ties with Cuba after more than 50 years. As part of that process, travel restrictions were eased. Subsequently, U.S. airlines like American Airlines and Delta started operating commercial scheduled flights to Cuba.

Now, if President Trump reverses this policy and puts the earlier restrictions in place, cruise operators and airlines in U.S. stand to lose approximately $712 million in revenues on an annual basis. Naturally, updates on this issue will be eagerly awaited by investors going forward.

Other Challenges

With economies like Venezuela and Nigeria in the doldrums, the airlines operating there (with dwindling foreign exchange reserves) are facing tough times with regard to repatriation.  Due to these difficulties, United Continental will reportedly no longer fly to Venezuela from next month.

Moreover, terror attacks like the recent ones in U.K. have the potential to hurt travel demand due to security concerns. Other issues including the ongoing dispute between leading U.S. carriers and their Gulf counterparts can present further challenges for the industry.

To Wrap Up

The above write-up clearly suggests that the airline industry, despite the optimism, is not bereft of headwinds. The challenges may drive away investors, especially the risk-averse ones, unless close attention is paid to solve the weaknesses.

Check out our latest Airline Industry Outlook for more news on the current state of affairs in this market from an earnings perspective, and how the trend looks for this important sector at the moment.

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