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Airline Industry Outlook - October 2017

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Airline stocks are unlikely to set the stage on fire in the third quarter of 2017, results of which are around the corner. Multiple headwinds of late have prevented the space from flying higher.

This scenario is reflected in the latest three-month performance of the NYSE ARCA Airline Index. The sector tracker has shed value to the tune of 2.5% in the period. The headwinds are likely to negatively impact third-quarter results of airline stocks.

Let’s delve into the challenges confronting this key sector.

Back-to-Back Natural Calamities

Hurricane Harvey, followed by Irma, caused airline stocks like Delta Air Lines (DAL - Free Report) and United Continental Holdings (UAL - Free Report) to call off multiple flights. United Continental was the worst hit by Harvey, as Houston is the carrier’s second-largest hub.

The Chicago-based carrier cited Harvey as one of the reasons for trimming its views with respect to pre-tax margin and passenger revenue per available seat mile (PRASM: a key measure of unit revenue) for the third quarter. In fact, Harvey is expected to hurt third-quarter PRASM to the tune of approximately 150 basis points. American Airlines Group (AAL - Free Report) also trimmed guidance for the third quarter due to the devastating impact of Irma.

That said, recent comments from management teams suggest that the hurricane impact may be a lot less severe than had been expected. This has helped the stocks recover some of their earlier losses.

High Costs

High fuel costs are also likely to limit third-quarter earnings growth. Harvey contributed to an increase in fuel prices due to gasoline shortages caused by the storm. Fuel costs have been on the rise lately, with oil prices hovering around the $50-a-barrel threshold. This upsurge can be attributed to an improving demand outlook for the commodity and OPEC deal extension talks.

United Continental projects third-quarter fuel price per gallon between $1.72 and $1.77 (earlier view: $1.56 to $1.61). The likes of Delta and Southwest Airlines (LUV - Free Report) have also lifted their respective forecasts for fuel prices.

Escalation in fuel cost apart, the surge in labor costs is also expected to distort the earnings picture of airlines. With airline companies inking pay-related deals with various labor groups, costs on this front have spiked. Escalated labor costs have hurt the bottom lines of carriers in the last few quarters, and the third quarter of 2017 is unlikely to be any different.

Soft Air Fares & Capacity Issues

Declining air fares are hurting the top lines of carriers. Low air fares bring good news for fliers but are a bane of airline companies.

According to research firm Hopper, air fares (roundtrip) in the United States are likely hit a low of $216 in October. Problems related to capacity over expansion are also hurting carriers. This is highlighted by the fact that the likes of JetBlue Airways (JBLU - Free Report) and Spirit Airlines (SAVE - Free Report) witnessed declining load factors (percentage of seats filled by passengers) in August as capacity expansion outweighed traffic growth in the month. July traffic reports also unveiled declining load factors for most carriers.

Other Headwinds

The price war between low-cost carriers like Spirit Airlines and legacy carriers like United Continental is another cause for concern in this sector. Issues related to customer dissatisfaction have hurt carriers this year. Apart from the infamous David Dao incident, issues relating to customer dissatisfaction have surfaced at other carriers like Spirit Airlines and Delta.

Zacks Industry Rank Highlights Gloomy Scenario

The Zacks Industry Rank of 228 (out of 250 plus groups) carried by the Zacks Airline industry further highlights the plight of the airlines. This unfavorable rank places the companies in the bottom 11% of the Zacks industries.

We classify our entire 250-plus industries into two groups: the top half (i.e. industries with the best average Zacks Rank) and the bottom half (the industries with the worst average Zacks Rank).

Over the past decade, using a week’s rebalance, the top half beat the bottom half by a factor of more than 2 to 1.

Click here to know more: About Zacks Industry Rank

Some Positives Remain

Even though stocks in the space are currently struggling, the sector does have a few bright spots. Latin American carriers like Copa Holdings and GOL Linhas (GOL - Free Report) are witnessing good times on the back of an improved Latin American economy. GOL Linhas holds a Zacks Rank #2 (Buy). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here

Moreover, the busy Labor Day travel period (Aug 30-Sep 5) for U.S. airlines this year further highlights that demand for air travel remains strong. This bodes well for airlines.

Attractive Valuation

Despite the headwinds, the sector is attractively valued, which also highlights that all is not lost for stocks in the space. Going by the EV-to-EBITDA (enterprise value to earnings before interest, tax, depreciation and amortization) ratio, which is often used to value airline stocks, given their significant debt levels and high depreciation and amortization expenses, the industry doesn’t look expensive at this point.

The industry currently has a trailing 12-month EV/EBITDA ratio of 7.7x, which is better than what the industry saw in the last five years. The ratio is much lower than the high end of the five-year range. The industry also compares favorably with the broader market on the same valuation metric.

The airline industry’s favorable positioning compared to the overall market certainly highlights the fact that despite its current struggles, the sector might rebound in the long term.

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