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Will the Ride Get Bumpier for Airline Stocks?

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It is a well-documented fact that stocks in the airline space have been plagued by multiple headwinds like weather-related disruptions, pricing issues and high costs. The turbulence in the sector is largely responsible for the NYSE ARCA Airline Index declining 2.5% over the last three months. With Q3 earnings season coming up, the ongoing turbulence may result in airlines performing disappointingly. Let’s delve into the details.

Harvey, Irma Ground Airlines - Q3 Unit Revenue Views Cut

Harvey, which wreaked havoc on America’s fourth-largest city, Houston, with heavy rainfall, has negatively impacted airline operations and caused multiple flight cancellations. In fact, air travel was hurt with two Houston airports, George Bush Intercontinental Airport (IAH) and William P. Hobby Airport (HOU), reportedly remaining closed for a few days (since the noon of Aug 27) due to Harvey-induced heavy rainfall. The airports are operational now.

United Continental Holdings (UAL - Free Report) , the parent company of United Airlines, was the worst hit, as Houston is the carrier’s second-largest hub. In September 2017, company trimmed 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 mainly due to Harvey. The carrier now expects PRASM to decline between 3% and 5% year over year (the earlier guidance provided in July was +1% to - 1%).

In fact, Harvey has impacted the third-quarter PRASM to the tune of approximately 150 basis points. The carrier now expects pre-tax margin between 8% and 10% (previous guidance was 12.5% and 14.5%).

Spirit Airlines (SAVE - Free Report) , which also has significant exposure to Houston, expects its top line to shrink to the tune of approximately $8.5 million in the third quarter due to the natural calamity. Currently, Spirit Airlines anticipates total revenue per available seat mile (TRASM) to decline between 7% and 8.5% (the previous guidance was 2% and 4%). In fact, per the company, 100 basis points of the trimmed guidance can be attributed to the negative impact of Harvey. Also, aggressive competitive pricing in its key markets contributed to the bleak forecast.

Southwest Airlines (LUV), which had to call off approximately 2,800 flights due to Harvey, now expects operating revenue per available seat mile (RASM) for the third quarter in the range of down 1% to slightly up, on a year-over-year basis. The metric was earlier projected to increase approximately 1% from the year-ago quarter.

Close on the heels of Harvey, came another natural calamity, Irma, which also hurt airline operations. American Airlines Group (AAL - Free Report) , which has significant exposure to Florida including its hub at Miami International Airport, had to cancel multiple flights due to Irma. The natural calamity also caused it to trim its third-quarter TRASM view.

High Costs Likely to Hurt Q3

With labor deals in vogue in the aviation space, labor costs have escalated, thereby hurting the bottom lines in the last few quarters. The picture is likely to be no different in the third quarter.  For example, labor costs shot up significantly at Alaska Air Group (ALK - Free Report) following the amendment to the pay-related pilots’ contract at its subsidiary, Horizon Air.

Following the agreement, the company expects third-quarter cost per available seat mile (excluding fuel and other special items) between 8 cents and 8.05 cents. High labor costs are also expected to hurt results at Allegiant Travel Company (ALGT - Free Report) . Allegiant carries a Zacks Rank #3 (Hold). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Moreover, increasing fuel costs do not bode well for airlines. Oil prices are currently hovering around the $50-a-barrel mark, way higher than the lows of around $26 a barrel touched in February last year. The rise in fuel costs, which again may be Harvey induced, are also likely to distort the Q3 earnings picture for airlines. For example, Delta Air Lines (DAL - Free Report) now expects fuel prices per gallon in the third quarter between $1.68 and $1.73. The figure was much less in the second quarter of 2017.

Capacity Overexpansion & Declining Airfare

Carriers like Spirit Airlines and JetBlue Airways Corp. (JBLU) registered declines in their respective load factors (percentage of seats filled by passengers) in August. The reason for the downturn was capacity expansion outweighing traffic growth in the month. The metric had declined for most carriers in July as well.

Woes related to capacity overexpansion plagued airline stocks in the not so distant past (particularly 2015) also. In light of the above traffic reports, it is quite natural for fears related to capacity overexpansion to resurface.

In such a scenario, investors fear that capacity expansion may lead to oversupply in the market even as fuel costs remain well below the highs of mid-2014, despite the recent resurgence (jet fuel prices climbed 8.5% in August). Moreover, airfares have remained low, with the metric declining in August as well after the fall in July.

According to research firm Hopper, air fares (roundtrip) in the United States are likely hit a low of $216 in October. Capacity over-expansion is believed to be the primary reason for the decline in airfares. While low air fares are favorable for fliers, it is a drag on the top lines of carriers due to their lesser profits.

Threat from Low-Cost Carriers

The emergence and success of low-cost carriers like Spirit Airlines and JetBlue Airways have posed significant threats to legacy carriers. In a price-sensitive economy, it is not only a question of the survival of the fittest but also of the cheapest. In fact, United Continental, while trimming its guidance for the third quarter attributed the move to its price war with carriers like Spirit apart from Harvey and high fuel costs.

United Continental and American Airlines introduced Basic Economy Fares earlier this year to attract more budget-conscious passengers. Recently, American Airlines announced its decision to expand basic economy fares to more domestic flights in a bid to compete more effectively with low-cost carriers.

Other Headwinds

In July 2017, American Airlines, Frontier Airlines and Delta were heavily fined by the U.S. Department of Transportation (DOT) for flouting rules pertaining to consumer protection. The DOT fined Frontier Airlines $400,000 for breach rules pertaining to oversales and disability. American Airlines was penalized to the tune of $250,000 as it failed to make timely refunds to passengers. Delta was fined $200,000 by the agency for revealing inaccurate baggage-related reports.

United Airlines, the subsidiary of United Continental, again grabbed headlines in July owing to passenger harassment issues, following the infamous David Dao episode in April. This time, the carrier reportedly forced a passenger, Shirley Yamauchi, on a flight from Houston to Boston, to remove her 27-month son from his seat, the ticket for which had cost almost $1,000. The toddler had to sit on his mother’s lap during the course of the journey while his paid seat was given to another passenger.

The twin terror attacks in Spain, in August 2017, also do not bode well for airlines. Such acts of terrorism affect airline stocks as there is a possibility of waning travel demand due to security fears. Moreover, as a result of mass shooting in Las Vegas, travel to this favorite tourist destination might be hurt. As a result, travel-focused stocks, which include airlines, are likely to be on the back foot.

Moreover, technical glitches have been a nuisance for carriers. Evidently, the likes of Delta and Southwest Airlines have seen their operations being affected by technological problems this year. Given that technological infrastructure is a key expense for airlines, the profitability of carriers might be affected in the event of such malfunctions, going forward.

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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