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Airline Industry Outlook - February 2018

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It seems that airline stocks are back in favor after being laid low for the better part of 2017 due to headwinds like the back-to-back hurricanes and higher fuel costs. The resurgence of airline stocks can be made out from the fact that the NYSE ARCA Airline Index has increased 10.9% over the last three months.

Lets delve deep to unearth the factors responsible for the turnaround.

Bullish Unit Revenues

The improving scenario with respect to unit revenues is a big positive for airlines. For example, Delta Air Lines (DAL - Free Report) , while revealing better-than-expected results in the fourth quarter of 2017, predicted total unit revenues (excluding refinery sales), a measure of sales relative to capacity for a carrier, to increase in the band of 2.5% to 4.5% (on a year-over-year basis) in the first quarter of 2018.

Delta expects to perform well on this front in 2018 as well, with passenger revenue per available seat miles (PRASM) growth estimated in each quarter. Delta carries a Zacks Rank #3 (Hold). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

American Airlines expects total revenue per available seat mile (TRASM) in the first quarter of 2018 to increase in the range of 2-4% year over year.  

Furthermore, rising fuel costs might lead to a rise in ticket prices and boost revenues. 

New Tax Law Likely to Aid Airlines

On Dec 22, 2017, President Trump signed the much-anticipated tax bill into law (Tax Cuts and Jobs Act). Under the $1.5 trillion tax overhaul package, corporate tax rates have been slashed to 21% from 35%. The significant reduction in corporate tax rate is likely to boost cash flow, which in turn will aid the bottom lines of carriers.

Since most airline companies are almost entirely exposed to the statutory corporate tax rate, the massive tax cut is expected to help them save a considerable amount in tax payment in the United States.

In fact, some market watchers believe that the tax cut would benefit low-cost carriers like Alaska Air Group (ALK - Free Report) and JetBlue Airways (JBLU - Free Report) more than the legacy carriers. This is because the likes of Delta had emerged from bankruptcy a few years ago. Consequently, they are utilizing past losses to avoid paying cash income taxes, so they do not stand to benefit immediately (tangibly) by the tax cuts. However, their smaller rivals are immediate gainers from the tax cuts as they had been paying higher taxes.

Naturally, low-cost carriers like Alaska Air, Southwest Airlines (LUV - Free Report) and JetBlue have declared bonuses ($1,000 per member) following the tax overhaul. Among legacy carriers, American Airlines has declared a bonus.

However, all types of airlines (low-cost or legacy) invest significantly in capital expenditures. In the new tax scenario, these companies will be able to deduct their capital expenditures from taxable income immediately, which was not allowed earlier. As a result, their annual tax bills would be lowered significantly due to higher deductions.

For example, Delta, which expects revenues in 2018 to increase between 4% and 6% on a year-over-year basis, lifted its earnings per share guidance, anticipating the new tax law to boost its results. The company now expects earnings per share in the range of $6.35 to $6.70 (previous outlook: $5.35 to $5.70).

More Shareholder-Friendly Activities Likely

Courtesy their financial prosperity, airlines have been consistently rewarding their shareholders. For example, United Continental Holdings (UAL - Free Report) and JetBlue announced new buyback programs late last year. Alaska Air announced an increase in its quarterly dividend payout, while unveiling its fourth-quarter 2017 results. Moreover, the likes of Delta and Southwest also hiked their quarterly dividend payouts last year.

We expect an uptick in these shareholder-friendly activities from carriers following the new tax law. Due to the significant reduction in their tax bills, more cash is expected to remain in the hands of these companies to fund their capital expenditures, acquisitions and share repurchases among others.

Bullish IATA Forecast for 2018

In December 2017, the International Air Transport Association (“IATA”) provided an encouraging outlook for the global airline industry. IATA predicts global net profit of $38.4 billion for the industry in 2018. This is much higher than the profitability forecast of $34.5 billion for the current year. The bright projection can be attributed to strong demand for air travel.

Global net profit margin is expected to improve marginally to 4.7% in 2018 from 4.6% estimated in 2017. The top line is projected at $824 billion in 2018 compared with $754 billion expected for 2017.

Optimism surrounding the air cargo business has also improved. Cargo revenues are forecast to increase to $59.2 billion in 2018 (estimated revenues for 2017 are $54.5 billion). According to the forecast, air travel growth of 6% is expected for 2018. The estimated figure for 2018 is above the average growth of 5.5% in the last 10-20 years.

Improving Zacks Industry Rank Supports Favorable Scenario

The Zacks Industry Rank of 81 carried by the 24-member Zacks Airline Industry also highlights the fact that its stocks are back in favor. Notably, a favorable rank places the industry in the top 32% of the 250+ groups enlisted. The bullish stance on the industry is further augmented by the fact there were 12 positive estimate revisions in the fourth quarter of 2017.

Also, the Zacks Industry Rank has improved immensely, given the industry’s 200+ rank only a few months ago.

We put 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 last 10 years, using a one week 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

Valuation Signals More Upside

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 6.5, which compares favorably with the market at large, as the current EV/EBITDA for the S&P 500 is at 12.7. The industry’s favorable positioning compared with the overall market certainly signals more upside.

Some Headwinds Remain

Despite the air of optimism surrounding the airline space, there are few headwinds of which one must be mindful. The constant rise in fuel prices (currently hovering around the $65 a barrel mark) do not bode well for airlines as fuel costs represent one of the largest input costs for airline companies.

IATA projects that jet fuel prices will escalate to around 12.5% to $73.8 per barrel in 2018. The fuel bill is likely to account for 20.5% of total costs in 2018 (18.8% in 2017). High labor costs are also hurting the bottom lines of carriers as they are constantly inking deals with various labor groups, courtesy their financial prosperity.

With their financial status likely to improve further mainly due to the savings from the new tax law, such deals are likely to continue pushing up labor costs. Moreover, glitches like the scheduling error at American Airlines, also have the potential to disrupt operations of carriers.

Furthermore, natural calamities like the recent winter storm Grayson cause significant revenue losses to airlines leading to multiple flight cancellations. Moreover, issues related to passenger dissatisfaction have been hurting U.S. carriers for quite some time.

Capacity-related fears gripped airline investors in the recent past (particularly in 2015). The fears were re-ignited, when United Continental, while releasing fourth-quarter results on Jan 23, stated that it expects 2018 capacity growth between 4% and 6% year over year. Moreover, similar growth in the metric is forecast in 2019 and 2020 as well. Following the guidance, investors fear that similar actions might be taken by rivals, triggering a price war.

Bottom Line

The above write-up suggests that despite a few headwinds, the overall sentiment is positive surrounding airlines. The introduction of the new tax law makes us believe that good things are in store for airlines in 2018. Given the significant reduction in taxes we expect the already cheap airline stocks to fly higher, going forward.

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