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Airline Stock Outlook: High Costs Pose Short-Term Challenges

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The airline industry is benefiting from strong demand for air travel. Declining air fares along with a much-improved job market and rising disposable income have provided consumers an added incentive to opt for air travel. The bullish projection by the Airlines for America (A4A) for the ongoing summer season confirms the robust demand. The association expects the season to be the busiest one for U.S. carriers in terms of air travel.

However, the rise in fuel costs has hurt airline stocks big time. Oil prices have risen roughly 10% year to date. Since expenses on fuel are significant for airlines, an increase in oil prices is unfavorable for the space.

In fact, the bearish forecast by the International Air Transport Association (“IATA”) on current-year airlines’ profitability highlights the fact that the woes are likely to continue for carriers. The research firm predicts global net profit for the industry to be $33.8 billion, much lower than the 2018 profitability forecast of $38.4 billion, unveiled in December 2017. Escalating oil prices apart, labor and interest costs also weighed on the profitability forecast.

Industry Underperforms on Shareholder Returns

Judging by shareholder returns over the past year, it seems that solid demand for air travel and the improving unit revenue scenario weren’t enough for instilling investors’ confidence as far as the industry’s growth prospects are concerned.

Headwinds like high fuel and labor costs, capacity-related issues and technological glitches have contributed to investors’ pessimism surrounding the space.

The  Zacks Airline industry, which is a 25-stock group within the broader Zacks Transportation Sector, has underperformed both the S&P 500 and its own sector over the past year.

While the stocks in this industry have collectively lost 12.1%, the Zacks S&P 500 Composite and Zacks Transportation Sector have rallied 13.4% and 0.8%, respectively.

One-Year Price Performance

Airline Stocks Trading Cheap

Thanks to the industry’s underperformance over the past year, the valuation looks really cheap now. One might get a good sense of the industry’s relative valuation by looking at its 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.

This ratio is essentially utilized by buyers to come to a conclusion regarding the reasonability of a target's valuation.

The industry currently has a trailing 12-month EV/EBITDA ratio of 6.07, near the lowest level over the past year. When compared with the highest level of 7.29 and median level of 6.31 over that period, there is apparently plenty of upside left.

The space also looks inexpensive when compared with the market at large, as the trailing 12-month EV/EBITDA ratio for the S&P 500 is 11.49 and the median level is 11.36.

Enterprise Value/EBITDA (TTM)

 

However, as transportation stocks have unique characteristics, a comparison of the group’s EV/EBITDA ratio with that of its border sector is probably the best approach. Such a comparison ensures that the group is trading at a decent discount. The Zacks Transportation Sector’s trailing 12-month EV/EBITDA ratio of 10.09 and the median level of 7.66 for the same period are significantly above the Zacks Airline Industry’s respective ratios.

Enterprise Value/EBITDA (TTM)

 

Underperformance May Continue Due to Bleak Earnings Outlook

The strong balance sheets of major carriers have enabled them to engage in shareholder and employee-friendly activities. Additionally, strong demand on the back of a buoyant U.S. economy coupled with low air fares may help airline stocks in delivering improved shareholder returns in the near future.

But what really matters to investors is whether this group has the potential to perform better than the broader market in the quarters ahead. The above ratio analysis already shows that there is hardly any value-oriented path ahead and one should not really consider the current price levels as good entry points unless there are convincing reasons to predict a rebound in the near term. 

One reliable measure that can help investors understand the industry’s prospects of a solid price performance is the earnings outlook for its member companies. Empirical research shows that a company’s earnings outlook significantly influences the performance of its stock.

One could get a good sense of a company’s earnings outlook by comparing the consensus earnings expectation for the current financial year with the last year’s reported number, but an effective measure could be the magnitude and direction of the recent change in earnings estimates.

While the consensus earnings estimate for the Zacks Airline industry of $3.59 per share shows a year-over-year deterioration, the trend in earnings estimate revisions is not favorable either.

Price and Consensus: Zacks Airline Industry

Looking at the aggregate earnings estimate revisions, it appears that analysts are losing confidence in this group’s earnings potential.

The consensus EPS estimate for the current fiscal year has been revised 11.4% downward since Mar 31, 2018.

Current Fiscal Year EPS Estimate Revisions

 

Zacks Industry Rank Indicates Bleak Prospects

The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates continued underperformance in the near term.

The Zacks Airline industry currently carries a Zacks Industry Rank #244, which places it at the bottom 5% of more than 250 Zacks industries. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.

Our proprietary Heat Map shows that the industry’s rank has been bearish over the past five weeks.

 

 

In fact, the basis of this bearish outlook could be the downward trend, albeit some fluctuations, in top line that airlines have been showing since the beginning of 2015.

 

 

Airline Stocks Promise Long-Term Growth

While the near-term prospects look unwelcoming for investors, the long-term (3-5 years) EPS growth estimate for the Zacks Airline industry appears upbeat. The group’s mean estimate of long-term EPS growth has been showing an upward trend since January 2018 to reach the current level of 13.4%. This compares to 9.8% for the Zacks S&P 500 composite.

Mean Estimate of Long-Term EPS Growth Rate

 

In fact, the basis of this long-terms EPS growth could be an increase in free cash flow for the industry since the beginning of the current-year.

 

 

The increase in free cash flow bodes well for airline stocks, as far as their dividend-paying capacity is concerned. This is because dividends are paid from a company's cash flow. We note that airline stocks like Southwest Airlines Co. (LUV - Free Report) have raised their dividend payouts this year. Moreover, an uptick in such shareholder-friendly activities in the space is likely due to the massive savings resulting from the new tax law.

Investors prefer dividend-paying stocks, as these are financially stable and mature, and can also generate steady cash flow irrespective of market conditions. Therefore, our anticipation that airlines will fly high in the long run is justified.

Bottom Line

Even though factors like an improving unit revenue scenario, increased demand for air travel, cheap valuation and infrastructural developments to attract more passengers are positives for the sector and might contribute to long-term growth, we believe that that airlines will fly low in the short term mainly due to the surge in fuel costs. According to IATA, jet fuel prices are likely to escalate around 27.5% to $70 per barrel this year. Fuel bill is likely to account for 24.2% of total costs in 2018 (21.4% in 2017).

Overall, the industry might not be able to tide over the challenges in the near term and therefore none of the stocks in our airline universe currently hold a Zacks Rank #1 (Strong Buy). However, below is a stock that has been witnessing positive earnings estimate revisions and carries a Zacks Rank #2 (Buy).

(You can see the complete list of today’s Zacks #1 Rank stocks here.)

SkyWest, Inc. (SKYW - Free Report) is a regional carrier operating in the United States. The Zacks Consensus Estimate for the current-year EPS has been revised 5.2% upward over the last 60 days.

Price and Consensus: SKYW

As mentioned throughout, there are a number of reasons to worry about the industry’s performance in the near to medium term. So, it would be prudent to stay away from some weak airline stocks for now. Stocks carrying an unfavorable Zacks Rank are particularly expected to underperform.

Delta Air Lines, Inc. (DAL - Free Report) : The stock of this Atlanta, GA-based airline behemoth has shed 2.9% of its value over the past six months. The Zacks Consensus Estimate for the current-year EPS has been revised 6.9% downward over the last 60 days. The stock carries a Zacks Rank #4 (Sell).

Price and Consensus: DAL

American Airlines Group Inc. (AAL - Free Report) : The stock of this Fort Worth, TX-based carrier has shed 19.7% of its value over the past six months. The Zacks Consensus Estimate for the current-year EPS has been revised 9.5% downward over the last 60 days. The stock carries a Zacks Rank #5 (Strong Sell).

Price and Consensus: AAL

JetBlue Airways Corp. (JBLU - Free Report) : The stock of this Long Island City, New York based carrier has shed 15% of its value over the past six months. The Zacks Consensus Estimate for the current-year EPS has been revised 8.1% downward over the last 60 days. The stock carries a Zacks Rank #4.

Price and Consensus: JBLU

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