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High Fuel Costs Dampen Airline Industry's Near-Term Outlook

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The Zacks Airline industry consists of companies that transport passengers and cargo to various destinations across the globe. Most of these operators maintain a fleet comprising multiple mainline jets, in addition to several regional planes. They operate with the help of their regional airline subsidiaries and third-party regional carriers. The industry participants utilize their respective cargo divisions for providing a wide range of freight and mail services.

The space includes legacy carriers like American Airlines (AAL - Free Report) , low-cost players like Southwest Airlines (LUV - Free Report) and regional operators like SkyWest (SKYW - Free Report) . Within the low-cost segment, there are ultra low-cost carriers like Spirit Airlines (SAVE - Free Report) .

Let’s take a look at the industry’s three major themes:

  • With oil prices surging in excess of 100% from the February 2016 levels of around $30 a barrel, operating expenses of airlines have increased significantly. Fuel being the major component of operating expenses for carriers, the bottom-line growth remains under pressure. In fact, in June 2018, the International Air Transport Association (“IATA”) trimmed its forecast for the industry’s 2018 profitability to $33.8 billion from its December 2017 prediction of $38.4 billion.
     
  • The airline industry is benefiting from strong demand for air travel. Affordable air fares along with a much-improved job market and rising disposable income have provided consumers an added incentive to opt for air travel. As an evidence, a record number of people took to the skies in the summer season and the Labor Day holiday period. Demand for air travel is expected to remain strong in the upcoming Thanksgiving travel period and the winter holiday season. As a result, passenger revenues should keep growing in the coming quarters. Not only in the near term, air travel demand is likely to remain strong in the long term as well. IATA expects 8.2 billion passengers to take the sky route by 2037. The forecast implies a 3.5% compound annual growth rate (CAGR).
     
  • The current tax law, which came into effect late last year, is a huge positive for the airline industry. A considerably lower corporate tax rate is boosting cash flow and improving the bottom line of carriers. Huge savings owing to the reduction in corporate tax rate implies that more cash will be available to fund their capital expenditures, acquisitions and share repurchases, among others. Shareholder-friendly activities apart, lower tax related outflow of most carriers have enabled them to undertake employee-friendly activities such as profit sharing.
     

Zacks Industry Rank Indicates Gloomy Prospects

The Zacks Airline industry is a 28-stock group within the broader Zacks Transportation sector. The industry currently carries a Zacks Industry Rank #202, which places it at the bottom 21% of more than 250 Zacks industries.

The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates bleak near-term prospects. 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.

The industry’s positioning in the bottom 50% of the Zacks-ranked industries is a result of negative earnings outlook for the constituent companies in aggregate. Looking at the aggregate earnings estimate revisions, it appears that analysts are losing confidence in this group’s earnings growth potential. In the past year, the industry’s earnings estimate for the current year has declined by 19.1%.

Despite the industry’s drab near-term prospects, we will present a few stocks that have the potential to outperform the market. But, before that, it’s worth taking a look at the industry’s shareholder returns and current valuation.

Industry Lags Sector & S&P 500

The Zacks Airline Industry has lagged both the broader Transportation Sector and the Zacks S&P 500 composite over the past year.

Over this period, the industry has declined 6.3% versus the broader sector and S&P 500 index’s gain of 1.9% and 6.7%, respectively.

One-Year Price Performance

Industry’s Current Valuation

On the basis of trailing 12-month enterprise value-to EBITDA (EV/EBITDA), which is a commonly used multiple for valuing airline stocks, the industry is currently trading at 6.45X compared to the S&P 500’s 9.91X. It is also above the sector’s trailing-12-month EV/EBITDA of 10.13X.

Over the past five years, the industry has traded as high as 16.24X, as low as 4.35X and at the median of 6.20X, as the chart below shows.

Trailing 12-Month Enterprise Value-to EBITDA (EV/EBITDA) Ratio

 

Trailing 12-Month Enterprise Value-to EBITDA (EV/EBITDA) Ratio

 

Bottom Line

The near-term prospects of the airline industry appear to be unwelcoming due to high operating expenses. Escalating oil prices apart, labor and interest costs are also limiting bottom-line growth. However, solid demand for air travel, affordable air fares and lower tax rates are the major growth drivers. While one should not expect the sunny days of the airline industry to return immediately, there are certainly bright spots based on which a recovery cannot be ruled out.

Below we present three stocks sporting a Zacks Rank #1 (Strong Buy) that are well positioned to grow amid challenges. You can see the complete list of today’s Zacks #1 Rank stocks here.

Spirit Airlines, Inc., based in Miramar, FL, has seen the Zacks Consensus Estimate for current-year earnings being revised upward to the tune of 8% over the last 30 days. Moreover, this stock has an expected earnings growth of 9.9% for the current year.

Price and Consensus: SAVE

Air France-KLM SA’s (AFLYY - Free Report) core businesses are related to passenger transport, cargo transport, and aircraft maintenance services. The Zacks Consensus Estimate for this company’s current-year earnings has been revised 1.4% upward over the last 30 days. The French carrier has an average positive earnings surprise in excess of 200% for the trailing four quarters.

Price and Consensus: AFLYY

International Consolidated Airlines Group, S.A. (ICAGY - Free Report) offers passenger and cargo transportation services globally. The Zacks Consensus Estimate for its current-year earnings has been revised 5.5% upward over the last 30 days. In 2018, its top line is expected to grow 6.1%.

Price and Consensus: ICAGY

 

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