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Airline Industry Stock Outlook - July 2016

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Airlines Impacted by Terror Attacks, Brexit

As had been widely expected, the Brexit decision has created ripples throughout the world, rattling global financial markets. Airline stocks have been hit hard with fears of travel demand slackening. According to the International Air Transport Association (IATA), with Brexit materializing, the U.K.’s air passenger market is expected to shrink in the band of 3% to 5% by 2020. In fact, the Brexit decision has worsened matters for U.S. carriers with exposure to Britain.

Moreover, prior to Brexit, Britain had been part of the EU's single aviation market. Consequently, carriers of member states could fly freely to/within members. Now with Britain exiting the EU, the entire issue has gotten complicated.

Prior to Brexit, airline stocks had been grappling with issues such as the mass shooting at a nightclub in Orlando, FL and the explosion at the Shanghai Pudong airport on June 12. Fears that such attacks could lead to a dip in air travel demand resulted in widespread sell-offs in the aviation sector.

To add to the distress, the frequency of such attacks is increasing by the day. The disappearance of an EgyptAir jet in May is also feared to be an act of terrorism. Airline stocks were hurt even then. Moreover, the Brussels attacks in March dealt a heavy blow to Delta Air Lines DAL as its passengers were among the casualties reported in the departure area at Brussels' Zaventem Airport. The Atlanta, GA-based carrier’s top line was negatively impacted to the tune of $5 million by the attacks.

In fact, on May 31, the U.S. State Department issued a global travel alert to U.S. citizens citing the possibility of terror attacks similar to those in Brussels and Paris (in Nov 2015). The ongoing European Soccer Championship in France has attracted many tourists. Moreover, the Catholic Church's World Youth Day scheduled to be held in Poland shortly is also likely to be heavily attended.

Citing fears of low travel demand, in May, European low-cost carrier Ryanair Holdings RYAAY issued a “cautious” outlook for fiscal 2017 on expectations of low airfares. Moreover, travel company Thomas Cook revealed a 5% decline in summer bookings compared to last year.

The twin threats are primarily responsible for the NYSE ARCA Airline index declining more than 5% over the last 30 days.

PRASM Concerns

As was the case in the past few quarters, issues related to passenger revenue per available seat mile (PRASM: a measure of unit revenue) hurt revenues of airline stocks in the first quarter as well. The metric, which is a measure of sales relative to capacity for a carrier, is expected to dent top-line growth in the second-quarter as well. For example, American Airlines Group AAL forecasts a 6% to 8% drop in the metric for the second quarter. 

Lower fuel surcharges on international flights due to weak oil prices have been one of the main reasons behind the persistent decline in PRASM. Furthermore, outbreaks of diseases like the Zika virus and disputes similar to the ongoing one between legacy U.S. carriers and their Gulf counterparts pose challenges to the stocks in the airline space. The tough times for airlines is exemplified by the fact that the “Trans-Airline” sector currently has a Zacks Industry Rank #222 – placing it in the bottom 1/3rd of the 260+ industry groups.

Estimates Trimmed

In view of the headwinds mentioned above, earnings per share estimates were lowered by analysts ahead of the first-quarter earnings season, thus making it easier for companies to outshine the Zacks Consensus Estimate in the quarter gone by. Consequently, the plethora of earnings beats in the space in the first quarter was mainly due to the “lowered bar” and is not anything to be excited about. A major tailwind for airlines in recent times -- cheap oil -- has in all probability been priced in, as prices have been soft for almost two years now.

Airline players, as in the past few quarters, dished out a below-par performance on the top-line front. In fact, the picture might well be similar in the second quarter as well. This can be gauged from our latest Zacks Earning Trends report which predicts that earnings per share for the S&P 500 players in the transportation sector (one of the 16 Zacks sectors), of which airlines is a part, will decline 11%. Meanwhile, revenues are projected to decline 1.3%.

Oil Rebound

Another worrying factor for airlines is that oil prices are currently on their way up and hovering around the $50 a barrel mark. This marks a significant increase from the second half of February, when the commodity had slumped to a 12-year low of $26.21.

Despite oil’s massive recovery since February, it’s still around $50 – about half the level witnessed in mid-2014. Moreover, many believe that the odds are firmly stacked against a sustained rally. Therefore, we believe bottom-line expansion for airline players will be evident at least in the remaining quarters of 2016.

Financial Strength

Rally or not, it cannot be denied that soft oil prices have been a huge blessing to carriers by virtue of trimming their operating expenses significantly, thereby causing huge savings. For example, Delta expects to generate savings of around $3 billion in 2016 due to low fuel costs.

Naturally, carriers are in the pink of financial health, courtesy the huge cost savings arising from cheap oil. This has given rise to a surge in shareholder friendly activities such as dividend payments and buybacks in the space. For example, in May, Delta and Southwest Airlines Co. (LUV - Free Report) hiked their respective quarterly dividend payouts.

The massive profits generated by carriers have encouraged them to shell out significant amounts to employees under their profit sharing schemes. Moreover, buoyed by their financial strength, carriers are constantly making additional infrastructural investments to enhance the flying experience of passengers.

Alaska/Virgin America Deal

In a bid to expand its operations, particularly on the West Coast, Alaska Air Group ALK inked a deal worth approximately $4 billion in Apr 2016, inclusive of debt and capitalized aircraft operating leases to buy low-cost carrier Virgin America VA. The deal, if it materializes, will enable Alaska Air Group to expand significantly and gain greater access to key cities across the U.S.

The expansion of Alaska Air Group following the merger will make it the fifth-largest among U.S. carriers in terms of traffic, displacing JetBlue Airways JBLU from the position. We note that airline stocks were in bad shape financially until a few years ago, such as when Delta plunged into bankruptcy in 2005. However, a spate of mergers led to a rebound in the space.

Consequently, mergers have been beneficial for the airline industry going by past records. Currently, there is the added incentive of cheap oil. With oil prices unlikely to touch the highs seen in mid-2014 any time soon, the Alaska-Virgin merger (if it happens) should flourish in the favorable backdrop.

Bullish Forecasts

At its Annual General Meeting in Dublin in June, the IATA increased its projection for 2016 global net profit for the industry to $39.4 billion from the earlier $36.3 billion. The comparable 2015 figure was $35.3 billion. In the event of the forecast coming true, 2016 will be the fifth successive year of profit improvement for the airline industry.

Cheap oil, which is projected at $45 per barrel in 2016, is the primary catalyst behind the bright forecast. Fuel bill is projected to fall to $127 billion in 2016, which represents a significant decline from $226 billion recorded only two years ago. Although it is a fact that most carriers hedge at least some of their fuel costs, the majority of them should still continue to benefit considerably from the plunge in oil prices. Notably, carriers use a combination of calls, swaps and collars at varying WTI crude-equivalent price levels to hedge fuel costs.

The bulk of the global profits ($22.9 billion) is expected to come from the North American region. The rosy picture painted by the IATA for North American carriers, comes shortly after the forecast provided by Airlines for America (‘A4A’). According to the projection, the three month period between June and August will be the busiest one for U.S. carriers in terms of air travel.

Cuba Approval Encourage

In what is seen as a major positive for airline stocks, The U.S. Department of Transportation (DOT) authorized six U.S.-based carriers to operate scheduled flights to nine second-tier Cuban cities, thereby taking a step toward restoration of diplomatic ties with the island nation after more than 50 years. Following the DOT approval, the carriers can start operating commercial flights to the island this fall itself.

The authorized carriers include airline heavy weights like American Airlines Group, Southwest Airlines Co. and JetBlue Airways Corp. The other airlines that have secured a go-ahead for the same are Frontier Airlines, Silver Airways and Sun Country Airlines. With Cuba a re-emerging tourist spot, the approval to launch commercial flights to the country should aid the top lines of the carriers significantly.

Moreover, approval is yet to come to fly to the much sought-after Havana. The DOT is likely to announce its decision on Havana routes later this summer. Approval to fly on the highly in demand Havana route should augment top lines further by attracting huge traffic.


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