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It is a well-documented fact that woes related to capacity overexpansion had plagued stocks in the airline space in the not so distant past (particularly 2015). In fact, the July 2017 traffic reports of most carriers have highlighted that such issues might resurface.

In such a scenario, investors fear that capacity expansion may lead to oversupply in the market even as fuel costs remain weak. Low fuel costs and capacity over-expansion are believed to be the primary reasons 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.

Will Capacity Woes Return?

Most carriers have seen their respective load factors (percentage of seats filled by passengers) decline in July. The reason for the downturn was capacity expansion outweighing traffic growth in the month. For example, load factor declined to 84.3% from 85.2% at American Airlines Group (AAL - Free Report) as capacity inched up 1.9% on a year-over-year basis while traffic growth was a mere 0.8%. American Airlines currently carries a Zacks Rank #3 (Hold). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Shares of the Long Island City, NY-based JetBlue Airways Corp. ((JBLU - Free Report) ) also depreciated following the release of its July traffic report on Aug 10 as load factor declined. The metric came in at 87.1%, down 70 basis points as capacity expanded 5.9% with traffic increasing 5.1%.

Apart from the above mentioned companies, the likes of Spirit Airlines (SAVE - Free Report) , United Continental Holdings (UAL - Free Report) , Allegiant Travel Company (ALGT - Free Report) also have seen their respective load factors decrease due to capacity overexpansion.

Apart from fears on capacity over expansion, the views on unit revenues for the third quarter of 2017 have lagged expectations. For example, American Airlines expects total revenue per available seat mile (TRASM: a key measure of unit revenue) growth in the band 0.5-2.5% year over year. The figure is pegged much below the 5.7% improvement registered by the carrier in the second quarter.

The third quarter TRASM guidance for Hawaiian Holdings (HA - Free Report) , the parent company of Hawaiian Airlines, is also concerning. The carrier expects the metric to grow in the band of 4.5–7.5%, whereas TRASM had climbed 9.2% in the second quarter.

Generally, carriers are forced to reduce fares as unit revenues decline in the face of capacity outpacing demand growth. The Airlines for America (A4A) Labour Day projection, also highlights the fact that carriers are adding capacity to meet the anticipated demand surge. According to the forecast, carriers are anticipated to add 133,000 seats per day during the Travel period (Aug 30-Sep 5).

Price Performance in July

In view of the disappointing July traffic reports, it is of little wonder that the Zacks Airline industry underperformed the broader market in the month. The S& P 500 Index gained 2.1%, while the industry contracted 3.6%.

 

 

High Costs – Another Headwind

Apart from woes related to capacity, the bottom line of airlines is being hurt in the second quarter due to high labor costs. However, with labor deals in vogue in the aviation space, labor costs have been on the rise.

The earnings picture was distorted in the second quarter due to high costs as was the case in the first quarter. For example, at American Airlines total operating expenses climbed 11.1% year over year. Expenses pertaining to salaries and benefits were up 12.5%.

Second-quarter results at Delta Air Lines (DAL - Free Report) were also hurt by higher costs. Total operating expenses, including special items, increased 9% year over year to $8,763 million. Non-fuel consolidated unit cost or cost per available seat mile (CASM: normalized), including profit sharing, climbed 5.5%, mainly owing to wage increases, product investments and the operational disruption in April.

The scenario is expected to be similar in the third quarter as well. Delta expects non-fuel unit cost (including profit sharing) to increase approximately 4% in the quarter. Additionally, consolidated cost per available seat miles (excluding special items and fuel) is anticipated to increase 5% at American Airlines in the third quarter.

Conclusion

With high costs expected to limit bottom-line growth in the near term, fears about the return of capacity woes highlighted by the declining July load factors pose further challenges for airline stocks. Consequently, we believe investors need to be mindful of such headwinds before investing in the space.

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