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The twin attacks of terror in Spain late last week hit airline stocks hard. Though the European airline stocks bore the brunt, their U.S. counterparts too felt the pinch.

In fact, heavyweights like American Airlines Group (AAL - Free Report) and Delta Air Lines, Inc. (DAL - Free Report) fell sharply on Aug 17, following the Barcelona attacks. Both stocks currently carries a Zacks Rank #3 (Hold). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Twin Attacks

On Aug 17, a van went through a crowd of tourists in Barcelona, killing at least 13 and injuring many. Such an inhuman act was followed by a second attack in the coastal town of Cambrils, located approximately 120 kilometers south of Barcelona.

Reportedly the five terrorists involved in the Cambrils attacks were shot dead by the police. Both the incidents have claimed the lives of at least 14 along with 130 others severely injured. Such acts of terrorism affected airline stocks as there is a possibility of waning travel demand due to security fears.

In fact, the timing of the attacks could not have been worse as the three-month period between June and August has been predicted to be the busiest one for U.S. carriers in terms of air travel.

According to the forecast by the Airlines for America (A4A) in May 2017, approximately 234.1 million passengers will be transported worldwide by U.S. airlines in the above-mentioned period, up 4% from the 2016 levels. Notably, air travel projection for summer is of 2.54 million fliers per day during the said period.

Given this backdrop, it is of little wonder that airline stocks shed value on the news of the attacks.

Buffett’s Airline Exposure Trimmed

According to the 13-F filing by Warren Buffett’s Berkshire Hathaway in the second quarter, the company reduced its stakes in three major U.S. carriers.

Reportedly, the Omaha, NE-based company reduced its stakes in Delta, American Airlines and United Continental Holdings Inc. (UAL - Free Report) by 4.6%, 3.5% and 2.6%, respectively, on a sequential basis.

Moreover, the Oracle of Omaha’s investment in low-cost carrier Southwest Airlines Co. reportedly remained unchanged.

In fact, Buffett is one of the most revered investors of all times and his decision to trim investments in three airline heavyweights also points at the fact that all is not well with this key sector.

High Labor Costs: Major Headwind

With airline companies constantly inking deals with various labor groups, it is of little surprise that costs on this front are increasing, which is limiting bottom-line growth.

At American Airlines, total operating expenses increased 11.1% year over year in the second quarter to $9.6 billion. Expenses pertaining to salaries and benefits were up 12.5%. Consolidated operating costs per available seat miles (CASM), excluding special items. also rose 6.8%.

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%. Additionally, consolidated cost per available seat miles (excluding special items and fuel) is anticipated to increase 5% at American Airlines.

Capacity Overexpansion: Major Challenge

Capacity-related woes had been plaguing stocks in the airline space for quite some time. In fact, the July traffic reports of most carriers have highlighted that such issues might resurface. Major carriers like American Airlines, United Continental and JetBlue Airways Corp. have posted declines in their respective load factors (percentage of seats filled by passengers) for the same month. The downturn was due to capacity expansion outweighing traffic growth.

Generally, carriers are forced to reduce fares as unit revenues decline in the face of capacity outpacing demand growth. While low air fares are favorable for fliers, it is a drag on the top lines of carriers with their profits being hurt.

Other Headwinds

Carriers like United Continental, American Airlines and Spirit Airlines have been laid low by passenger-related issues this year.

In fact, Spirit Airlines has issued a lackluster guidance with respect to total revenue per available seat miles (TRASM: a key measure of unit revenue) for the third quarter. This was mainly due to the dispute with its pilots in May leading to multiple flights cancellations, thereby causing passenger harassment. The metric is expected to decline in the band of 2%-4% on a year-over-year basis, as well.

Moreover, technical glitches have been a great nuisance for carriers. Evidently, the likes of Delta and Southwest Airlines have seen their operations being affected by technological problems this year. Given that technological infrastructure is a key expense for airlines, the profitability of carriers might be affected in the event of such malfunctions, going forward.

Price Performance

In view of the above headwinds, it is of little wonder that the Zacks Airline industry underperformed the broader market in the last three months. The S&P 500 Index gained 1.7%, as against the industry’s decline of 0.6%.

Some Positives Remain

According to many market watchers, the impact of the terror attacks in Spain is likely to be short-term in nature. This is in keeping with the trend that market weakness resulting from such anti-social incidents is usually short lived, especially when the frequency of occurrence is rapid as has been the case of late.

Notably, the recent forecast by A4A on the upcoming Labor Day travel period (Aug 30-Sep 5) has highlighted the fact that U.S. carriers will make hay during the period with approximately 16.1 million passengers expected to avail services of the U.S. airlines. Travel demand is projected to increase 5% on the back of low air fares and improving disposable income. The improving unit revenue scenario is another positive for airlines.

Furthermore, the bullish Zacks Industry Rank of 50 (out of 265 groups) carried by the 22-member Airline industry highlights the fact that there are still reasons to be positive on the sector despite some hiccups. In fact, the airline industry falls under the broader Transportation sector (one of 16 Zacks Sectors). The favorable rank places the companies in the top 20% of the Zacks industries.

We put our X industries (all 265 of them) 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

How to Pick Winners?

The above commentary clearly reflects that despite headwinds all is not lost for airline stocks and there exists few hidden gems in the space which investors can unearth. In fact, the stocks have the potential to generate handsome returns.

However, given the vastness of the airline space, it is by no means an easy task to identify the few bright spots. We have utilized our Zacks Stock Screener  to pinpoint such stocks. The Zacks Rank, which justifies a company’s strong fundamentals, can come in really handy.

Our Choices

SkyWest Inc. (SKYW - Free Report) operates as a regional airline in the United States through its subsidiaries. The company currently sports a Zacks Rank #1 and a Value Score of A. The Zacks Consensus Estimate for its current-year earnings moved up 1.9% over the last 60 days to $3.24.

Deutsche Lufthansa Aktiengesellschaft (DLAKY - Free Report) functions as an aviation company in Germany as well as internationally. The company sports a Zacks Rank #1 and has a Value Score of A. The Zacks Consensus Estimate for its current-year earnings climbed 30% over the last 60 days to $3.73.

Ryanair Holdings plc (RYAAY - Free Report) is an Irish low-fare airliner that primarily operates from Europe. The carrier sports a Zacks Rank #1 and has a Growth Score of A. The Zacks Consensus Estimate for its current-year earnings moved up 5.6% over the last 60 days to $7.75.

Gol Linhas Aereas Inteligentes SA (GOL - Free Report) is engaged in providing mobile geolocation services to its passengers and designing a Website featuring accessibility resources to assist people with visual and motor impairments. The company carries a Zacks Rank #2 (Buy) and has a Growth Score of B.

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