Airline stocks ended the year 2016 on a strong note after having struggled for the greater part of the year. Woes related to unit revenues, which had been hurting carries for quite some time, seem to be mitigating. Moreover, increase in fuel costs might lead to a surge in airfares, thereby driving top-line growth.
In spite of the optimism about airline stocks flying high again, there are certain roadblocks one must be mindful of before investing in the sector. Let’s delve into the details.
High Labor Costs May Hurt Earnings
With airline companies constantly inking deals with various labor groups, it is of little surprise that costs on this front are increasing. In fact, this was one of the main reasons for the lackluster bottom-line performance of many air carriers in the fourth quarter. At Delta Air Lines (DAL), earnings declined almost 30% year over year due to higher costs. Consolidated unit cost or cost per available seat mile (CASM), including profit sharing, increased 10.6%, mainly due to the agreement with pilots that was ratified in December.
At United Continental Holdings (UAL), consolidated unit cost – excluding fuel, third-party business expenses and profit sharing – increased 4.1% year over year, primarily due to the labor deals ratified. United Continental expects unit costs in the first quarter to increase in the band of 4.5–5.5% due to higher in labor costs.
At American Airlines Group (AAL), total operating expenses climbed 5.4% year over year to $9 billion, primarily due to an increase in labor costs. Expenses pertaining to salaries and benefits surged 17.4%. Consolidated operating costs per available seat miles (CASM: excluding special items) increased 7.6%. Consolidated CASM (excluding fuel and special items) is projected to increase 9% in the first quarter.
Will Capacity Woes Return?
Capacity-related woes had been plaguing stocks in the airline space for quite some time. In fact, the January traffic reports of most carriers have highlighted that such issues might resurface. Apart from American Airlines, traffic updates from the likes of Delta Air Lines, United Continental Holdings and Alaska Air Group (ALK) have revealed a fall in load factor as capacity expansion outpaced traffic growth.
In fact, capacity-related fears among investors were re-ignited last month when American Airlines, at its fourth-quarter earnings call, hinted at increasing domestic capacity but reducing the same internationally in 2017.
Technology a Major Headwind
Technical glitches have been a great nuisance for carriers. United Continental Holdings was the latest victim of disruption in operations due to technological failure. Last month, Delta suffered a computer outage, which led to the cancellation of multiple flights and caused undue harassment to passengers.
Other major carriers like Southwest Airlines (LUV) too have seen their operations being affected by technological problems in the last year. Given that technological infrastructure is a key expense for airlines, the profitability of carriers could be affected in the event of such malfunctions.
Rising Oil Prices Lead to IATA’s Tepid 2017 View
The International Air Transport Association (IATA) provided a lackluster view for carriers with respect to the profitability for 2017. The research firm predicts global net profit for the industry of $29.8 billion. This is much lower than the 2016 profitability forecast of $35.6 billion.
The tepid projection may be attributed to the anticipation of rising oil prices. The firm projects that jet fuel prices are likely to escalate around 24.6% to $64.9 per barrel next year. Global net profit margin is expected to shrink to 4.1% in 2017 from the 2016 estimate of 5.1%. According to the forecast, load factor (percentage of seats filled by passengers) for 2017 is expected to decline 40 basis points to 79.8% as capacity expansion is likely to outweigh traffic growth.
Trump's Travel Ban Policy
Last month, President Donald Trump issued a ban on travelers from seven predominantly Muslim nations – Iraq, Iran, Syria, Yemen, Sudan, Somalia and Libya – from entering the U.S. Though the ban (issued on Jan 27) is temporary (restricting travel from these nations for three months apart from suspending the admission of refugees for four months), the executive order indicated that the ban could be extended in the coming days.
As expected, the immigration ban spelled challenges for airlines stocks as the travel demand is likely to decline. Fears of long-term consequences of the ban caused the stocks of major carriers like Delta, American Airlines and JetBlue Airways (JBLU) significantly losing value. Consequently, the NYSE ARCA Airline Index registered a decrease of 1.78% on Jan 30. In fact, the index slid to its lowest level ($108.48) in almost eight weeks. Many carriers, including big players like American Airlines Group, have exposure to Africa and the Middle East. However, with courts refusing to reinstate the ban, focus will remain on the issue going forward.
The aforesaid executive order is aimed at preventing terrorism in the U.S. The unfortunate rise in terror attacks across the globe has justly raised concerns regarding security. Terrorism hurt airline stocks owing to rising concerns about security amid multiple such incidents. Terrorist attacks are likely to hurt carriers by reducing the demand for travel due to security fears going forward.
In January, at least five people lost their lives and many more were injured when a man, subsequently nabbed and identified as Esteban Santiago, opened fire in the baggage claim area of Terminal 2 (where Delta Air Lines operates) of the busy Fort Lauderdale-Hollywood International Airport.
The ongoing dispute between leading U.S. carriers and their Gulf counterparts is another challenge for the industry. CEOs of leading U.S. carriers like Delta, American Airlines and United Continental Holdings are seeking to meet U.S. Secretary of State Rex Tillerson, over the dispute with Gulf carriers. We expect investors to remain focused will be on the subsequent updates.
It is a well-known fact that carriers regularly come across labor-related challenges that often impact their operations. For example, on Nov 29, workers (non-unionized) at Chicago’s O’Hare International airport went on strike in an attempt to raise their wages and secure union rights. Furthermore, labor strife has hurt Germany’s Deutsche Lufthansa Aktiengesellschaft (DLAKY) for quite some time. The carrier carries a Zacks Rank #4 (Sell).
The emergence and the subsequent growth and success of low-cost carriers like Spirit Airlines, Inc. (SAVE) and Southwest Airlines have raised concerns for legacy carriers. In a price-sensitive economy, it is not only the survival of the fittest but also of the cheapest. After United Continental, American Airlines announced the introduction of “Basic Economy Fares” to attract more and more budget conscious passengers. The Basic Economy tickets (which are the cheapest at American Airlines) are on sale from Feb 10.
As if the above challenges were not enough, the outbreak of diseases like the Zika virus last year hurt demand for travel.
You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.
The challenges faced by the industry, unless resolved soon, might hamper the growth prospects of stocks in the space. The headwinds can result in investors, especially the risk-averse ones, shying away from the sector.
Check out our latest Airline Industry Outlook for more news on the current state of affairs in this market from an earnings perspective, and how the trend looks ahead for this important sector at the moment.
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United Continental Holdings, Inc. (UAL): Free Stock Analysis Report
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