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Analyst Downgrade Hits Airline Sector, Stocks Rally Anyway

Zacks Equity Research

The key airline stocks like Delta Air Lines DAL and Southwest Airlines Co. LUV lost value in early trading on Mar 22, after Morgan Stanley downgraded the sector to in line from attractive. The Morgan Stanley analyst attributed its actions to concerns pertaining to oversupply (capacity overexpansion). In fact, the firm expects supply on the domestic front to rise in the band of 4% to 5% in the next couple of years, which is much higher than real GDP growth.

Additionally, diminishing margins is likely to result in lackluster earnings growth, moving ahead. Moreover, an unfavorable view on the sector resulted in the airline ETF – U.S. Global Jets ETF JETS – trading in the red in the early part of the session.

In fact, capacity related fears are not new to investors in the airline space. Such fears had gripped the space in 2015 as well with investors dreading that airline capacity growth at a rate higher than the U.S. GDP will lead to an oversupplied market. These fears were re-ignited in January this year, when American Airlines Group AAL hinted at increasing domestic capacity in 2017, while releasing fourth-quarter results. Generally, carriers are forced to reduce fares as unit revenues decline in the face of capacity outpacing demand growth.

Earlier in the month, United Continental Holdings UAL raised its consolidated capacity view for 2017. The rise in the guidance was driven by expansion both on the domestic as well as international fronts.

American Airlines Too Downgraded by Morgan Stanley

Apart from the bearish view on the sector, Morgan Stanley also refrained from favoring one of the leading players in this space, the Fort Worth, TX-based American Airlines Group. In fact, the firm believes that American Airlines' weak margins, cash flow and high debt levels are likely to limit its earnings growth, going ahead. And, in the view of the above challenges, the firm lowered its rating on the Zacks Rank #3 (Hold) stock to “equal weight” from “overweight”. You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Opinions of broker(s)/analysts on a particular stock serve as an important pointer for investors. Analysts attend company conference calls/presentations and scrutinize every detail available publicly before advising investors about their course of action. Naturally, more often than not investors pay heed to such well-researched information. Hence, it comes as no surprise that the stock plunged in early trading on Mar 22, following the downgrade.

American Airlines exited 2016 with a debt-to-capitalization ratio in excess of 86%, which remains a concern. While the Morgan Stanley analyst has trimmed the ratings on American Airlines, its peers like Delta, Southwest Airlines and Alaska Air Group ALK have not fallen out of favor. The firm maintained its overweight rating on the stocks on the back of their stronger margins and healthier cash positions.

Stocks and ETF Rebound After Early Losses

While airline stocks and the related ETF suffered losses in early trading, they rebounded during the course of the day to close the trading session on a healthier note. For example, the likes of Delta, Southwest Airlines, Spirit Airlines SAVE and Alaska Air Group all ended the day in green.

The airline ETF -- U.S. Global Jets ETF -- ended Mar 22 at $27.45, up 0.55%. The NYSE ARCA Airline index also gained on Mar 22, ending at $107.85 per share, up 0.89%.

Airlines Suffering Lately

The sector has witnessed turbulence of late, the most recent being the Morgan Stanley’s downgrade. This is exemplified by the fact that the Zacks categorized Transportation - Airline industry has performed worse than the S&P 500 Index over the last one month, losing 6.45% compared with the S&P 500’s decline of 0.96%.

Long term Prospects Bright

We believe that the space is by no means unattractive in the long run on the back of its cheap valuation. Going by the EV-to-EBITDA (enterprise value to earnings before interest, tax, depreciation, and amortization) ratio, which is often used to value airline stocks, given their significant debt levels and high depreciation and amortization expenses, doesn’t look expensive at currently.
The industry currently has a trailing 12-month EV/EBITDA ratio of 5.75, which is favorable than what the industry saw over the last five years. The ratio is nearer the low end of 4.62 and far off the high end of 16.5 during the period.

Additionally, the reading compares favorably with the market at large, as the current EV/EBITDA for the S&P 500 is 11 and the median level is 9.1. The industry’s favorable positioning compared with the overall market certainly signals more upside.

The bullish Zacks Industry rank of 56 carried by the 25-member Zacks categorized Transportation-Airline industry also highlights the fact that airline stocks are worth considering. The favorable rank places the industry in the top 22% of the 250+ groups enlisted.

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Southwest Airlines Company (LUV): Free Stock Analysis Report
Delta Air Lines, Inc. (DAL): Free Stock Analysis Report
Alaska Air Group, Inc. (ALK): Free Stock Analysis Report
United Continental Holdings, Inc. (UAL): Free Stock Analysis Report
Spirit Airlines, Inc. (SAVE): Free Stock Analysis Report
American Airlines Group, Inc. (AAL): Free Stock Analysis Report
US GLOBAL JETS (JETS): ETF Research Reports
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