Airline Industry Stock Outlook - April 2014 - Industry Outlook

By Zacks | Updated July 30, 2014 AAA

The global aviation industry holds a steady outlook for 2014 as solid economic recovery and rising cargo demand lend optimism to the sector. These outweigh the negative impacts of developments in jet fuel price and growth concerns in emerging economies.

After surviving the 2008 financial scare, the ongoing economic upturn is believed to be much stronger than that of 2012 and 2013. The outlook is particularly favorable for the U.S. economy, with GDP growth expected to materially improve from the pace of the last few years.

While not much is expected from the Euro-zone, the region’s economy has definitely stabilized, lifting the clouds of the last few years. On the flip side, reversal of capital flows into the emerging economies in a post-QE world is expected to become a challenge to the region’s growth.

Air cargo volumes – an important indicator of business confidence – are expected to continue trending up. The cargo business is expected to see expansion of 4.0% in 2014, way above 1.4% growth achieved in 2013.

This improved outlook is behind the positive projections from trade groups. The International Air Transport Association (IATA) remains cautiously optimistic on the industry and projects overall airline profits of $18.7 billion for 2014, with 3.30 billion passengers in total.

The current profit forecast marks 5.1% deterioration from the previous projection of $19.7 billion. Net profit margin is expected at 2.51%, up from 1.82% estimated previously. The industry is expected to generate $5.65 from every departing passenger on average, quite a soft number for a high risk business.

Regional Forecast

North America: With the world’s largest economy improving, North American airlines look brighter for 2014. Consolidation benefits, growing travel demand and a number of new and enhanced ancillary revenues also provide impetus. Although, performance will vary substantially between different U.S. carriers, a strong 2013 has increased 2014 profit forecast to $8.6 billion.

Europe: Europe, which continues to recover slowly, will benefit from its joint ventures with North Atlantic carriers, thus driving profitability. IATA expects this year’s profit to reach $3.1 billion versus $1.2 billion in 2013.

Asia-Pacific: These carriers are expected to post profits of $3.7 billion in 2014, higher than $3.0 billion recorded in 2013. Strong passenger and cargo demand will boost profitability.

Middle East: Per IATA, profits from the Middle East carriers are expected to grow from $1.6 billion in 2013 to $2.2 billion in 2014. The region will likely witness robust traffic growth owing to strong passenger demand. Cost control measures, joint ventures and product innovations will drive profitability.

Latin America and Africa: The region’s profitability is expected to enhance 2.5 times from $400 million in 2013 to $1.0 billion in 2014. The picture is similar in Africa, where a profit of $100 million is forecasted compared to a loss of $100 million in 2013.

Emergence of Several Airways in the Middle East

As the U.S. passenger carriers try to remain disciplined in capacity additions, several Gulf-based airlines continue to fortify their positions within the global airline industry. Emirates has led the pack by expanding in Europe, Africa and the BRICS thus making Dubai one of the largest international connecting hubs in the world. Emirates’ success was followed by two other regional players namely Etihad Airlines and Qatar Airways, which are trying to emulate the size and stature of the former.

The large-scale plane orders only confirm the long-term ambitions of these airlines. The three Middle Eastern carriers already have a much impressive fleet of wide bodied jets as compared to U.S. carriers. These Gulf airlines have placed orders worth $162 billion with The Boeing Company (BA) and Airbus, deliveries of which are expected over the next decade.

Emergence of these cash rich airline companies remains a concern for the legacy carriers including the U.S. ones, which might lose a chunk of their international market as most passengers continue to move through the Gulf.

India - A Strong Long-term Opportunity

The aircraft manufacturing giant Airbus and Boeing have both raised their 20-year outlook on India owing to the high appetite for growth but low market penetration of airline services. Demographic trends in India support the growth of air transportation service as the country's working class population continues to rise. The optimism swelled after Boeing received orders for 42 B-737 aircraft from SpiceJet worth $4.4 billion, while Tata Groups’ two airline joint ventures with Singapore Airlines and Air Asia Berhad have opted for Airbus' A-320 fleet.

According to Boeing’s estimates, Indian carriers will buy 1,600 aircraft worth $205 billion between 2013 and 2032 compared to its previous same-period projection of 1,450 planes valued at $175 billion. Boeing’s counterpart Airbus has also raised its 2013–32 outlook to 1,290 aircraft valued at $190 billion from $1,045 billion planes at $145 billion. The aircraft manufacturing duo has predicted that a significant part of the order will constitute single-isled narrow bodied aircraft like Airbus A320 or Boeing 737s.

The long-term rosy picture is however partially offset by the short-term weakness within India's aviation industry, which continues to suffer from over capacity. High capacity as compared to demand is forcing the carrier to fly with a lot of empty seats, thus affecting load factor. Additionally, airfares have also surged in the last five years resulting lower demand for air service.

Underlying Factors for 2014 Profits

In the base-case scenario, there are several dynamics that will act as driving factors for the overall airline profits in 2014. These include:

Passenger & Cargo: Solid air travel demand, growth in ancillary revenues and economic recovery in Europe and North America are expected to drive growth. IATA is projecting global airline passenger growth of 5.8% and average industry load factor 80.2% this year. The improved supply-demand balance globally is expected to result in modestly lower passenger yield this year.

Fuel Price Effect: Airline profit outlook depends on fuel prices, the major variable component in the industry. For 2014, average oil prices are expected to stay at $108.0 per barrel, lower than $111.8 per barrel in 2012 and around $108.8 in 2013, primarily due to increased fuel supply in North America. Lower fuel prices are beneficial to airlines. But if the price reduction is due to weak demand on account of economic issues, then it’s a net negative for the carriers.

Service and Fleet Restructuring: many carriers are scrapping flights in small and unprofitable airports in order to reduce costs, with bottom-line concerns trumping market share gains. To that end, the companies are replacing old and depleted airplanes with new and upgraded ones. Though initially expensive, new and improved aircraft are more fuel efficient than the existing ones and will help in lowering operating and maintenance costs.

Over the next 20 years, global airlines are expected to invest in excess of $4 to $5 trillion in fleet development. Apart from the high demand from the oil rich Gulf nations, a major part of the fleet demand will also be driven by China, India and continuous expansion of low budget carriers around the world. For this, the airlines are banking on top aircraft manufacturers such as The Boeing Company, Embraer SA (ERJ) and Airbus.

Over the long run, the carriers aim to replace their old narrow-body jets – A320’s/B757-200/300 – with advanced narrow-body airplanes such as A-321, A320 Neo and the B737 Max, for better service and demand-supply equilibrium.

Delta Air Lines Inc. (DAL) plans to replace two-third of its older 50-seat regional less efficient aircraft with Boeing’s 717-200 and 737-900 aircraft over the next two year. This fleet is already generating superior margins in markets where it is already deployed and expected to further enhance domestic capacity.

Jet Renovation: With passengers demanding comfort and quality service along with proper security, airlines are focusing on aircraft redesigning with new and attractive products and services within the travel plan.

United Continental Holdings Inc. (UAL) is offering premium flat-bed cabin seats on every long-route international flights. Further, the carrier has installed in-seat power on more than half of its mainline flights and has revamped the interiors of most of its Airbus fleet. Delta also plans to invest $750 million over the next two-year period to roll out Wi-Fi as well as renovate the interiors of its narrow-bodied aircraft over the next three years.

Hedging Strategies: Hedging strategies are used by airline companies to cope with the rising fuel prices. The carriers use a combination of calls, swaps and collars at varying WTI crude-equivalent price levels to hedge.

U.S. Airlines – 20-Year Projection

Over the last few years, the global economy has been hit by a recession in Europe, slow growth in China and volatile performance by some emerging economies. Although U.S. airlines experienced slow growth in the recent past due to these headwinds, these are expected to improve in the long run as predicted by the U.S. Federal Aviation Administration (FAA).

The U.S. airline industry is expected to remain profitable over the next two decades given the improving worldwide economic activity. An uptick in economic activity will fuel demand for airline service. Passenger enplanement is expected to grow 0.8% to 745.5 million in 2014 and about 2.1% in the future, reaching $1.03 billion by 2028 and nearly $1.15 billion by 2034.

The FAA projects air traffic, customarily measured in billions of revenue passenger miles (implying a unit of one mile flown by one passenger), to grow many folds over the same period. Revenue passenger miles will jump from 822.2 billion reported in 2012 to almost 1.47 trillion by 2034 at an average annual rate of 2.7%.

International traffic is forecasted to move up at an average rate of 4.2% per year, reaching 434.8 million in 2034. This projection assumes steady economic recovery with no major headwinds like a significant rise in oil price, changes in macroeconomic policy or financial meltdowns. Further, major North American airlines will raise capacity (available seat miles) at an annual rate of 2.1%, reaching 1.75 trillion by 2034.

Zacks Industry Rank - Positive

Within the Zacks Industry classification, airlines are broadly grouped into the Transportation sector (one of 16 Zacks sectors).

We rank all the 260-plus industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry. To learn more visit: About Zacks Industry Rank.

As a point of reference, the outlook for industries in the top one-third of the list (with Zacks Industry Rank #88 and lower) is ‘Positive,’ the mid one-third of the list (between #$89 and #176) is ‘Neutral’, while the last one-third ( from #177 and above) is ‘Negative.’

The Zacks Industry Rank for the airline industry is currently #56, implying that the outlook remains positive.

Earnings Trends

The broader Transportation sector, of which railroads are part, reflects a stable growth pattern. So far, 100% of the sector participants have reported fourth-quarter results, which have been fairly good in terms of both beat ratios (percentage of companies coming out with positive surprises) and growth.

In the fourth quarter, the transportation sector registered revenue "beat ratio" of 54.5% and earnings beat ratio of 45.5%. Total earnings for the companies in this sector grew 15.8% year over year on 4.5% revenue growth. Earnings showed meaningful improvement from 13.2% in the third quarter 2013, while revenue growth was flat at 4.5%.

The Consensus earnings expectation is pegged at 19.9% for the first quarter and 8.2% for 2014. The second quarter is expected to register a modest earnings growth of 1.2%. The first quarter revenue expectation is pegged at 4.8% while full-year growth stands at 4.5%. The second quarter is expected to register revenue growth of 4.4%.

For more details about earnings for this sector and others, please read our latest ‘Earnings Trends.’

OPPORTUNITIES

We believe industry consolidation and various ancillary revenues will boost the profitability and cost performance of most air carriers going forward. This is a suitable time for companies to consolidate for higher profits and operational efficiency.

Additional Revenue Gains: A number of supplementary revenue streams helped the airline industry gain ground in 2013. Air carriers are adding novel features to their service and introducing products to improve passenger satisfaction and experience. The IATA projects total revenue of $745 billion in 2014.

Mergers & Acquisition: Airline companies unite in order to restore lost profits and broaden their perimeter. This was evident in the past mega mergers within the industry involving Northwest Airlines and Delta Air Lines in 2008, United Airlines and Continental Airlines in 2010 and AirTran Holdings and Southwest Airlines Co. (LUV) in 2011. All three companies – Delta, United and Southwest are long-term beneficiaries on capacity and cost fronts.

The recently merged U.S. Airways Group Inc. and American Airlines Inc. have gained in size and capacity by creating the largest global carrier American Airlines Group Inc. (AAL). Despite the merged entity having more pricing power and control over a larger number of slots, we believe it will have little effect on the dynamics of the U.S. aviation industry as 80% of the same market will be dominated by the new American, United, Delta and Southwest.

Expansion: North American carriers continuously strive to increase domestic and international flights. United is planning an international service between Los Angeles and Melbourne from Oct 2014. To expand operations in Central America, United plans to operate flights between Newark in New Jersey and Santiago in Dominican Republic from summer 2014.

Delta Air Lines is strengthening its position in the western coastal city of Seattle and is building it as an access point to Asia. Meanwhile, Southwest is looking to tap opportunities in the international market with its debut in three Caribbean markets in Jul 2014. The company also aims to offer non-stop service to several domestic destinations from Dallas Love Filed airport where flight limitations will finally be lifted in Oct 14. The carrier also expects to strengthen in markets like Memphis, Tennessee, Cleveland, where rival carriers have downsized their operations.

JetBlue continues to successfully expand its network footprint in major growth regions – Boston, Fort Lauderdale, the Caribbean and Latin America. The company is banking heavily on the new services offered from Fort Lauderdale to different locations in the Caribbean and Latin America.

New Choices: The merger between U.S. Airways and American Airlines has opened up new opportunities for low budget carriers. As part of the agreement with Department of Justice (DOJ), U.S. Airways and American need to give up 52 take-off and landing slots at Washington’s Reagan National Airport (DCA) and 17 pairs at New York’s LaGuardia Airport (LGA). Further, the carriers have to divest two gates and related facilities at each of the Boston, Chicago, Dallas, Los Angeles and Miami airports.

Carriers like Southwest, Virgin Atlantic and JetBlue have reaped the most benefit of these slot divestments. Southwest has been the beneficiary at both DCA and LGA winning 27 and 12 pairs respectively, while JetBlue won 20 such pair slots at DCA, including 8 that it has leased from American Airlines. Virgin America has won the remaining 5 pairs of slot at LGA. Both Southwest and JetBlue have announced their intentions to expand from DCA, with the former planning 40 daily departures, while the latter targeting 24 daily services from the airport.

Technology Upgrades: Air carriers are opting for numerous technology upgrades and system automation for various activities such as airline reservation, flight operations and website maintenance. These upgrades allow the companies to function effectively and efficiently, minimize expenses and render better customer service.

Carriers like Cathay Pacific, Malaysia Airlines, KLM, Delta, Qantas and British Airways have made Apple's iPad available to passengers in their lounges, rent them out in the air as well as use them as a self-service kiosk, customer survey tool and food ordering tool. Meanwhile, United Airlines has installed satellite-based first-ever Wi-Fi service for flyers on any long-haul international route and is presently available on nearly 170 flights.

Emergence of Smaller Carriers

Although consolidation within the U.S. aviation industry will reduce competition, it is expected to be short lived because of the low barriers to entry within the same. Further, the rising profit margins within the industry have allowed the smaller operators to expand. The most aggressive of these has been Spirit Airlines Inc. (SAVE), which plans to double its fleet size by 2017.

These ultra-low fare carriers are gaining popularity by providing low cost options for domestic travelers, thus gaining popularity among low end customer. Other small carriers like Allegiant Travel Company (ALGT) and Frontier Airlines Group Inc. along with Spirit could capture a greater market share if they continue with their present expansion mode.

The major outperformer will be American Airlines and Alaska Air Group Inc. (ALK), that have a Zacks Rank #1 (Strong Buy). We also like a few Zacks #2 Rank (Buy) stocks such as JetBlue Airways, Southwest Airlines, Delta Airlines, Hawaiian Holdings Inc. (HA) and Copa Holdings SA (CPA). United Continental and Allegiant currently hold a Zacks Rank #3 (Hold).

CHALLENGES

Of the many challenges facing the industry, the most crucial ones include slow economic recovery, volatile fuel prices, natural calamities, industry consolidation, government regulation, unionization, airport infrastructure constraints, technological investments and safety concerns.

Pitfalls of Industry Consolidation: Over the last few years, the U.S. aviation industry has seen several consolidations with the most significant ones being U.S. Airways with American Airlines in 2013 and Continental with United in 2010. With major and legacy airlines of the U.S. joining forces, the total number of carriers operating within the industry is becoming less. This has resulted in less competition, higher airfares and increased fees, thus affecting the flyers.

Cannibalization: Smaller airlines could also be dominated by their bigger counterparts, which will try to drive them away either via price competition or through strategic acquisitions. Frontier Airlines became the recent target when it was acquired by Phoenix-based private equity firm Indigo Partners LLC.

Oil Price Volatility: Fuel price volatility continues to be one of the significant challenges, as fuel costs are largely unpredictable. Airline carriers’ ability to pass along the increased costs of fuel to its flyers is restricted by the competitive nature of the industry. Although fuel price is currently stable, any significant geo-political issue in the oil producing country can affect profitability.

Unionization: The airline business is labor intensive. Most of the employees are unionized and depend on various U.S. labor organizations. The relation between airlines and labor unions are governed by the Railway Labor Act, which states that a collective bargaining agreement between an airline and a labor union does not expire – instead it becomes amendable as of a stated date.

Failure to amend terms and conditions suitably may lead to work stoppages or strikes, and thereby hamper operations. Similarly, the airline industry in rest of the world is also exposed to labor related concerns − proved by the ongoing pension-related dispute of Aer Lingus and its largest trade union.

Federal Regulations: The airline industry is highly regulated, in particular by the federal government. All companies engaged in air transportation in the U.S. are subject to the regulations implemented by the Department of Transportation (DoT).

Further, airlines are also regulated by the Federal Aviation Administration, a division of the DoT, primarily in areas of flight operations, maintenance and other safety and technical matters. The new stringent pilot duty and rest rules under FAR117 will increase the carriers’ expense as the companies need to hire more pilots to comply with the aforementioned rules.

Large Investments: The air carriers are investing a lot of money to enhance their products and services to gain a competitive edge. However, returns from these investments are uncertain.

Technological Failure: Technological investment is a key expense for air carriers. The profitability of airlines could be affected by technology glitches or failure to invest in new technologies. The most prominent example is an electrical system problem in Boeing 787 Dreamliner stemming from its lithium-ion batteries, which can affect the buyers of these mega carriers.

We expect Republic Airways Holdings Inc. (RJET) and SKYWEST Inc. (SKYW), to underperform the broader market. Both hold a Zack Rank #5 (Strong Sell).

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