3 Airline Stocks Ready to Take Off

A robust economy and high consumer demand should have produced favorable tailwinds for airline stocks, but they've encountered severe turbulence in the form of soaring fuel costs. Nonetheless, Rajeev Lalwani, an analyst with Morgan Stanley, sees a "better narrative ahead" for U.S. airlines, propelled by "robust demand and broadly positive pricing," according to Barron's. "With pricing health and moderating unit costs, we see a more favorable set-up ahead with margin stability and achievable estimates," he says. Lalwani's top picks are listed below.

Morgan Stanley's Picks: Ready to Take Off

Stock Ticker Gain Since June 29
Alaska Air Group Inc. ALK 5%
Delta Air Lines Inc. DAL 11%
Southwest Airlines Co. LUV 18%

Sources: Barron's, Yahoo Finance; gains computed as of 8/15 1:30 pm New York time.

Lalwani also indicates that airline costs are on a "more stable path" for the remainder of 2018 and into 2019, Barron's adds. Michael Linenberg, an analyst with Deutsche Bank, also likes Alaska and Southwest, per another Barron's story, "for their self-help stories and defensive nature." 

Why These Stocks Will Fly

  • Pricing health
  • Moderating unit costs
  • Margin stability
  • Achievable estimates

Source: Morgan Stanley, as reported by Barron's.

Southwest offers a particularly interesting case, especially since it is the airline of choice for price-sensitive leisure travelers, and which has been expanding its service area widely in recent years, though it remains largely a domestic U.S. carrier. Founded in 1967, its ticker symbol LUV derives from the decision to keep its base in lower-cost Love Field when other airlines shifted operations to the new Dallas/Fort Worth International Airport (DFW) in 1974.

Southwest: Earnings Stability

Southwest has been hampered by a fatal accident in April, the first on a U.S. airline since 2009, when an engine broke apart and a fragment sliced though a window, killing a passenger. Bookings on the airline have been down since then, which Southwest attributes to reduced advertising, per a third Barron's report. Adding to Southwest's troubles, fuel represents about 25% of its operating costs, and the price of jet fuel is up by about 50% over the past year. If that were not enough, some competitors, such as United Continental, have aggressive expansion plans in the works, Barron's adds. (For more, see also: How Is Southwest Different From Other Airlines?)

Bullish analysts, however, observe that Southwest has a more stable earnings history than most of its rivals, as the only major airline that turned a profit during the last economic crisis, Barron's says. As a result Helane Backer, an analyst with Cowen & Co,, has argued that Southwest deserves a forward P/E ratio of about 15 times projected earnings. Given a current forward P/E of 11.7, per Yahoo Finance, a revaluation to a P/E of 15 would imply 27% jump in the stock price, all else equal. Becker adds that Southwest has been buying back stock and has increased its dividend. The forward dividend yield is now 1.1%.

On the cost side, Barron's notes that, unlike most of competitors, Southwest hedges against increases in fuel costs. Should the price of oil rise above $80 per barrel, management indicates that this hedging activity will deliver big savings. Benchmark West Texas Intermediate (WTI) crude oil currently trades at a spot price of about $67 per barrel. Meanwhile, Southwest should be a bog winner from the reduction in federal corporate income tax rates, since it typically has paid a higher effective rate than its rivals, Barron's adds.

Delta: Boost From Tax Reform

Delta enjoyed 9.6% year-over-year (YOY) revenue growth in the second quarter, but pre-tax income fell by 10.2%, largely on ths basis of jet fuel costs that increased by 30.7%, The Motley Fool reports. However, Delta was a big beneficiary of tax reform, as EPS rose by 11.3%. Delta also performed well on the basis of a key airline industry metric, revenue per available seat mile (RASM), which was up 4.6% YOY. Looking ahead, the company has plans underway to cut underperforming flights from its schedule, the Motley Fool adds. (For more, see also: Delta Stock Breaks Out to All-Time High After Earnings.)

Alaska: Three Headwinds

Alaska Air faces three stiff headwinds, rising fuel prices, intense price competition in its home market, the U.S. west coast, and problems integrating Virgin America, per another report in The Motley Fool. Second quarter EPS plummeted by 86%, and its RASM fell by 1.5% YOY, largely due to heavy reward redemptions during peak travel periods. The company projects that reward travel will continue to dent revenues in the third quarter, but expects to make changes in the fourth quarter that will fix the problem.

Despite those headwinds, Morgan Stanley sees positives for Alaska Air going into 2019. In particular, to gain a turnaround in RASM and profit margins, the company is lowering its projected rate of capacity expansion. Also, Morgan Stanley sees "continuing progress on synergies and various initiatives starting to come through," per their report dated August 10, "2Q Review: A Pivotal Period," covering aerospace, defense and airlines. They have set a target price of $76, which is 22.8% above the August 13 close.

Impact of Trade Wars

Among the big three U.S.-based international carriers, in additional to Delta, up by 10.2%, United Continental Holdings Inc. (UAL) is up by 16.5% and American Airlines Group (AAL) is down by 2.8% since the end of June. Despite their low valuations and healthy balance sheets, Linenberg notes that big international carriers such as Delta, United Continental and American have an especially high degree of sensitivity to global economic activity, particularly to levels of international trade, which makes growing trade conflict a big source of worry for them.

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