The skies have been friendly for airline companies. Low oil prices, combined with a strong U.S. dollar and falling unemployment, have led customers to spend more on travel. That’s a promising mix of economic tailwinds.
In fact, many U.S. airlines have enjoyed record profits. With Brent crude oil prices falling from a high of more than $114 per barrel in June 2014 to $35 now, airlines have drastically reduced the amount they are spending on fuel — a cost that typically accounts for a third of an airline’s expenses, analysts say.
The huge reduction in costs allows Delta Air Lines (ticker: DAL), American Airlines Group (AAL) and Southwest Airlines Co. (LUV) to sell more seats by increasing the number of flights they offer, boosting both profits and revenue, says Savanthi Syth, airline analyst for the Raymond James financial service company.
But looking at the stocks, you never would guess the view was so rosy. Over the past three months, the New York Stock Exchange ARCA airline index has fallen 8 percent. The reason? The same capacity growth that boosts companies now can also lead to problems down the road.
“Capacity has been growing at a faster clip than general GDP growth,” Syth says. “This level of growth is not bad, but capacity is hard to take back.”
Since the stock market looks forward, some analysts are concerned that airline stocks are due for some headwinds of their own. Here’s a look at three of the biggest U.S. airlines.
Delta shines with customer options. It seems like a simple request, but any flyer knows that simply arriving on time isn’t a foregone conclusion. Delta, however, is the highest-rated legacy carrier when it comes to punctuality. This reliability draws in corporate travel, which grew by 4 percent in 2015.
But for many customers, price is even more important than on-time performance. And the growth of ultra-low-cost options, such as Spirit Airlines (SAVE), indicates that more travelers are willing to trade comfort and convenience for a significantly cheaper ticket. The strategy has turned Spirit into a $2 billion company, wrestling sales from larger players like Delta.
To counter this trend, Delta added a fourth section — “basic economy” — to its aircraft in 2014. Basic economy doesn’t allow customers to change their itinerary or pick their seats, but it lets Delta slash prices to compete with low-cost operators.
“It enables them to be cost-competitive with the low-cost carriers,” while providing the same service to other sections of the cabin, says Helane Becker, an analyst for New York City financial services firm Cowen & Co.
Basic economy fares have helped Delta revenues jump 8 percent since 2013. With a forward price-to-earnings ratio of 6.3, DAL stock is priced below the industry average, leading Becker to value Delta stock at $62 per share — about 40 percent above its current price.
American Airlines is spending on its fleet. In late 2013, American Airlines completed its merger with U.S. Airways. While this made American the largest U.S. carrier, the effort to combine the two companies left some overlap that still hasn’t been resolved. Most notably, both companies had signed plans prior to the merger to overhaul their fleets. That means while other airline companies are paying down debt, American continues to spend.
Syth estimates that American is spending $5 billion to $6 billion a year to overhaul its fleet — about what Delta and United Continental Holdings (UAL) spend annually combined. That gives American much more debt on its books — Syth estimates that the adjusted debt-to-capital ratio for Delta is 38 percent, while American has a ratio of 80 percent.
“American has a much more leveraged balance sheet,” Syth says. “Delta is in a far stronger position.”
But there’s good news ahead. American expects to finally reduce its fleet cost next year, leaving it with a fleet that’s younger and more modern than newer carrier Southwest, Syth says.
American’s debt leaves AAL stock with little room to grow in the short term. Becker values the stock at $42, a 7 percent upside to its current value.
Southwest’s capacity growth could become a problem. Since airlines are a cyclical business, analysts don’t want to see them increase the number of seats they offer too quickly — when consumer spending drops, an airline could be stuck with a lot of empty seats.
Southwest has grown the fastest of all the large U.S. carriers, increasing capacity by 7.2 percent in 2015. It expects 5 to 6 percent growth this year.
Part of the reason for Southwest’s growth is the end of the Wright Amendment in the Dallas/Fort Worth market. The law limited the number of nonstop flights carriers could offer out of the area. Headquartered in Dallas, Southwest now offers nonstop service to 50 destinations. That growth won’t “sustain over the long-term,” Syth says.
However, unlike the legacy carriers, Southwest does have options for future growth that it’s only now beginning to take advantage of: international flights. LUV flies only to a handful of international destinations in Mexico and the Caribbean, but that’s expected to change in the coming years.
LUV stock’s forward P/E ratio of 8.4 is well above the average of mature airlines. While Southwest may deserve some premium to American, Delta or United because of this room for growth, Syth doesn’t believe it should trade with that much of a gap. In fact, priced as it currently is “stretching it,” Syth says.
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Clear Skies Ahead? The Long-Term Prospects of 3 Airline Stocks originally appeared on usnews.com
