Second-tier airlines often fly under the radar of the legacy carriers in investors’ minds, but these budget-minded airlines are doing just as well, or even better, financially as the bigger names.
Many foreign-flagged airlines are also financially fit, although they trail some of the U.S. carriers as far as margins go. “Globally the industry is doing relatively well,” says Jonathan Root, senior credit officer and lead U.S. airlines analyst for Moody’s in New York. “The big guys get the headlines.”
The wind beneath the wings of all airlines is low fuel costs, Root says. How much fuel costs affect a company’s operations depends on hedging programs, location and other factors. Between 50 and 70 percent of an airline’s total operating expenses are for fuel and labor, another major cost, he says.
Smaller airlines, though, benefit from lower labor costs. Being relatively newer, most of their labor isn’t yet unionized so their labor costs are typically less, he says.
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A report from Oliver Wyman analysts backs that claim up. In their Airline Economic Analysis 2016-2017 report, the analysts said systemwide U.S. airline unit costs, which exclude transport-related expenses, declined 4.1 percent year-over-year to 11 cents during the second quarter 2016, continuing the multi-year trend of declining unit costs. The value carriers — Allegiant Travel (Nasdaqr: ALGT), Frontier Airlines, JetBlue Airways ( JBLU), Southwest Airlines ( LUV) and Spirit Airlines ( SAVE) — reduced systemwide costs 6 percent from 10.4 cents in 2015 to 9.8 cents in 2016.
The question is how long can this cost-cutting continue? Oliver Wyman analysts believe that although discount airlines are in a better position than the legacy carriers, it won’t last. Value airlines usually have lower labor costs, but eventually wage pressure affects them as well.
Bigger doesn’t mean better. Profit margins for the second-tier airlines can be stronger than for the legacy carriers. “If you look at all the margins side-by-side, the large guys are not uniformly more profitable than the small guys,” Root says. “In terms of margin, smaller companies have very competitive, if not stronger, margin.” He says niche player Hawaiian Holdings ( HA) has the strongest margins of any company, and Allegiant has been the most profitable airline in the U.S. for years.
Sven Reinke, senior vice president for Moody’s in London, covers European airlines and says the picture is much the same for these carriers, with minor differences. The profits for European carriers are improving as expensive fuel hedges have matured and as airline consolidation picks up.
But the real tailwind for European carriers is a resurgent European economy. “The European growth rate is the highest since the financial crisis, and unemployment is falling,” Reinke says. “That fuels demand for air passenger traffic.”
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In Asia, Hideki Kunugi, senior vice president of ANA, the Americas, a Japanese airline, says the firm’s operating revenue rose 11.7 percent in the first quarter, with much of the profit increase coming from the acquisition of Peach Aviation, a budget airline.
The trend of staving off the competition through acquisition is also occurring in the U.S., Root says, as the major carriers invest in smaller airlines to help manage capacity. Root notes Air France-KLM bought a 31 percent stake in Virgin America in July, while Delta Air Lines ( DAL) and China Eastern Airlines bought a 10 percent stake in Air France-KLM. Delta already has a stake in Virgin. “They have the ability to cooperate more closely on capacity and pricing,” which helps them manage their performance on a collaborative basis, he says.
The Oliver Wyman analysts think the key to airline profitability will likely depend on each carrier’s ability to avoid drops in unit revenue this year, as cost-cutting has probably reached its limit.
Josh Blechman, director of capital markets at ACSI Funds in Ann Arbor, Michigan, says in the current economy, his firm prefers the smaller airlines to the legacy carriers. Because of low fuel prices, profitability for the smaller airlines has been settled, so he expects these carriers to compete further by improving service.
Prices on certain routes are becoming commoditized, making each carrier’s service more important for consumers. “They’re going to go with the ones that make them more comfortable and offer more value,” he says.
As a result, ASCI Funds likes Jet Blue and Alaska Air Group ( ALK), which perennially rank higher on customer satisfaction scores, Blechman says. “In airlines, that plays a big role in where they’re going to spend their money,” he says.
Turbulence ahead? Newer planes that can fly longer, like the Airbus A380, mean more airlines could be touching down in the U.S. Kunugi says ANA sees growth potential in international travel and is accelerating preparations to introduce the A380 in 2019, as well as roll out new products and services.
Newer aircraft allow upstarts like Norwegian Air and Icelandair to get a toehold in the U.S., Root says. European airlines have dealt with upstarts like Ryan Air and Easy Jet carving out territory in the short-haul segment, Reinke says, but legacy carriers like Lufthansa have started to copy that model, too. Still, the smaller airlines aren’t going away.
These experts also say it’s too early to tell what impact the Norwegian Airs and Icelandairs will have on U.S. airlines’ profitability. “Norwegian has some issues,” Reinke says. “They might be growing a little bit too fast to keep everything under control. That’s a situation worth watching.”
Newcomers to the U.S. airspace have their own issues, such as budget airline Air Berlin, which filed for bankruptcy recently.
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In the U.S., a robust economy won’t last forever, and when it slows, all airlines will need to manage their network and capacity better to remain profitable. Currently, airlines have a uniform earnings strategy or have been maximizing return on capital, but they may have to shift gears if competition heats up. “The industry has not yet been tested with a demand shock or price shock,” Root says.
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Second-Tier and Foreign Airlines Fly High originally appeared on usnews.com
