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Can Airline Stocks Fly Out of the Turbulence?

21 July 2015 in Trading Ideas

Airline stocks have soared by nearly 30 percent in the past nine months—and that seems to have made investors a little too nervous.

As a recent piece in Barron’s pointed out, nearly a year ago Wall Street had predicted that the country’s big four airlines, which control more than three quarters of the domestic market, would grow their combined 2015 operating earnings by 7 percent to $22.7 billion.1

Of course, that was before the plunge in the price of fuel, typically the biggest operating expense for airlines. The U.S. price has plunged 40 percent in a year to around $1.70 a gallon.

As a result, the latest forecast for the big four—American Airlines, Delta, Southwest and United Continental—is for 40 percent growth to $29.2 billion.

That’s good, right?

Not so much for investors who have begun to fret that the newly prosperous group will take the next step and start adding more capacity to their operations.

At some level the fears aren’t unfounded. Revenue per average seat mile—how much money is brought in per unit of capacity—is expected to decline 3.5 percent. What’s more, brinkmanship between Southwest and American hasn’t helped investors’ nerves. Southwest has been adding capacity in Dallas, where the two airlines have hubs at different airports.

Addressing an industry meeting last month, American’s Chief Executive Officer, Doug Parker, warned that too much industry growth could hurt profits. Shortly afterward, both companies reported declines in unit passenger revenue, and Southwest said it would scale back growth.

A month ago, the resulting angst had left the big four’s stocks down 21 percent for 2015 to date—although still 10 percent higher than the same time a year prior.

Since then, however, some investors have begun to poke around at possible bargains. The Taking Flight motif, almost one third weighted with the big four airlines, has gained 3.4 percent in the past month, according to Motif Investing’s inhouse data. In that same time, the Standard & Poor’s 500 has increased 1.3 percent. Over the last 12 months, the motif has risen 13.9 percent; the S&P 500 is up 8 percent.

As Barron’s put it, the question facing investors now is whether the expected drop in revenue per seat mile is a sign of another nosedive or a simply brief patch of turbulence. The latter seems more likely, for two reasons.

First, declines in the revenue per seat mile metric tend not to last long. Second, lower fuel costs mean that airlines can always improve profits by adding seats.

Ultimately Barron’s suggested that other upward-trending factors are more important to the future of airline shares than capacity. The U.S. economy is slowly gaining strength, with economists predicting growth of 2.2 percent this year, rising to 2.8 percent next year.

In addition, jet fuel prices don’t appear to be headed significantly higher, due to the twin forces of a U.S. drilling boom and Saudi Arabia pushing crude prices lower to protect market share. Meanwhile, the estimated $10 billion in yearly fuel savings the big four carriers now enjoy—equal to nearly 10 percent of their combined stock market value—could be used to pay down debt, buy back shares, and refit or replace planes.

That may be enough to encourage investors to buckle in and enjoy the ride.

1 Hough, Jack, “Airline Stocks Could Soar Up to 50%,” Barron’s, June 20, 2015.