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Airline Stocks Are Cruising

12 November 2014 in Trading Ideas

The airline sector isn’t taking a backseat to anybody in enjoying the low price of fuel.

Last month, several operators delivered a decidedly upbeat outlook on the industry in reporting strong profit growth amid a compelling combination of cheap fuel and strong customer demand.

Profit at American Airlines came in at $942 million, the highest in the airline’s history and 87% above the combined total a year earlier by American and US Airways prior to their merger.1

United Continental’s profit more than doubled, while Southwest Airlines saw its profit lift 27%. JetBlue’s earnings, meanwhile, rose 11%.

All four of the companies reported gains in the closely watched industry benchmark of passenger revenue per available seat mile (PRASM).

Southwest Chief Financial Officer Tammy Romo said that PRASM in October was running about 2% higher than last year’s level. Bookings in November and December for Southwest were “also good,” she said.

Shares of airline companies have, in turn, won renewed favor from investors. The Taking Flight motif, which is 78.5% weighted with airline stocks, has gained 24.5% in the past month. In that same time frame, the S&P 500 has increased 7.1%.

So far this year, the motif has risen 36%; the S&P 500 is up 12.2%.

Analysts said the profit increases reflected higher fares enacted by several carriers as well as the gains from various cost-cutting initiatives.

Airlines were also able to reduce their spending on jet fuel due to lower oil prices and the benefits from fleet upgrades to more fuel-efficient models.

Fuel costs at United fell 4.1% in the most recent quarter, while dropping 1.3% at American and 4.4% at Southwest.

Airlines also notched higher revenues from additional fees, including for baggage and in-flight food, with United scoring a 10.9% gain in these “ancillary” revenues to $22 per passenger.

Ancillary revenue is an increasing focus for all airlines, regardless of size. The most recent projection by IdeaWorks/CarTrawler anticipates a $7.3 billion gain in ancillary revenue for the global airline industry in 2014 to $49.9 billion. That means ancillary revenue now represents 6.7% of total industry revenue. Just four years ago, the level was 4.8%.2

The near-term picture also appears positive for the airlines. Southwest’s Romo noted that into the fourth quarter “the demand environment remains solid and strong revenue trends have continued,” and the airline hadn’t seen any noticeable negative impact on demand from any macroeconomic news such as Ebola, or renewed terrorist threats.

Many Wall Street analysts were in agreement. Cowen’s Helane Becker and Conor Cunningham were among those taking the airlines’ strong financial results and future estimates at face value – when they weren’t finding them too conservative.3

“The domestic demand environment remains very strong with modestly increasing PRASM trends,” the analysts wrote, noting that forward comments delivered by companies regarding PRASM were surprising to the upside.

For example, the analysts pointed out that American forecast fourth-quarter PRASM growth of flat to up 2%, in line with Delta. However, when one excludes the impact of Venezuela on American’s results, PRASM would have been up 2% to 4%, well ahead of the industry.

The analysts said JetBlue’s October PRASM forecast of an increase 1% to 2%, was ahead of their initial expectations and driven by a strong domestic market.

Meanwhile, the analysts thought United was underselling its fourth-quarter PRASM forecast of down 1% to up 1%. “There is probably some opportunity for an upside surprise if the demand environment continues to hold steady,” the analysts wrote.

Cost guidance has been better than expected, they noted, with modest non-fuel cost creep and dramatically lower jet fuel prices. Given the strong demand environment and declining jet fuel costs, year-over-year margins should expand in the fourth quarter, the analysts declared.

While a spike in fuel prices could certainly change the current proposition, airline operators have created the perception they’re cruising in the sweet spot.

1Sophie Estienne (AFP), “US airline profits lift on cheaper fuel, strong demand,” businessinsider.com, Oct. 23, 2014, http://www.businessinsider.com/afp-us-airline-profits-lift-on-cheaper-fuel-strong-demand-2014-10, (accessed Nov. 10, 2014).

2Nick Vivion, “Airline ancillary revenue rockets to a projected $49.9 billion globally,” tnooz.com, Nov. 4, 2014, http://www.tnooz.com/article/airline-ancillary-revenue-rockets-projected-50-billion-globally/, (accessed Nov. 10, 2014).

3Ben Levinsohn, “Never Mind Ebola, Airline Stocks Keep Flying,” barrons.com, Oct. 14, 2014.