With third-quarter earnings season wrapping up for airlines, analysts see reason to stay bullish on the sector.
Where we were: Airlines have largely trailed behind the market this year and during the recent market weakness.
Where we’re headed: Analysts see a brighter 2019 ahead, helped by better outlooks for margins, capacity, and fuel prices.
Airline analysts are in a reflective mood about the group, which remains largely stuck in the red year to date.
JPMorgan Chase’s Jamie Baker takes a look at the industry, writing that he’s still fundamentally bullish on airlines in general, as the “case for industry margin expansion remains the best we’ve seen in four years.”
While investors may be frustrated at airlines’ performance in terms of margins in the past two years, Baker argues that expansion was never in the cards, given the labor cycle in 2017 and oil’s rapid rise in 2018. “By comparison, the current setup looks highly compelling to us. 2019 capacity is anticipated to be tighter than 2018 (~3.5% versus ~4.5%), and we remain of the view that further cuts are likely in the event fuel rises from here.”
Moreover, labor contracts shouldn’t be a risk to the industry, although Baker is building into his financial model a 7% wage increase for pilots at United Continental (UAL) in 2020. He calls the forward curve for fuel prices “comparatively benign,” saying economic output is strong and airline management teams have been emphasizing margin expansion in a way that they haven’t in the past. “Sure, we could model for 5% GDP and $50 crude, but the current fundamental setup appears to be of the highest, plausible quality that we could reasonably construct, if simply handed a blank sheet of paper,” Baker says.
You don’t need to be a market-timing genius to buy and hold airline stocks now, he writes: In the past 11 years, buying airline stocks in September and October, and holding them until April or May has, on average, allowed investors to outperform the broader market, even buying at seasonal highs and selling at lows.
Then there’s the fact that consolidated growth in capacity looks like it will come in 0.5 percentage point higher than expected in 2019, but still roughly a point below the 2018 level. (Capacity, remember, has been a bugaboo this year, as investors have worried that too much supply will gut airlines’ pricing power at a time when they need to raise fares to pass along higher fuel costs. Third-quarter earnings have eased these fears a bit.)
Sounds great, but the stocks, with the exception of United, have had a pretty abysmal year. Baker admits that most airlines are trading within 10% of their recent lows, but that also suggests that “seasonal trade-winds may lift equities as they often do.”
Still, given how far the stocks have fallen, he lowered his earnings estimates for a number of companies, even as he sticks with his bullish thesis. He downgraded United and Spirit Airlines (SAVE) to Neutral from Overweight, taking his price targets to $95 from $98 and $59 from $51, respectively. Baker cut Southwest Airlines (LUV) to Underweight from Neutral, shaving $11 off his price target to $52. (Cost challenges for Southwest are good news for the rest of the industry, given the company’s focus on low fares.) The analyst also upgraded JetBlue (JBLU) to Overweight from Neutral, with a $20 price target. He has Outperform ratings on American Airlines (AAL) and Delta Air Lines (DAL).
Macquarie’s Susan Donofrio also came out with a review of airlines’ third-quarter earnings season on Tuesday. She writes that the results were largely unsurprising given earnings preannouncements, but that stocks moved sharply in response to companies’ guidance and other commentary on the outlook.
“Generally speaking, we believe we are seeing the continuation of a strong demand and revenue environment into the end of the year, lending itself to fare increases and ancillary opportunities,” she writes. “However, higher and ever-rising fuel costs leave little margin for error as it relates to achieving pretax margin expansion in 2019. This explains adverse reactions to company-specific issues like Southwest’s elevated cost outlook for 2019.”
Looking forward, she says, revenue trends are likely to be solid, and airline management should maintain their discipline in reining in capacity. Carriers’ upcoming analyst days “should be enough to shed a spotlight on the group overall, settle down skittish investors, and push airline stocks higher in the upcoming months,” Donofrio writes.
Thus, she too maintained a bullish stance on the industry, citing the potential for expanding margins, capacity discipline, new fee structures, and ongoing demand for air travel. Southwest, a stock she thinks has been oversold, remains her top pick. In order of preference, her other Outperform-rated stocks are Hawaiian Holdings (HA), Delta, American, United, and Spirit.
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