Warren Buffett for years dismissed airlines as an investment, describing the industry as a “bottomless pit.” But as a top three shareholder in American Airlines (AAL) and Southwest Airlines (LUV), the Sage of Omaha is among the beneficiaries as the sector stages a rebound after a trying 2018.
A string of forecast-beating earnings from America’s leading carriers last month, alongside some optimistic commentary from executives, has driven the NYSE Arca Airline index (.XAL) up about 16 per cent this year, almost double the rise of the S&P 500 (.SPX).
Although the oil price has rebounded this year, it is just over 25 per cent lower than it was in October and remains a tailwind for the airlines. But how long that will last is just one of the questions facing investors in a sector that is famously cyclical. A slowing domestic economy, rising labour costs and the threat of another government shutdown are all high on the list of risks.
“In general, investors are very reluctant to pay full multiples they believe are coming only because oil prices are low, because they aren’t confident the airlines are able to retain those fuel savings,” says Joseph DeNardi, aviation analyst at Stifel.
One reason low oil prices may prove fleeting, is that the industry is preparing for new emissions standards for the shipping industry requiring the use of cleaner fuel. Regulatory changes from the International Marine Organisation could add more than $5 to a barrel of Brent crude when they come into effect next year, translating to a 20 per cent rise in the price of jet fuel, Morgan Stanley estimates.
Adding to potential jet fuel headwinds are rising labour costs. The three “legacy” carriers — American Airlines, Delta Air Lines (DAL) and United Continental (UAL) — have labour agreements that are up for negotiation over the coming year “that will place incremental pressure on unit costs in 2019 and beyond”, says Rajeev Lalwani, an aviation analyst at Morgan Stanley.
United’s negotiation period for pilot salaries began at the end of last month. The company’s chief financial officer said an expected 4 per cent increase in labour expenses had already been factored into its profit guidance.
Overall, cost per available seat kilometre, excluding fuel, is forecast to rise an average 6 per cent industry-wide in 2019, up about one tenth of a percentage point from last year’s increase, according to FactSet data.
There is still lingering uncertainty about the impact of the partial federal government shutdown, which temporarily ended on January 25 after President Donald Trump agreed a deal for interim funding. While some airlines have put a price on the episode — with Delta estimating costs of $25m a month, and Southwest saying it had lost an estimated $10m to $15m — the potential for more far-reaching disruption was on display late last month. Flights at three major US airports were hit by delays of more than an hour due to air traffic controller staffing shortages.
The credit rating agency Moody’s pointed to the impact from such events when it recently warned that unit revenues — typically measured by the closely watched industry metric passenger revenue per available seat mile, or RASM — could come under pressure. It flagged risks if the US economy “experiences weaker-than-expected growth, trade tensions worsen, the partial US government shutdown persists beyond February and/or airlines fail to scale back capacity additions if bookings decline”.
Signs of strain in unit revenue figures have already emerged. United, for example, expects passenger RASM to be flat to 3 per cent higher this quarter from a year ago, compared with a 5 per cent pace in the final three months of 2018.
That could be typical of US carriers as a whole this year, reckons Mr Lalwani of Morgan Stanley. Even with capacity growth expected to be moderate this year, he forecasts unit revenue growth for airlines to be flattish to 0.5 per cent in 2019 from a four-year high of almost 3 per cent last year.
Still, most airlines have shrugged off such concerns and used their quarterly earnings to talk up their prospects for 2019. “Despite all the stock market volatility and pandering, despite the government shutdown, our business bookings, as measured by all large corporate accounts and travel agencies, were up,” Scott Kirby, United president, told analysts.
The other “big four” carriers have also described a robust start to the year. Delta management told Wall Street analysts that corporate demand had been strong, up 7 per cent from a year ago, and they were optimistic about the March quarter. American said it had not seen any slowdown in bookings so far this year, and Southwest painted demand as “healthy”.
All told, earnings are forecast to increase more than 20 per cent in 2019, about triple the pace of last year, according to estimates from Factset. Almost all analysts have ratings of “neutral” or higher on the majority of US carriers, but even that may not be enough to convince market watchers and bottom-fishing investors over the medium term.
“Airlines are going to be pretty volatile: there’s a reluctance to own these stocks at the end of the cycle,” Stifel’s Mr DeNardi says. “They have to prove to the market they can be more durable in an economic cycle than they have been in the past.”
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