Price slump for U.S. Airline stocks offers opportunity

Profitability remains strong, and fear-driven price drop may have been overblown, Morningstar analysts say.

Vikram Barhat 17 October, 2018 | 5:00PM

Like every year, U.S. airlines have had their share of turbulence in 2018. There have been allegations of price collusion, lawsuits alleging anti-Semitism, wrongful death litigation, a fatal mid-air engine explosion and other instances of reputational losses and public relations disasters. Further, operations and revenue have been frequently walloped by weather events. American Airlines, for instance, lost US$55 million in revenue due to flight cancellations forced by Hurricane Florence last month. Nationwide, more than 1,500 flights were cancelled as the hurricane wreaked havoc in its path.

Yet, airlines are faring stronger than ever. The industry is projected to make US$33.8 billion in net profit this year, according to the International Air Transport Association (IATA). The bulk of the global profit (44%) will come from North American carriers, which are expected to post a net profit of US$15 billion for 2018.

Industry consolidation has played its part by driving roughly 80% of U.S. domestic market share into the hands of four major carriers, partially alleviating the excess supply issue that historically plagued the airline industry and improving margins, says Morningstar equity analyst Danny Goode.

There remains, however, a disconnect between the industry outlook and the prices of airline stocks. Year-to-date, the major U.S. network airlines are down between 7% and 30% versus a gain of nearly 10% for the S&P 500, as of Oct. 9. The S&P 500 Airlines Industry index slipped more than 7%, for the same period.

The lag represents an attractive entry point for investors looking to buy airline stocks as the industry benefits from rising passenger air travel (forecast to expand by 7% in 2018) and a further boost from stronger economic growth.

Delta Air Lines Inc.
Ticker: DAL
Current yield: 2.43%
Forward P/E: 7.7
Price: US$52.09
Fair value: US$63
Value: 17.3% discount
Data as of Oct. 15, 2018

One of the world's largest airlines,  Delta (DAL) flies to more than 325 destinations in 60 countries. The carrier generated more than US$41 billion in revenue in 2017.

With 40% of Delta's network passing through Atlanta, the airline commands greater share of domestic regional traffic than peers. "By dominating the hub airport in Atlanta, the busiest airport in the world, Delta garners unmatched benefits from connecting this hub to other parts of the country," says a Morningstar report, noting that "Delta extracts a revenue premium per available seat mile from its unique network but also has lower unit costs when compared with other network carriers."

The airline is boosting its capacity by replacing its smaller planes with larger aircraft, known as fleet upgauging. "Delta plans to convert a substantial portion of its small regional jets (50-seaters) and medium-sized aircraft (MD-88s) to larger planes," says Goode, who recently raised the stock's fair value from US$60 to US$63.

In 2017, upgauging accounted for nearly 60% of Delta's domestic capacity growth. "The benefits of rolling markets up into bigger planes will manifest into higher margins and prove durable through our midcycle period due to Delta's unique network structure and dominance at Atlanta," says Goode.

Over the past 10 years, Delta has cleaned up its balance sheet, saw its credit rating improve to investment-grade and generated returns above its cost of capital. Delta's frequent flyer program has enhanced value further. "The carrier has benefited from its lucrative loyalty program, Delta SkyMiles, logging estimated profit margins of 60% and growth over 12% annually after changing its point accrual system from distance-based to revenue-based," says Goode, adding that the "program will continue delivering strong profit margins."

American Airlines Group Inc.
Ticker: AAL
Current yield: 1.29%
Forward P/E: 5.0
Price: US$31.88
Fair value: US$44
Value: 27.5% discount
Data as of Oct. 15, 2018

U.S. legacy carrier  American Airlines (AAL) operates nearly 7,000 flights daily to more than 350 destinations in 50 countries. The company produced over US$40 billion in revenue in 2017.

"We expect margin improvement from American on the back of successful cost and revenue initiatives in tandem with its highly profitable frequent flyer program," says a Morningstar report, adding that "American expects over US$4 billion in revenue and cost improvements through 2021."

The airline has drawn 30% to 50% profit margin from its frequent flyer program, more than any other airline in the U.S. "American's network optimization and growth initiatives are crucial to the success of its loyalty program, which makes a significant operating income contribution," says Goode, who appraises the stock to be worth US$44, implying more than 3% revenue growth from 2018 through 2022.

Improved core airline operations and lucrative loyalty programs will allow American to log profits for many years to come, he adds.

The success of the program is crucial to the airline's push for cleaning up its balance sheet, which also includes measures such as trimming capital spending in order to "buttress cash flows in the high oil price environment," says Goode.

American now expects non-aircraft capital expenditures of US$470 million (down from US$500 million) and gross aircraft capital expenditures of US$551 million (from US$566 million).

The airline recently raised revenue projections for its loyalty program and contracted services to US$740 million from US$690 million. Under the carrier's revised guidance, higher total revenue per available seat mile (TRASM) has been raised to 2.5%, from 2%, supported by higher domestic yields in the previous quarter.

Southwest Airlines Co.
Ticker: LUV
Current yield: 0.99%
Forward P/E: 11.7
Price: US$57.84
Fair value: US$62
Value: 6.7% discount
Data as of Oct. 15, 2018

The largest domestic carrier in the United States by the number of passengers,  Southwest Airlines (LUV) operates around 700 aircraft in an all-Boeing fleet. The firm, which generated over US$21 billion in revenue in 2017, specializes in short-haul flights, but is expanding into longer routes.

Southwest currently commands the largest percentage of U.S. domestic market travel of any major carrier. The airline has consistently generated profit for more than 40 years owing to exceptional execution of its low-cost carrier strategy, short-haul routes and distinct company culture, says a Morningstar report. "Unlike most major carriers that rely on third-party distributors for ticket sales, Southwest has succeeded using its own distribution channel, which accounts for roughly 85% of bookings," the report says.

Historically, Southwest has operated short- to medium-haul routes that fit its point-to-point low-cost strategy, but as opportunities become increasingly scant, the airline has begun adding international and long-haul domestic routes that tap into more price-inelastic travellers who prefer flying with legacy carriers.

"We anticipate top-line growth will peak in 2019 thanks to the California reinforcement and an emergence of routes between California and Hawaii beginning either at the end of 2018 or in early 2019," says Goode, who recently upped the stock's fair value from US$58 to US$62, implying 3% revenue growth from 2018 to 2022.

He cautions, however, that long-haul routes may weigh on profit margins and that pursuing travellers higher up the cost curve will drive unit cost and unit revenue higher as Southwest adds amenities to lure travellers from industry heavyweights.

On the short-haul side, though, the carrier still holds considerable presence in many mid-size markets, with over 50% market share in a host of mid-size cities, and controls 24% of the U.S. domestic market. The success of Southwest's rapid rewards program has generated 65% of its ancillary revenue, which Goode forecasts will "improve through midcycle as the airline increases its focus on business travellers and long-haul routes."

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
American Airlines Group Inc26.28 USD1.88
Delta Air Lines Inc58.57 USD0.91
Southwest Airlines Co50.68 USD1.79

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Vikram Barhat

Vikram Barhat  Vikram Barhat is a freelance writer.