All's Not Well In The Airline Industry: Here's Why

Despite the multiple first-quarter 2016 earnings beats for airline stocks, the NYSE ARCA Airline index has declined over 12% in the last three months. This clearly hints at some underlying problems plaguing the sector.

Truth Behind the Beats

The first quarter of 2016 has seen airline heavyweights like Delta Air Lines (NYSE:DAL), Inc. (DAL), Southwest Airlines Co. (LUV), American Airlines Group Inc. (AAL) and Alaska Air Group (ALK) report better-than-expected earnings. A detailed analysis of the releases reveal a picture quite contrary to the belief that only low oil price has driven the beats.

Oil prices have been weak for almost two years now. In view of the extended slump, it is quite natural that analysts had taken this into consideration while issuing their earnings per share estimates for the airlines. With cheap oil already factored in, it is clear that the reason behind the bottom-line outperformance lies elsewhere.

In fact, analysts had slashed their first-quarter estimates in the wake of multiple headwinds plaguing the industry. The downward revisions resulted in a highly conservative Zacks Consensus Estimate which made it easier for companies to record a beat. To illustrate our point, let’s take a look at Chicago-based United Continental Holdings, Inc. (UAL). The Zacks Consensus Estimate for first-quarter 2016 earnings for this carrier was $1.17, down 54.8% from the comparable figure in the fourth quarter of 2015.

Brexit

On Jun 24, Britons voted in favor of exiting the European Union. As had been widely expected, the Brexit decision has created ripples throughout the world, rattling the global financial market. Airline stocks too have been hit hard with fears of travel demand slackening. In fact, the Brexit decision has worsened matters for U.S. airlines with exposure to Britain. According to the International Air Transport Association (IATA), with Brexit materializing, U.K.’s air passenger market is expected to shrink in the band of 3% to 5% by 2020.

Rise in Terror Attacks

The mass shooting at a nightclub in Orlando, described as the worst in the history of the U.S., and an explosion at the Shanghai Pudong airport on Jun 12 have hit airline stocks hard. However, these are not the only instances of terror attacks in recent times. The disappearance of the EgyptAir jet in May is also feared to a victim of terrorism. Such acts of terror impact airline stocks as there is a possibility of waning travel demand due to security fears. For instance, the Brussels attacks in March impacted Delta Air Lines’ revenues substantially in the first quarter of 2016.

On May 31, the U.S. State Department issued a global travel alert to U.S. citizens citing the possibility of more terrorist attacks. Meanwhile, European carrier Ryanair Holdings (RYAAY) recently stated that it expects a widespread cut in airfares as terror attacks usually have a direct impact on travel demand. Moreover, travel company Thomas Cook revealed that summer bookings had declined 5% in May from a year ago. Such fears were also reflected by the IATA projection which expects passenger travel growth (6.2%) in 2016 to be less than that recorded in 2015 (7.4%).

Unit Revenues

In the past few quarters, key revenue metric PRASM (a measure of sales relative to capacity for a carrier) impacted revenues for most of the carriers. Lower fuel surcharges on international flights due to reduced oil prices have been one of the main reasons behind the persistent decline in PRASM. Consequently, plunging oil prices have become a double-edged sword for airlines.

That PRASM will continue to hurt stocks can be made out from the second-quarter projections. United Continental expects consolidated PRASM to decline in the band of 6.5% to 8.5% for the second quarter while American Airlines forecasts a 6% to 8% drop in the metric. Low-cost carrier JetBlue Airways (JBLU) now predicts a 7.5% to 8.5% decline in preliminary revenue per available seat mile (RASM) for the second quarter of 2016 as compared to a 7% decline projected earlier. The company has also lowered its capacity guidance for the year. Projected ASM growth has been slashed to a range of 8%–9.5% from 8.5%–10.5% expected earlier.

Woes related to capacity and pricing have been haunting investors in the airline space for quite some time. Investors fear that capacity expansion may lead to oversupply in the market even as fuel costs remain weak. Capacity woes are likely to continue to hurt carriers in 2016, as has been predicted by the IATA, which expects capacity growth (6.8%) to outpace traffic expansion (6.2%).

Repatriation Issues

With economies like Venezuela and Nigeria are in the doldrums, the airlines operating in the belageaured nations (with dwindling foreign exchange reserves) are facing tough times with regard to repatriation. In the wake of such issues, United Continental Holdings announced its decision to terminate flights connecting Houston and Lagos from Jul 1, thereby exiting Africa completely. According to a Bloomberg report, the Nigerian economy owed approximately $575 million (in airfares) to the airlines, as of Mar 31, 2016. The report also revealed FX reserves declining to as low as $26.5 billion leading to dollar repatriation being limited.

The story is no different in Venezuela as carriers like LATAM Airlines Group and Lufthansa (DLAKY) recently decided to suspend operations in the recession hit nation.

Shareholders’ Revolt

Problems on the labor front are not unique to airlines. Earlier in the year, United Continental faced opposition from some of its shareholders. Hedge funds PAR Capital Management, Inc. and Altimeter Capital Management, L.P, who collectively have a 7.1% stake in the company, were apparently dissatisfied with the company’s performance and expressed their lack of faith in the current leadership. The issue has been settled for now with United Continental giving in to the demands. However, occurrence of such events dampens investor confidence in the stock to a large extent.

Other Challenges

Apart from the issues cited above, outbreaks of diseases like the Zika virus, technical glitches and disputes similar to the ongoing one between legacy U.S. carriers and their Gulf counterparts are a major threat to stocks in the aviation sector. Moreover, continuous probes like the one by the Department of Justice into American Airlines, Delta Air Lines, United Continental Holdings and Southwest Airlines on the possibility of unlawful co-ordination to limit the availability of seats with the objective of keeping airfares high also serves as a major challenge for carriers.

Check out our latest Airline Industry Outlook for more news on the current state of affairs in this market from an earnings perspective, and how the trend looks ahead for this important sector at the moment.