The global airline industry continues to face challenges from
the deepening of the European debt crisis that is wiping out the
positive impacts of lower fuel prices, increasing air traffic and
improved freight market. The scenario is unlikely to change for the
remainder of the year.
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The International Air Transport Association (IATA) still projects
overall airline profits of $3.0 billion for 2012 with net profit
margin of 0.5% on the back of healthy growth in North and South
America. The profit outlook is less than $7.9 billion earned in
2011 and $16 billion earned in 2010. This steep decline in the
industry's profitability is a function of the overall unfavorable
macro backdrop in which the industry has to operate this year.
North American airlines are seeing improving growth prospects as
the year progresses thanks to tight capacity, rising travel demand
and a number of new and enhanced ancillary revenues. The carriers
are performing at record levels when it comes to customer service
including on-time arrivals, baggage handling, fewer customer
complaints, lower cancellations and lower overbooked flights. As a
result, these carriers are expected to generate $1.4 billion in
profits this year, up from the previous expectation of $900
These carriers are expected to record a profit of $2.0 billion in
2012, down from the previous forecast of $2.3 billion. IATA made
the downward revision on the heels of weak cargo performance and
the slowdowns in Chinese and Indian economic growth. Notably, this
is the highest profit-producing region in the industry outside the
Middle East & Latin America:
Per IATA, profits from the Middle East carriers are expected to
grow to $400 million, down from the previous expectation of $500
million. Profit projection for Latin American carriers increased to
$400 million from $100 million forecasted previously.
African air carriers are expected to incur a loss of $100 million
due to weaker yields after touching the break-even point in 2011.
As for the European airlines, the IATA expects this year's loss to
widen to $1.1 billion given intensifying Eurozone woes, continued
weakness in cargo and passenger businesses and higher taxes. The
forecast is almost double the previous expectation of $600 million.
Underlying Factors for 2012 Profits
In the base-case scenario, there are several factors that will
drive overall airline profits in 2012:
Cargo & Freight
Passenger markets are growing at a slower pace while freight has
also been modestly weak since the beginning of the year. The cargo
market has bottomed out, following a sharp fall in 2011 and we
expect it to remain stable in the second half.
While the economic slowdown in several countries like Europe and
U.S. will keep travel growth trends at check, markets in Asia,
Latin America and the Middle East would continue to boost growth in
the second half of the year. The IATA projects global airline
passenger growth of 4.6% in 2012 versus 4.2% forecasted previously.
Coming to demand-supply balances, demand (measured in traffic) will
outpace capacity (combined passenger and cargo) as the year
advances. Capacity is expected to show an increase of 3.3% while
air travel demand is expected to see a 4.8% pickup.
Fuel Price Rise: Boon or Bane?
The airline profit outlook depends on fuel prices, the major
variable component in the industry.
Crude oil price has dropped about 15% in the recently concluded
second quarter. Lower fuel price no doubt cuts airline operating
expenses, but it also indicates a slowing economy and the
consequent fall in global air travel demand. However, if pricing
remains stable despite the questionable macroeconomic outlook, the
carriers should experience better profitability solely on the back
of falling fuel costs.
Even with the falling fuel prices, the Association projects fuel to
account for 33% of the overall operating costs, which is at similar
levels when oil prices spiked in 2008 but 13-14% higher than a
High crude oil prices, largely a function of geostrategic forces,
are beyond the control of the airlines. However, using Brent crude
oil as the basis, IATA expects crude oil price will hover around
$110 per barrel this year. We expect crude oil and jet fuel prices
to increase further this year because of the political tension in
the Persian Gulf, but forecasting this key variable with any level
of accuracy has always been extremely challenging.
Given the weak macroeconomic data points, we believe the carriers
are ready to accept the burden of rising fuel prices as they are
well positioned to endure the current crisis. Successfully passing
on the increased cost to customers in the form of fare hikes and
efficient use of fuel-hedging strategies are helping them to combat
the rising fuel prices (hedging strategies discussed below).
Getting Rid of Unprofitable Jets
Most of the air carriers are scrapping or cutting flights in many
small airports that are unprofitable in order to reduce their fuel
cost burden. North American carriers lead the way in capacity
Over the last two years,
Delta Air Lines Inc.
United Continental Holdings Inc.
US Airways Group Inc.
) and American Airlines, a subsidiary of
) slashed their capacity by about 16.6%, 16.3%, 14.3% and 8.4%,
respectively as per the Center for Aviation (CAPA).
Other international airlines like Air Canada,
), Qantas Airways, Korean Airlines and All Nippon Airways also
reduced their capacities over the past two years.
Hedging strategies provide a cushion to the rising fuel prices and
are being used extensively. The carriers use a combination of
calls, swaps and collars at varying WTI crude-equivalent price
levels to hedge.
Passengers are demanding high quality services with proper
security. Airlines are using obsolete, old and less-fuel efficient
aircraft, flying which are no longer feasible in a fuel-expensive
environment. Hence, air carriers are also focusing on fleet
Though initially expensive, the new aircraft are more fuel
efficient than the existing ones and have helped in lowering
operating and maintenance costs. Global airlines are expected to
invest $3.5 trillion to buy 27,800 new airplanes, having seating
capacity of more than 100, over the next 2 decades (2011-2030). New
airlines business, advanced technology and dynamic growth of air
travel in emerging markets throughout the world are boosting demand
for these airplanes.
About one-third of the demand is expected to come from Asia, which
currently accounts for 28% of global air passengers. The demand in
Europe and the U.S. is expected to fall to 23% and 20% by 2030,
respectively, from the current 27% that each enjoy.
Airbus, the world's leading aircraft manufacturer, will deliver the
largest number of aircraft to the airline companies, followed by
The Boeing Co.
). The U.S. air carriers have started buying new planes from these
manufacturers in order to provide good customer service. The
progress thus attained would help these companies to regain their
U.S. Airlines: 20-Year Projection
The U.S. airline industry is expected to remain profitable over the
next two decades given the improving worldwide trends in air
travel. However, growth may be held back until 2015 due to
increases in fuel costs and the ongoing economic difficulties in
the U.S. and Europe.
Although U.S. airlines will likely see a small dip this year, the
demand for air travel will double over the next 20 years, as
predicted by the U.S. Federal Aviation Administration (FAA).
Passenger demand is expected to grow 2% to $746 million in 2013 and
about 3% in subsequent years, reaching $1 billion by 2024 and $1.2
billion by 2032.
The FAA projects air traffic, customarily measured in billions of
revenue passenger miles -- a unit of one mile flown by one
passenger -- to grow by more than 90% over the same period. Revenue
passenger miles would jump from 815 billion reported last year to
1.57 trillion by 2032 at an average annual rate of 3.2%.
International traffic is expected to grow 4.2% per year, in
contrast to domestic travel that will growth at a more modest clip
of 2.7% annually through 2032. This projection assumes a steady
economic recovery with no major calamities like a large rise in oil
price, swings in macroeconomic policy or financial meltdowns.
Further, major North American airlines would raise capacity
(available seat miles) at an annual rate of 3.1%, reaching 1.89
trillion by 2032.
The 20-year trajectory is expected to stem from the implementation
of NextGen, the satellite-based navigation system that aims to make
air travel more efficient. The carriers are taking numerous steps
to improve their profitability as described in the above sections.
Moreover, the growing demand for air travel and a relatively lesser
number of planes will make future fare hikes possible over the next
two decades. Airline mergers and consolidation will bring down the
number of flights and reduce the number of cities served.
We believe industry consolidation and various ancillary revenues
will boost profitability and cost performance of most air carriers
going forward. This is an opportune moment for companies to
consolidate in order to regain their lost profits and operational
A number of supplementary revenue streams helped the airline
industry gain ground in 2010 and 2011 after two years of drought.
Ancillary revenues shot up 66% over two years to $22.6 billion in
2011. Air carriers are adding novel features to their services and
expanding new products to improve passenger satisfaction and
experience. The IATA projects total revenue of $631 billion for
2012, down slightly from $633 million projected in March.
Carriers are going wireless with in-flight entertainment systems
such as American Airlines' Gogo "Vision" wireless video-on-demand,
Delta Air Lines' "Delta Connect," Lufthansa's "BoardConnect,"
Emirates' "ice OnDemand" and Southwest's "Live TV." Other carriers
such as Virgin America, Qantas and Virgin Australia will soon
launch their in-flight entertainment systems.
Cathay Pacific, Malaysia Airlines, KLM, Delta, Qantas and British
Airways have also made
) iPad available to passengers in their lounges, rent them out in
the air as well as use them as a self-service kiosk, customer
survey tool and food ordering tool.
Further, major U.S. carriers remain focused on expanding their
product and service offerings on board and on the ground for higher
ancillary revenues. Delta Air Lines and United Continental are
installing winglets, WiFi and flat-bed seats apart from expanding
Economy Comfort or Economy Plus seats to their fleet. United
Continental is also introducing streaming wireless video in its
Southwest Airlines Co.
) is benefiting from EarlyBird check-in, unaccompanied minor travel
and pet fees. The company is renovating in-flight cabins and
redesigning interiors, and has labeled the new appearance as
Evolve: the New Southwest Experience. These fleet modernization
plans and the All-New Rapid Rewards program is contributing to
JetBlue Airways Corp.
) is experiencing solid growth given continued success in the
Getaway Vacations Division, as well as the Even More Space product.
Airline companies consolidate in order to restore lost profits.
This is evident from the past three mega-mergers: Northwest
Airlines and Delta Air Lines in 2008, United Airlines and
Continental Airlines in 2010, and AirTran Holdings and Southwest
Airlines in 2011. All the three companies -- Delta, United and
Southwest -- are the long-term beneficiaries on both capacity and
Again, the airline industry is awaiting another major
consolidation. The rumors about American Airlines merging with
another airline have been heating up since the company filed for
bankruptcy protection in November last year. American Airlines is
evaluating its merger proposal with US Airways, JetBlue,
Alaska Air Group
), Frontier Airlines, a subsidiary of
Republic Airways Holdings
) and Virgin America.
We see American Airlines-US Airways as the hottest pair in the
industry. Three months ago, the three labor unions of American
Airlines supported a merger with US Airways. The combination would
create an airline on par with the largest U.S. air carrier, United
Continental, in terms of revenue and traffic, and bigger than the
current second-largest airline, Delta. As a result, American
Airlines should emerge as a successful candidate by balancing its
debt level and lowering costs.
The consolidation of American Airlines, if successful, would be the
fourth in the last three years. Nevertheless, any potential merger
with AMR will take several months or a year to materialize, as
American Airlines has yet to complete its court restructuring
process and will undergo antitrust scrutiny.
North American carriers are making continuous efforts to increase
their domestic and international flights. Delta Air Lines is
focusing on adding flights in New York, Latin America, Mexico and
Brazil. Delta Air Lines is progressing well on the $1.2 billion
expansion at New York-JFK, scheduled to open in 2013.
Internationally, Delta's deal with a Chinese international airline,
China Eastern, should prove profitable.
Southwest started new services in Atlanta and will introduce
services to new and unexplored domestic markets including New York
LaGuardia, Boston Logan, Milwaukee and Baltimore/Washington as well
as many smaller domestic cities. Further, Southwest is looking to
tap the opportunity in the international market with its debut in
the Caribbean, Central America, Latin America and Mexican markets
United Continental is benefiting and enhancing its access from each
other's hubs and networks. JetBlue continues to successfully expand
its network in two major growth regions: Boston to New York and the
Air carriers are involved in numerous technology upgrades and
system automation for various activities such as airline
reservation system, flight operations system, website maintenance
and in-flight entertainment systems. These upgrades enable
companies to perform better, lower costs and enhance customer
The major outperformer is expected to be Republic Airways, which
has a Zacks #1 (Strong Buy) Rank for the short term (1-3 months).
We also recommend
Spirit Airlines Inc.
Allegiant Travel Company
Hawaiian Holdings Inc.
), U.S. Airways and Air France that have a Zacks #2 (Buy) Rank.
We also like a few Zacks #3 (Hold) Rank stocks such as Alaska Air
Group, AMR Corp., Delta, JetBlue, Southwest, United Continental and
Of the many challenges facing the industry, the most important ones
include volatile fuel prices, economic weakness, natural
calamities, government regulation, unionization, airport
infrastructure constraints and safety concerns.
Oil Price Volatility:
Fuel price volatility continues to be one of the significant
challenges, as the cost of fuel is largely unpredictable. Fuel
prices remain well below the 2008 level of over $140 per barrel
that had ravaged the airlines industry. The company's ability to
pass along the increased costs of fuel to its customers is limited
by the competitive nature of the airline industry. Thus, even a
small change in fuel prices can significantly affect profitability.
The airline business is labor-intensive. Most of the employees are
unionized and depend on various U.S. labor organizations. The
relation between airlines and labor unions are governed by the
Railway Labor Act, which states that a collective bargaining
agreement between an airline and a labor union does not expire.
Instead it becomes amendable as of a stated date. Failure to amend
terms and conditions suitably may lead to work stoppages or
strikes, and thereby hamper operations.
The airline industry is highly regulated, in particular by the
federal government. All companies engaged in air transportation in
the U.S. are subject to the regulations implemented by the
Department of Transportation (DOT). The DOT recently laid new
pricing rules for air carriers, effective January 26, 2012. As per
the new rules, airline companies have to include all taxes and fees
while advertising fares for their flights. As passengers are
switching to low fares, the new rules might weaken travel demand,
thereby leading to lower profits for the industry.
Further, airlines are also regulated by the Federal Aviation
Administration (FAA), a division of the DOT, primarily in areas of
flight operations, maintenance and other safety and technical
The airline industry has a poor record of capacity discipline,
though it has largely been mindful of this issue in this cycle. It
remains to be seen how long the current trends remain in place
before old habits return.
The air carriers are investing a lot of money to enhance their
products and services in order to make them competitive. The proper
returns from these investments are uncertain or the timings are
unknown. The carriers might also lose money invested in the
business for the new developments.
Ryanair Holdings plc
), which has a Zacks #4 (Sell) Rank, to underperform the broader