Airline Industry Stock Outlook - Dec 2012 - Zacks Analyst Interviews

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Going into 2013, the outlook for the global airline industry is likely to remain clouded by the uncertain economic backdrop, particularly the unsettled European situation. These factors are expected to offset the positive impacts from increased passenger traffic and an improved freight market.

The International Air Transport Association (IATA) - an international trade body of a group of airlines, comprising 84% of the worldwide air traffic - projects overall airline profits of $4.1 billion for 2012 as compared with the earlier forecast of $3.0 billion. The outlook, however, is less than $8.4 billion earned in 2011 and $16 billion earned in 2010. Net profit margin is expected to be 0.6%, up slightly from the previously estimated 0.5%.

The 2013 profit expectation is much higher at nearly $7.5 billion, buoyed by the introduction of an improved fleet along with a more efficient operating base and various alliances. Profit margin for the year will be around 1.1%.

Regional Forecast

North America: North American airlines show strong growth prospects for the coming months courtesy of tight capacity, rising travel demand and a number of new and enhanced ancillary revenues. The carriers are performing impressively in terms of customer service including on-time arrivals, baggage handling, fewer customer complaints, lower cancellations and overbooked flights. As a result, they are expected to generate $1.9 billion in profits in 2012, up $400 million from the previous expectation.

Asia-Pacific: These carriers are expected to record a profit of $2.3 billion in 2012, much more than the previous forecast of $2.0 billion. IATA expects to see better cargo performance and an improvement in Chinese economic conditions. Notably, this is the highest profit-producing region in the industry outside of the home market.

Middle East & Latin America: Per IATA, profits from the Middle East carriers are expected to grow to $700 million, up from the prior expectation of $400 million. Profit projection for the Latin American carriers was reiterated at $400 million.

Africa: African air carriers are expected to break-even in 2012, better than the prior loss forecast of $100 million.

Europe: As for the European airlines, the IATA expects this year's loss to widen to $1.2 billion (previous forecast was loss of $1.1 billion) given intensifying Eurozone woes, continued weakness in cargo and passenger businesses, higher taxes and unfavorable regulatory conditions.

Underlying Factors for 2013 Profits

In the base-case scenario, there are several factors that will drive overall airline profits in 2013:

Passenger & Cargo: While the economic slowdown in several European countries and in the U.S. will keep travel growth at check, markets in Asia, Latin America and the Middle East would continue to boost growth in 2013. IATA projects global airline passenger growth of 4.5%, while cargo business will see an expansion of 2.4%.

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 3.8% while air travel demand is expected to see a 3.9% pickup.

Fuel Price Rise: Airline profit outlook depends on fuel prices, the major variable component in the industry.

Lower fuel price no doubt cuts the airlines' operating expenses, but it also indicates a slowing economy and the consequent fall in global air travel demand. With pricing decrease or increase (as it did by 15% in the third quarter of 2012), the profitability level of the carriers will fluctuate.

The Association projects fuel to account for 32% of the overall operating costs in 2013, which is at a similar level with the oil price spike in 2008.

High crude oil prices, largely a function of geopolitical forces, are beyond the control of the airlines. However, IATA expects crude oil price to hover around $105 per barrel in 2013 using Brent crude oil as a basis. We expect crude oil and jet fuel prices to go up further because of the economic-political tensions in many parts across the globe, but forecasting this key variable with any level of accuracy has always been extremely challenging.

Getting Rid of Unprofitable Jets: Most of the air carriers at large 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 discipline.

Over the last two years, Delta Air Lines Inc. ( DAL ), United Continental Holdings Inc. ( UAL ), US Airways Group Inc. ( LCC ) and American Airlines - a subsidiary of AMR Corp. - slashed their capacity by about 16.6%, 16.3%, 14.3% and 8.4%, respectively as per the Centre for Aviation (CAPA).

Recently, Delta Air Lines entered into an agreement with Canadian firm Bombardier Aerospace to purchase 40 new CRJ900 two-class regional jets. These and superior two-class 76-seat aircraft will replace Delta's old and depleted 60 single-class 50-seat domestic airplanes.

The other international airlines that reduced their capacities over the past two years are Air Canada, Air France, Qantas Airways, Korean Airlines and All Nippon Airways.

Rightsizing: Passengers are demanding comfortable and quality services with proper security. Hence, airlines are focusing on fleet rightsizing by bringing in new and advanced aircrafts that gel in a fuel-expensive environment.

Though initially expensive, the new aircrafts are more fuel efficient than the existing ones and have helped in lowering operating and maintenance costs. Over the next 2 decades (2011-2030), global airlines are expected to invest $3.5 trillion to buy 27,800 new airplanes, having seating capacity of more than 100. New airlines business, advanced technology and dynamic growth of air travel in emerging markets throughout the world are boosting the demand for these airplanes.

About one-thirds of the global demand is expected to come from Asia, which currently account 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, is expected to deliver the largest number of aircraft to the airline companies, followed by The Boeing Co. ( BA ). The progress thus attained would help the companies regain their lost profits.

Hedging Strategies: Hedging strategies are used by airline companies to cope with the rising fuel prices. The carriers use a combination of calls, swaps and collars at varying WTI crude-equivalent price levels to hedge.

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 the increase in fuel costs and ongoing economic turmoil in the U.S. and Europe.

Although U.S. airlines experienced sluggish growth over the last few months, the demand for air travel will nearly double over the next 20 years, as predicted by the U.S. Federal Aviation Administration (FAA). Passenger enplanements is expected to grow 2.0% to 746 million in 2013 and about 3% in the future 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 -- implying 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 grow at a more modest clip of 2.7% annually through 2032. This projection assumes a steady economic recovery with no major headwinds 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 airline growth 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 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.

OPPORTUNITIES

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 efficiency.

Additional Revenue Gains: A number of supplementary revenue streams helped the airline industry gain ground in 2011 and 2010 after two years of drought. Ancillary revenues shot up 66% over the past 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 $636 billion for 2012 and $660 million for 2013.

Carriers are going wireless with the 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." Singapore Airlines, a top-notch carrier, is expected to incur a spending of more than $350 million for the installation of superior in-flight entertainment and communications system.

Cathay Pacific, Malaysia Airlines, KLM, Delta, Qantas and British Airways have also made Apple Inc.'s ( AAPL ) 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. 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 aircraft.

Dallas, Texas-based Southwest Airlines Co. ( LUV ) 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 are contributing to revenue growth.

Passenger air transportation services provider JetBlue Airways Corp. ( JBLU ) is experiencing solid growth given continued success in the Getaway Vacations Division, as well as the Even More Space product.

Mergers & Acquisitions: 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 the capacity and cost fronts.

Recently, Delta Air Lines confirmed its plans to acquire a 49% stake in British carrier Virgin Atlantic for £224 million or $360 million from Singapore Airlines. With this acquisition, Delta Airlines will gain more control over one of the busiest air routes in the world - New York to London. The deal will also hugely benefit customers with a broader network of flights, enhanced connectivity and convenient booking options.

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 ( ALK ) and Frontier Airlines - a subsidiary of Republic Airways Holdings ( RJET ) and British Airways.

We see American Airlines-US Airways as a good pairing in the industry as it will be in the best interest of the customers. This collaboration would bring the merger airline on the same pedestal with the largest U.S. air carrier - United Continental - in terms of revenue and traffic. As a result, American Airlines should emerge as a successful candidate by balancing its debt level and lowering costs.

Expansion: 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. The company is involved with a $1.4 billion development program directed toward two major New York airports. The company will invest about $1.2 billion to set up a new international terminal at John F. Kennedy International Airport, while incurring a spending of $200 million to improve and expand operations at LaGuardia Airport 's two terminals.

Southwest plans to start new non-stop services between a number of airports from June next year. These include services between Wichita and Chicago (Midway), Dallas Love Field, and Las Vegas; San Juan and Baltimore/Washington; Houston (Hobby) and New York LaGuardia; and Chicago (Midway) and Tulsa. Further, the company is looking to tap opportunities in the international market with its debut in the Caribbean, Central America, Latin America and Mexican markets by 2015.

United Continental is benefiting and enhancing its access from each other's hubs and networks, while JetBlue continues to successfully expand its network in two major growth regions: Boston to New York and the Caribbean.

Technology Upgrades: Air carriers are opting for numerous technology upgrades and system automation for various systems such as airline reservation, flight operations, website maintenance and in-flight entertainment. These upgrades allow the companies to function effectively, minimize expenses and render better customer service.

The major outperformer we expect to be Skywest Inc. ( SKYW ), which has a Zacks #1 Rank (Strong Buy) for the short term (1-3 months). We also recommend US Airways Group that has a Zacks #2 Rank (short-term Buy).

We also like a few Zacks #3 (Hold) Rank stocks such as Spirit Airlines Inc. ( SAVE ), Allegiant Travel Company ( ALGT ), Hawaiian Holdings Inc. ( HA ), Delta, JetBlue, Southwest, United Continental and GOL Linhas ( GOL ).

CHALLENGES

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. Airline carriers' ability to pass along the increased costs of fuel to its flyers is limited by the competitive nature of the industry. Thus, even a small change in fuel prices can significantly affect profitability.

Unionization: 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.

Federal Regulations: 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). In January this year, the DOT laid new pricing rules for air carriers that direct airline companies to include all taxes and fees while advertising fares for their flights. As the passengers are switching to low fares, the new rules might hurt travel demand, thereby leading to lower profits for 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 matters.

Large Investments: The air carriers are investing lot of money to enhance their products and services in order to make them competitive. However, proper returns from these investments are uncertain or the timings are unknown. The carriers have the possibility to lose the money that was invested in the business for the new developments.

We expect All Nippon Airways Co. Ltd. ( ALNPY ) and LATAM Airlines Group S.A. ( LFL ), which have a Zacks #4 (Sell) Rank, to underperform compared to the broader market.

BOEING CO (BA): Free Stock Analysis Report

DELTA AIR LINES (DAL): Free Stock Analysis Report

JETBLUE AIRWAYS (JBLU): Free Stock Analysis Report

US AIRWAYS GRP (LCC): Free Stock Analysis Report

SOUTHWEST AIR (LUV): Free Stock Analysis Report

UNITED CONT HLD (UAL): Free Stock Analysis Report

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: BA , CAPA , DAL , DOT , FAA

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