Can Copa, Avianca And Latam Pick Up The Airline Rally In 2017?

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After a weak start, U.S.-based airlines rebounded through the second half of 2016. But the fourth quarter reporting season finds the industry under rising scrutiny, as analysts grow increasingly concerned about valuation and margin pressure amid rising labor and fuel costs.

"Investors continue to focus on unit revenue, but costs are outpacing any improvement in revenue," said Helane Becker, a Cowen analyst in a report. "It's critical for the companies to discuss their plans to expand margins, with a clear timeline on when margins improve."

Southwest Airlines ( LUV ) on Thursday reported a 17% earnings decline in Q4, its first slip in 17 quarters. The number topped analyst targets. The company noted pressure from rising fuel and labor costs, but shares still surged more than 8% in heavy trade.

JetBlue ( JBLU ) reversed its early gains and dropped 2% on Thursday. Its earnings declined 11% - the first drop in 11 quarters - yet still also topped views. But the key metric of passenger revenue per available seat mile slipped nearly 2% for the quarter vs. a 6.5% increase in operating expenses.

But while the U.S. economic cycle is getting long in the tooth, Latin America was a bright spot for U.S. airlines, especially American Airlines Group ( AAL ), which has the most exposure there.

Latin American airlines flashed signs of recovery in 2016, boosted in part by stronger currencies.

Fundamentals for regional players, such as Panama-based Copa Holding s ( CPA ), have improved as the industry aggressively reduced capacity. Copa turned in its first earnings and revenue gain in nine quarters in Q3. Analysts expect a 40% earnings increase when it reports Q4 results after the close on Feb. 15.

Delta Air Lines ( DAL ), American, United Continental Holdings (UAL) and JetBlue have forecast improving unit revenue, another key industry metric related to airlines' available seats and how far they fly. The U.S. industry could turn positive in 2017, analysts say.

But Latin America's airline industry posted positive unit revenue last year, says a Cowen & Co. report.

There, analysts are eyeing capacity discipline among carriers amid hopes a wider recovery will take hold. Analysts are also paying close attention to Avianca Holdings (AVH), the region's second-biggest carrier behind Chile-based Latam Airlines (LFL).

Analyst expect a 119% earnings gain from Avianca in its fourth quarter, while revenue declines are forecast to slow to less than 1%. The company has not yet announced a fourth quarter reporting date.

Colombia-based Avianca is reported to be mulling selling a stake to Delta or United. Another possible scenario - a merger with Panama's Copa - could shake up the industry, analysts say.

As it stands, the outlook for Latin America's airlines has improved, says Felipe Vinagre, analyst at Credit Suisse.

"If you combine improving currencies, fleet restructuring and cost cutting, a rational stance on capacity, and a better demand environment then I think better times will be possible," Vinagre said in an interview.

IBD'S TAKE:American Airlines, United Continental and Delta Air all traded just below buy points on Thursday.

He says Brazil is key to the industry's recovery and a turnaround in demand, as business travel picks up and its consumers have more income to take vacations.

A crippling recession hit Brazil in 2015, but Brazil's currency, the real, bounced back in 2016. The country unexpectedly slashed its benchmark interest rate in January, aiming to jump-start its moribund economy. While inflation has slowed, high debt levels and weak consumer confidence persist.

Those conditions coerced three out of the four major domestic airlines in Brazil to reduced capacity last year. Avianca Brazil was the exception, says Vinagre. Brothers German and Jose Efromovich, who control Colombia's Avianca, also own Avianca Brazil, a separate airline.

Avianca Eyes The Big Leagues

Some analysts say Brazil's airline industry needs more consolidation to boost industry profits. Delta has a 10% stake in Gol Linhas Aereas (GOL) while United has a 5% stake in privately held Azul. Brazil currently limits foreign ownership to a 20% company stake.

If either Delta or United can grab a stake in Colombia's Avianca, it could lead to a partnership with Avianca Brazil, giving them a bigger footprint to compete vs. American in the region, says Vinagre. But he says the "best solution" would be for Gol to buy Avianca Brazil.

U.S. regulators in November approved Delta's plans to raise its stake in Grupo Aeromexico, Mexico's largest airline, to as much as 49% as part of an expanded partnership.

A merger between Copa Holdings and Colombia's Avianca, on the other hand, would move the Panama-based carrier into the big leagues, analysts say. The combined company would dominate the two main hubs in the region, Tocumen, Panama and Bogota, Colombia.

Avianca and Copa serve 33 common destinations out of the two hubs, and the destination overlap makes a merger attractive, says Savanthi Syth, an analyst at Raymond James, said in an interview.

IBD'S TAKE:Airlines have eased to a No. 21 ranking on Thursday among the 197 industry groups tracked by IBD .

"There's a lot of opportunity for Copa in the merger," added Syth. "But, it would be a sizable acquisition and not without risk."

Copa managed to weather the region's economic downturn with good margins and a strong balance sheet, Syth says. It also benefited from Panama being a U.S. dollar based economy. As a result, Copa had fewer headwinds than other regional carriers, whose revenue is in local currencies while expenses, such as fuel, are U.S. dollar-based.

Copa simplified its fleet to lower costs, flying mostly Boeing 737s, rather than a mix of aircraft like other carriers, Syth added. Avianca, though, flies Airbuses.

Maintaining Capacity Discipline

In December, Copa renamed its Colombian subsidiary Wingo and launched its as a low-cost carrier focused on point-to-point destinations. With Mexico-based, budget-carrier Volaris expanding operations to Costa Rica and other parts of Central America and Viva Air debuting in Peru, analysts say Copa is exploring the low-cost business model as a long-term strategy.

Despite periodic currency meltdowns, Latin America remains an attractive market, contends Syth. The region's air travel remains under average compared to Asia, Europe and the U.S. That means, as the middle class grows, there is potential for seat demand to climb.

For Latin American airlines, the big issue is whether they can remain disciplined. A jump in industry capacity could snuff out a stock rally amid the region's fragile recovery, analysts say.

"Most airlines are taking a cautious approach," said Syth.

Analysts say Latam Airlines has been reducing capacity. In 2016, Qatar invested over $600 million in Latam for a 10% stake, easing its liquidity concerns. Since then, Latam has been relocating capacity to international markets, establishing routes to Spain and Italy, says Vinagre.

While U.S. value airlines have increased short-haul flights to Mexico and the Caribbean, targeting leisure travelers, the big U.S. carriers have shown restraint. American, United and Delta will hike capacity in Latin America in the low single digits in 2017, says a Cowen report, though Southwest will again add capacity at a double-digit clip, albeit in limited destinations.

Wall Street has called for airlines to focus on profit rather than on expanding inefficient capacity and money-losing routes. It wasn't long ago when industry overcapacity led to record low fares. Those fares spurred huge losses, ignited battles with unions over givebacks and sent many airlines into bankruptcy.

Warren Buffett's Berkshire Hathaway (BRKN) in November disclosed new stakes American, Delta, Southwest and United. That's a sharp contrast to 2013, when Buffett called airline stocks a "death trap."

Consolidation has left the top four carriers with 86% of industry revenue, says Barclays, which initiated coverage of the sector in December. "Margins have more than doubled" and relative debt levels are down among the largest airlines, said Barclays analyst Brandon Oglenski in a report.

Citigroup analyst Kevin Crissey initiated coverage of airline stocks in November. The last successful new entrant, he noted, was Virgin America in 2007.

"The U.S. airline industry has been hosting a renaissance party for investors," Crissey said in a report. "All of the stocks have tripled or better in the past five years. Although we are staying at the party from a ratings perspective, we've moved away from the punch bowl."


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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 Nasdaq, Inc.

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

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