Is the bull case for airline stocks running out of gas?
Global players
Deutsche Bank cut its ratings on the trio last week and warned their shares are likely to be range-bound for at least the rest of 2015.
"The combination of a strong US dollar, greater-than-expected capacity increases by non-US airlines and decelerating global GDP growth are likely to further pressure" international sales, the firm argues.
One thing Deutsche Bank doesn't seem concerned about is the risk from rising oil prices. The drop in crude oil and corresponding fall in jet fuel has certainly been a benefit -- Deutsche figures every $1 per barrel change in jet fuel prices moves pre-tax industry profits by $400 million – but the analysts argue the industry has "has demonstrated its ability to offset most, if not all, of the rise in fuel expense." Most notably, in 2011 the industry offset a 40% jump in fuel expenses in the face of pitiful U.S. economic growth and demand shocks from the Japanese tsunami and Arab Spring.
Another element at play is the concern that the demand side of the oil price equation is lacking. Lackluster economic growth, particularly from a slowing Chinese economy, is a factor in pricing alongside the U.S. supply boom and one that is not favorable for the airlines.
Since mid-2014, the correlation between the major airline stocks and the U.S. crude oil benchmark has weakened. Even more significantly, the energy sector and the airline group have decoupled after formerly tracking each other relatively closely, as shown in the table below, via financial data startup Kensho.
While 2015's continued decline in oil prices may not be doing much for the big airlines' share prices, it's undoubtedly continuing to help their businesses. When a major cost for your operation is at considerably lower prices it should improve margins with all else equal.
Find out what’s happened to the oil industry--and where it’s headed next.
Deutsche estimates that 140% of the $7.3 billion improvement in operating profits for the industry is attributable to lower fuel prices. Those figures seem to illustrate the significant benefits from cheaper oil prices, but shareholders don't seem too inclined to give the carriers much more credit for those benefits or the possibility that savings will be passed on to investors, a view that hasn't gained traction, according to Deutsche Bank's calls to investors, "especially those looking at the group for the first time."
If it sees limited upside for the Big Three, the firm also sees something of a cap to the downside. Share repurchase authorizations should allow American, United and Delta to be opportunistic buyers of their own shares if their stocks languish but earnings come through as anticipated.
"It has become apparent from our client meetings over the past several months that potential new investors are less enamored with the Big Three carriers today than six months ago," Deutsche says, citing concerns about the group's significant outperformance over the last three years that outweigh attractive valuations.
The analysts are more upbeat on U.S.-centric airlines, including Southwest Airlines and
The market certainly seems to agree. Southwest and JetBlue easily outperformed the Big Three in the first quarter of 2015, the latter by a healthy margin.
Hodges Capital's Craig Hodges agrees in some respects. His firm's handful of funds have owned a number of airline stocks in recent years and remain holders, arguing that "demand is good, not great, and base fares are firming."
At present, Hodges favors American, United Continental and
Janus Capital's Marc Pinto, who manages the Janus 20 fund and co-manages the Janus Balanced Fund, thinks some investors may have used the airlines as a way to bet on falling oil prices, a trade that seems to have run its course.
His bet in the space, United Continental, is more a bet on the continued efficiencies being wrung out by the mergers that whittled the industry's six biggest players (Delta, Northwest, United, Continental, American and US Airways) to three.
"I think the industry's priority is getting their balance sheets in order," he says, and with United continuing to mine the benefits of its integration with Continental he thinks further progress lies ahead.
"You're finally seeing capacity matching demand," Pinto says, comparing the airlines today to railroad operators more than a decade ago, when consolidation helped a fragmented industry finally out-earn its cost of capital. Hodges expresses a similar sentiment, noting that fleet sizes seem to be declining industry-wide, a signal that the carriers aren't battling each other by adding capacity on unprofitable or less profitable routes.
As stable demand and pricing power help generate free cash flow, balance sheets improve and ultimately shareholders get rewarded in the form of dividends and share repurchases.
Pinto isn't quite sure the airlines should be pushing all their bounty out to investors just yet, but a path toward capital return is one attractive component of the industry.
Deutsche Bank certainly agrees in the long-term, pointing to improving free cash flow, shareholder-friendly management teams – the firm highlights the recent return of American Airlines to the S&P 500 as an endorsement – and record profits as evidence for a bull case in the years ahead, if no the short-term.