The 2-Minute Thought: Airlines

Airline stocks are underperforming this year.  The big three U.S. carriers -- Delta, United, and American – are up a market cap-weighted average of 1.4%, while the S&P 500 is up 5.3%.  And that is after including Wednesday’s big 8.8% jump in United after it raised its profit forecast.  

United now stands out as the one airline to have raised profit projections.  It just guided full-year adjusted earnings about 25 cents higher, to $7.25 to $8.25, while both Delta and American have cut theirs. 

Nevertheless, most airlines have had a tremendous run if you look at the last five years.  The stock of the best of the big three, Delta, has more than quadrupled since the beginning of 2013 -- even though it’s down 6% so far this year.   And all the airlines have transformed their businesses the last half decade. 

Airlines were such awful businesses for such a long time, they’re still viewed with suspicion.  But they’ve done a lot.  They cut costs, got disciplined about adding capacity, and boosted revenue by segmenting business and leisure travelers, creating ever more cabin classes, and charging for everything from snacks to early boarding.  Of course they also made flying a much less pleasant and dignified experience for most people -- but that’s another story.

The travel market today remains healthy.  The economy is strong and so is demand.  But the problems are rising fuel and labor costs, along with limited pricing power.  Jet fuel is up nearly 50% the last year, while wages are up a good 20% on some airlines.  That’s significant.  Fuel can account for 20% to 30% of total operating costs, and so can labor.  Airlines still are able to push through fare increases, but not by enough to cover the jump in expenses.  In this competitive environment, as capacity gets added, airlines lose pricing power.

It’s worse for smaller low-cost airlines than for the full-service ones.  U.S. capacity overall is expected to rise 5.5% this year, but the likes of Spirit, Frontier, Alaska, and Jetblue are adding more.  Alaska and Jetblue plan to raise capacity by 7.5%, Allegiant by 11% to 15%, and Spirit and Frontier by almost 20%.

Many smaller airline stocks may look attractive at first: Year-to-date, the stock of Alaska Air is down 15%, Jetblue is down 11%, and Spirit is down 9%.  But we’d say, hold on.  Fuel and labor costs will be major headwinds at least for the remainder of the year.  And you really need to worry about the way low-cost carriers are expanding routes and service in a bid to gain share.  That’s going to limit each airline’s ability to raise ticket prices.

In the face of higher costs, the plan for many airlines is to go for higher seat density and even more customer and cabin segmentation.  But how much farther can they take this, given how far they’ve already come?  They probably still have some room to run.  But at some point, seats can only get so small.  And as far as the class warfare that so much cabin segmentation is engendering – there may be a limit to that too.