(UAL) Airline Stock Outlook – January 2012 – Industry Outlook

The airline industry was hit hard in 2011, by the unrelenting market turmoil and rising fuel costs after a strong rebound in 2010. Major carriers experienced declining year-over-year earnings and revenues. Unfortunately, we foresee a similar scenario in 2012.

Conditions could worsen in 2012, stemming from the weak outlook for Europe given its financial problems. According to the International Air Transport Association (IATA), airlines are expected to generate overall profits of $3.5 billion in 2012, down from the estimated $6.9 billion in 2011 and $16 billion 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.

Regional Forecast

North America: North American airlines like United Continental Holdings Inc. (UAL), Delta Air Lines (DAL), Southwest Airlines Co. (LUV), JetBlue Airways Corporation (JBLU) and US Airways Group Inc. (LCC) that were untouched by the Euro-crisis will benefit the most in 2012. These carriers have also shown improvements thanks to higher ticket prices, capacity cuts and improved ancillary revenues. These firms together are expected to post profits of $1.7 billion in 2012.

Asia-Pacific: The 2012 profit projection from the Asia-Pacific carriers is $2.1 billion. Notably, this is the highest profit-producing region in the industry outside the home market, outstripping other areas.

Middle East & Latin America: Per IATA, profits from the Middle East and Latin American carriers are expected to plunge from 2011 levels to $300 million and $100 million, respectively.

Africa: African air carriers are expected to incur a loss of $100 million due to weaker yields after touching the break-even point in 2011.

Europe: As for the European airlines, the IATA projections show a loss of $600 million for 2012, indicating a downswing from a profit of $1 billion in 2011. The weak economy and higher passenger taxes are largely responsible for the downturn.

Lagging Indicators

Airfreight is declining as world trade is deteriorating and shippers are moving away from costlier air transport. The end of 2011 showed weak traffic growth in Europe and the other affected markets, particularly in the Middle East/North Africa region. Though Tunisia is showing signs of recovery, traffic to Egypt and Libya are still disrupted. Hence, we believe the recovery of airfreight depends on the overall health of the European economy.

Despite the weak economic growth, travel demand is picking up. The IATA projects a slowdown in global airline passenger growth to 4% in 2012 from 6% in 2011. The cargo market is expected to remain stable in 2012.

In the worst-case scenario of a full-blown Euro-zone crisis, Europe will likely drag the U.S. into a recession as well, pulling down growth in China and other emerging economies. In that scenario, losses in the global airline industry would be quite large, perhaps the worst since the 2008 financial crisis. Every region of the world would be affected, though Europe would be worst hit, followed by North America and then the Asia-Pacific region.

In the base-case scenario, there are several factors that will drive airline profits in 2012:

Fuel Price Rise: Bane or Boon?

Airline profit outlook depends on fuel prices, the major variable component in the industry. Escalating fuel prices are making aircraft operations expensive and are changing the sector’s overall dynamics. Airlines need to figure out ways to counter rising fuel expenses.

High crude oil prices, largely a function of geostrategic forces, are outside of the control of the airlines. We expect crude oil and jet fuel prices to remain largely stable this year, but forecasting this key variable with any level of accuracy has always been extremely challenging (Hedging strategies discussed below).

While air carriers are contemplating a more effective and enduring way to counter the rising costs, passing on the increased cost to customers in the form of fare hikes seems an easy way out. Airlines have already imposed about 10 broad fare increases in 2011, which has been successful with the rise in travel demand. If demand remains strong and the fuel price continues to rise, then carriers will be able to earn higher through fare hikes in 2012.

Getting Rid of Unprofitable Jets

Air carriers believe capacity reduction is another way to counter rising fuel costs. The companies are scrapping or cutting flights in many small U.S. airports that are unprofitable.

According to the Airports Council International, 27 airports including those at St. Cloud, Minnesota and Oxnard, California lost services from the well-known airlines over the last two years. Instead, the carriers are adding long-distance flights. It is easy to charge more from passengers traveling long distance rather than the shorter routes.

New Advertising Rule

The U.S. Department of Transportation (DOT) laid new pricing rules for the air carriers effective January 26, 2012. Airline companies have to include all taxes and fees while advertising fares for their flights. Previously, the carriers were allowed to advertise ticket prices excluding taxes and fees, which could add up to 20% to the price of air travel.

We are apprehensive that the new advertising policy will look expensive to passengers and hit the stocks. As the passengers are switching to low fares, the new rules might hurt the travel demand, thereby leading to lower industry profits.


Air carriers are also focusing on fleet rightsizing. Though initially expensive, it seems the correct strategy to lower non-fuel costs. Air carriers are replacing their older fleet with new fuel-efficient aircraft, to optimize cost efficiency of their aircraft.

Delta Air Lines, United Continental and Southwest would add new aircraft from Boeing Co. (BA) over the next few years. JetBlue will buy Pratt & Whitney engines from United Technologies (UTX) to power its A320neo jetliners.

Hedging Strategies

Hedging strategies provide a cushion to the rising fuel prices and is being used extensively.

Delta Air Lines is 40% and 15% hedged of its expected consolidated fuel consumption for the first half and the second half of 2012, respectively, at current jet fuel prices. United Continental is hedged 47% and 36% for the first two quarters of 2012 and JetBlue has hedged approximately 21% for full 2012 using a combination of calls, swaps and collars. Southwest is 50% hedged for 2012 through fuel derivative contracts at varying WTI crude-equivalent price levels.


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.

Ancillary Revenue: A number of supplementary revenue streams helped the airline industry gain ground in 2011 and 2010 after two years of drought. Air carriers are adding new features to services as well as expanding new products to improve passenger satisfaction and experience. The IATA projects total revenue of $618 billion for 2012, up slightly from $596 million projected for 2011.

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” and Lufthansa “BoardConnect.” 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 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 to aid growth in 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. Southwest Airlines is benefiting from EarlyBird check-in, unaccompanied minor travel and pet fees. The company is upgrading its fleet with the new Boeing Sky Interior and the All-New Rapid Rewards program is contributing to revenue growth. JetBlue is experiencing solid growth given continued success in the Getaway Vacations Division as well as the Even More Space product.

Consolidation: Airline companies are consolidating in order to restore profits. The first in this grouping was Delta Air Lines’ successful acquisition of Northwest Airlines in 2008. The merger catapulted Delta to the position of the second largest airline in the world, generating significant cost savings for both.

In 2010, United Airlines merged with Continental Airlines and formed a new company, United Continental Holdings. This merger created the world’s largest airline, overtaking Delta Air Lines. The third merger was between Southwest Airlines and fellow discounter AirTran Holdings, which was completed in May 2011.

Another airline consolidation is seemingly underway. American Airlines, a wholly owned subsidiary of AMR Corporation (AMR), filed for bankruptcy protection in November, which would help it to cut down expenses and position it for consolidation. Looking back, bankruptcies in the airline industry pave the way for mergers and acquisitions. This is because carriers seek protection to emerge as a low cost provider with a strong competitive position in the industry. There is a good chance of American Airlines merging with US Airways.

The merger of American Airlines and US Airways, if successful, would be the fourth in the last three years. Though the deal is not yet official, we believe it could change the competitive dynamics of the airline industry. US Airways has been looking for a merger candidate following its bankruptcy protection filing in 2002 and has long-standing problems with its pilot union. The company failed to acquire Delta when it went bankrupt in 2006. As a result, US Airways might take American Airlines’ bankruptcy as a great opportunity to take over its larger rival.

Expansion: Carriers are making continuous efforts to increase their domestic and international flights. Delta Air Lines is focusing on adding flights in 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, and the new Maynard H. Jackson Jr. International in Atlanta, slated to open in 2012. Internationally, Delta’s deal with a Chinese international airline China Eastern in early June should prove profitable.

United Continental is benefiting and enhancing its access from each other’s hubs and networks. Southwest gained a valuable market presence in Atlanta, the busiest airport in the U.S, post the Air Tran acquisition in May 2011. The company is introducing services to new and unexplored domestic markets and expanding services in New York LaGuardia, Boston Logan, Milwaukee, Baltimore/Washington and many smaller domestic cities. The company will also debut in the Caribbean and Mexican markets in mid-2012.

JetBlue continues to successfully expand its network in two major growth regions: Boston to New
York and the Caribbean.

Technology Upgrades: 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 service.


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, though high currently, 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.

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 airlines engaged in air transportation in the U.S. are subject to the regulations implemented by the DOT. Further, airlines are also regulated by the Federal Aviation Administration, a division of the DOT, primarily in areas of flight operations, maintenance and other safety and technical matters.

Capacity Creep: The airline industry has a lousy 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.

Currently, we have a long-term Neutral rating on Delta Airlines, United Continental Holdings, Southwest Airlines and JetBlue supported by a Zacks #3 Rank (Hold).

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

UTD TECHS CORP (UTX): Free Stock Analysis Report

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