Saturday, January 07, 2017

Airlines Face New Test Amid Rising Fuel Prices, Labor Costs: Delta to kick off industry’s earnings results; sector has notched seven consecutive years of profitability

The Wall Street Journal
Jan. 7, 2017 7:00 a.m. ET

Delta Air Lines Inc. is expected to kick off fourth-quarter earnings results for U.S. airlines on Thursday, as the industry faces a fresh test of its financial resilience amid rising fuel prices and labor costs.

The sector has notched seven consecutive years of profitability, the longest and strongest cycle in what has traditionally been a turbulent industry prone to big booms and busts. While no one is betting on a recession soon and airlines are expected to be profitable this year, some investors are questioning how long the winning streak can last.

Delta’s results likely will telegraph the outlook for the sector. The No. 2 carrier by traffic already has warned that higher costs will shrink its operating margin in 2017 from last year’s solid 16.5% performance. Other big carriers are expected to report later this month.

Cowen & Co. has lowered its ratings on five U.S. carriers on signs that margins “are expected to compress” because revenue growth isn’t outpacing cost increases. The International Air Transport Association trade group suggested that global airline profits peaked in 2016 and will decline this year.

Meanwhile, low-cost carriers continue to gain market share. The industry also remains vulnerable to external shocks such as terrorism. Some analysts question whether airlines can wring more revenue from fliers for perks such as advanced boarding and better seats. Adjusted for inflation, domestic airfares have fallen by more than a quarter since 1999.

Yet industry executives believe airlines are better prepared to withstand a downturn than in any of the five downturns that have battered the sector since 1980.

Doug Parker, chief executive of American Airlines Group Inc., the nation’s largest by traffic, said, “Our projections, even in difficult economic environments, have this company being nice and profitable.”

Bankruptcies after the 9/11 terrorist attacks were followed by a series of mergers that left the top four U.S. airlines controlling more than 80% of domestic capacity. These changes allowed them to increase efficiency, repair balance sheets and funnel profits into new products. Economic recovery since the latest recession ended in 2009, coupled with low fuel prices, gave airlines a strong tailwind.

“This business is not only more durable and sustainable; it’s something you can count on for some time,” Delta CEO Ed Bastian said recently. Delta continues to aim for operating margins of 17% to 19% in the future, targets that seemed unattainable a few years ago.

Investor sentiment toward U.S. airlines has improved. Two months ago, Warren Buffett’s Berkshire Hathaway Inc. disclosed stakes in American, Delta and United Continental Holdings Inc. that totaled $1.3 billion—even though he had previously spurned airline shares, calling the business capital-intensive and not very profitable.

Those investments are “an endorsement that things are different this time,” said Jamie Baker, a J.P. Morgan analyst. Mr. Baker anticipates that airlines would remain profitable even if margins slip to about 10%, the former peak.

Smead Capital Management, a Seattle-based investment firm, is another investor that has changed its perspective. “Over the long term, we thought airlines were a bad place to put capital,” said Tony Scherrer, research director for the Smead Value Fund. But the fund recently placed its first bet on an airline stock by acquiring a stake in Alaska Air Group Inc.

Not only has broader consolidation made the industry “a better business now,” he said, but Smead was attracted to Alaska’s business model and opportunity to gain from its recent acquisition of Virgin America Inc.

Airlines also are adding fewer seats as traffic continues to rise, helping to drive up fares. Unit revenue—the amount earned for each seat flown a mile—is approaching positive territory after two years of declines.

That the industry is checking its capacity growth “is lining up as good for a recession scenario,” said Kristopher Kelley, an equity analyst at Janus Capital Group Inc., a Denver-based investment manager with holdings in American, United and Southwest Airlines Co.

Airlines also are hopeful about President-elect Donald Trump’s pledge to cut corporate taxes. “The potential impact of tax reform on earnings and cash flows for the airlines is broadly positive, but very company-specific,” said David Vernon, a Sanford C. Bernstein analyst.

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