With the global economy continuing to improve, there is steady improvement in demand for air travel as well as cargo since the beginning of 2010, after being badly affected by the economic downturn. Business travel, which is directly affected by the economic environment, plunged to an all-time low in 2009 as many corporations slashed travel budgets. Leisure travel as well as cargo also showed a remarkable decline.
With improving economic sentiment, business travel and demand for air cargo are gradually catching up. However, leisure demand is still low and is expected to take a greater time to reverse, since spending in this area is highly discretionary. We may not see a noticeable improvement in that segment until clear evidence of labor-market improvements take hold.
To combat the recessionary effects, the airlines have cut costs, slashed capacity and increased load factor. However, as travel demand catches up, the airlines can avoid additional capacity cuts. Conversely, airline capacity is expected to improve in 2010. This would help to keep fares in check, besides making it easier for travelers to book last-minute seats.
Though we think the worst is over, industry drivers all point to a slow recovery (at best) during the remainder of 2010. The economy is still far from healthy, with unemployment likely to remain high throughout the year. Growth in consumer spending is also expected to be sub-par as compared with the prior years. However, we expect faster growth in the next four years as the economy gathers momentum, consumers and business sentiments recover and spending increases.
Consolidation, the Only Viable Route
In a severely fragmented industry, consolidation is the writing on the wall, as the recent merger announcement between United Airlines and Continental Airlines shows. The 2009 recession and a drop in travel demand has been difficult for almost all air carriers, with small companies finding it hard to subsist, thus making consolidation imperative. This is the optimal way for the industry to deliver sustainable profitability, by gaining better efficiency, greater economies of scale and reduced operating costs.
On the consolidation front, a major development in 2008 was the merger between Delta and Northwest Airlines, which made Delta the world's largest airline. The merger provided significant cost advantages for the operation of both airlines. Further mergers and acquisitions appear likely, provided that some operators would inevitably find it harder to recover than others. Low-cost airlines, which have weathered the storm in 2009, stand in a more favorable position now, and may even end up purchasing some regional operators.
Oil Price Volatility
The airline industry is cyclical and sensitive to a number of key drivers, the most prominent of which is the world price of crude oil. The ATA estimates that for every dollar increase in the price of jet fuel -- a derivate product of crude oil -- both the domestic and international airline industry incurs an additional $445 million in fuel expenses. While prices have eased a bit recently, they remain significantly above year-earlier levels. This is of concern to the airline industry, as it will directly increase the cost of fuel purchase, shrinking profits. Oil prices are predicted to trend even higher in response to an increased demand as the world shakes off the recession.
However, in order to offset the loss from oil price volatility, the airlines are considering levying additional fees and charges. Hedging strategies are another profit protection tool, and will be more extensively undertaken.
Though almost all carriers are expected to benefit from the improving economy, we favor United Airlines, a wholly owned subsidiary of UAL Corp. (UAUA) particularly, with a Zacks #1 Rank. The company has been reporting improving revenues, with its Corporate segment recording an increased demand from international markets. Pricing trends have also shown an improvement. UAL’s recently announced merger with Continental Airlines will make it the biggest airlines with an enhanced capacity and improved service.
Our next pick is Delta Air Lines Inc. (DAL - Analyst Report) with Zacks #2 Rank. Delta is uniquely positioned to benefit from its merger with Northwest Airlines, which has made it the world’s largest airline generating economies of scale. Moreover, Delta has recently seen a surge in business travel volumes and improved pricing, a trend which is expected to continue.
Others with a Neutral recommendation and a Zacks #3 Rank are AMR Corp. (AMR), Continental Airlines (CAL), Jetblue Airways (JBLU - Analyst Report) and Southwest Airlines (LUV - Analyst Report).
Overall we view the industry to post strong growth in the coming years. However, near-term risks associated with the airlines shares are the fluctuations in the price of fuel, disease outbreaks, or concerns that the economy may slow down further.
We think Republic Airways Holdings (RJET - Snapshot Report) with a Zacks #4 Rank will be an Underperformer in the near term as it continues to face strong competition in Denver and Milwaukee, the main markets in which it operates. Moreover, fuel price volatility will continue to exert a downward pressure on the earnings.