Leaner Airlines Meet Cheap Oil: Profits Set To Surge

After more than a decade of bankruptcies, big mergers and billions of dollars in losses, the airline industry is headed for a year of surging profits, analysts say.

A big part of that surge reflects the sharp drop in oil prices. But airlines have also grappled with capacity issues, added more efficient aircraft and cultivated an array of ancillary fees to help feather their nests.

Fourth-quarter earnings and 2015 outlooks across the industry received a big boost from oil prices that fell 50% from June through December. The cost of jet fuel, which accounts for nearly a third of airline costs, also tumbled.

An employee refuels an Alaska Airlines 737-800 at Seattle-Tacoma International Airport in Seattle. Low fuel prices are just one element in forecasts...

An employee refuels an Alaska Airlines 737-800 at Seattle-Tacoma International Airport in Seattle. Low fuel prices are just one element in forecasts… View Enlarged Image

Jet fuel spot prices are down 47% from last year’s highs, but that’s not the actual cost for most airlines. Most still operate according to hedge contracts negotiated before the sharp drop in oil, and therefore pay a higher price. Month by month, as more hedges expire and new ones are arranged, airlines lock in the current price scheme.

Anyone watching oil prices knows market conditions could change in a flash and alter the outlook.

“The wild card is oil and economic strength, and seat capacity growth,” said Vaughn Cordle, analyst and founder of Ionosphere Capital, which works with some of the largest institutional investors. “Europe, Asia and South America have shown some weakness, but the U.S. domestic (airline) market is solid and the capacity growth moderate because of the industry’s consolidation.”

Travel, Taxes And A Strong Dollar

The strong dollar will have some impact on airline earnings. The greenback has been rising as the Federal Reserve backed out of its quantitative easing program last year. That helps lower gas and other energy costs for U.S. consumers, keeping more money in their wallets which they could use for travel. A strong dollar is also bringing down the cost to travel to Europe and elsewhere.

Airlines could see some negative impact, as international carriers repatriate profit from overseas and incur additional tax payments in the U.S.

A more durable plus in the industry outlook owes to the restructuring that eliminated excess capacity on flights and has lowered competition in some areas. Planes are flying, on average, near a strong 84% of capacity. The result: Airlines are under less pressure to lower fares and engage in price wars.

“The mergers squeezed out a lot of inefficiencies and increased profit,” said Cordle.

With the jump in profits, many airlines have been returning some of that to shareholders.

After more than a decade of bankruptcies, big mergers and billions of dollars in losses, the airline industry is headed for a year of surging profits, analysts say.

A big part of that surge reflects the sharp drop in oil prices. But airlines have also grappled with capacity issues, added more efficient aircraft and cultivated an array of ancillary fees to help feather their nests.

Fourth-quarter earnings and 2015 outlooks across the industry received a big boost from oil prices that fell 50% from June through December. The cost of jet fuel, which accounts for nearly a third of airline costs, also tumbled.

An employee refuels an Alaska Airlines 737-800 at Seattle-Tacoma International Airport in Seattle. Low fuel prices are just one element in forecasts...

An employee refuels an Alaska Airlines 737-800 at Seattle-Tacoma International Airport in Seattle. Low fuel prices are just one element in forecasts… View Enlarged Image

Jet fuel spot prices are down 47% from last year’s highs, but that’s not the actual cost for most airlines. Most still operate according to hedge contracts negotiated before the sharp drop in oil, and therefore pay a higher price. Month by month, as more hedges expire and new ones are arranged, airlines lock in the current price scheme.

Anyone watching oil prices knows market conditions could change in a flash and alter the outlook.

“The wild card is oil and economic strength, and seat capacity growth,” said Vaughn Cordle, analyst and founder of Ionosphere Capital, which works with some of the largest institutional investors. “Europe, Asia and South America have shown some weakness, but the U.S. domestic (airline) market is solid and the capacity growth moderate because of the industry’s consolidation.”

Travel, Taxes And A Strong Dollar

The strong dollar will have some impact on airline earnings. The greenback has been rising as the Federal Reserve backed out of its quantitative easing program last year. That helps lower gas and other energy costs for U.S. consumers, keeping more money in their wallets which they could use for travel. A strong dollar is also bringing down the cost to travel to Europe and elsewhere.

Airlines could see some negative impact, as international carriers repatriate profit from overseas and incur additional tax payments in the U.S.

A more durable plus in the industry outlook owes to the restructuring that eliminated excess capacity on flights and has lowered competition in some areas. Planes are flying, on average, near a strong 84% of capacity. The result: Airlines are under less pressure to lower fares and engage in price wars.

“The mergers squeezed out a lot of inefficiencies and increased profit,” said Cordle.

With the jump in profits, many airlines have been returning some of that to shareholders.

When Alaska Air (NYSE:ALK) reported fourth-quarter results on Jan. 22, it announced a 60% dividend increase. Last year was the Seattle-based carrier’s fifth consecutive year of profitability in every quarter.

Alaska’s management also suggested it has no intention in engaging in airfare price wars.

“While fuel has been a nice tailwind in the fourth quarter, several of you have asked us if we are pricing to account for the lower fuel prices,” said Andrew Harrison, senior vice president. “And the answer is no. When pricing tickets, we look at the supply and demand in each of our markets and adjust prices to balance the two. Approximately 90% of our flying is in the U.S. domestic market and the U.S. economy continues to be strong.”

A String Of Industry Shocks

The airline industry has long operated under extremely thin profit margins that quickly turn to losses when disruptions occur. The first of three big shocks began in late 2000 when the Nasdaq bubble popped and airline revenue fell. The second disruption began after the 9/11 terrorist attacks. Airlines were already weakened at that point by big labor wage hikes that followed a long business cycle expansion that peaked in 2000, said Cordle.

“Massive losses after 9/11 were also the result of too many airlines, causing destructive price competition,” said Cordle.

The third industry shock came in 2008 when demand and revenue fell during the Great Recession of 2007-08 as oil prices spiked.

The result is that, from 2001 through 2009, the U.S. airline industry reported a cumulative net loss of $ 68.7 billion, which included nonrecurring charges related to restructurings.

“A decade ago, in many respects, airline management were laughed at and not making money, until they reinvented,” said John Heimlich, chief economist and vice president at Airlines for America, an industry trade association.

A Rebound From Years Of Doom

Surviving through that period resulted in taking on loads of debt while maneuvering through the various mergers that culled of a lot of excess competition and capacity.

“They are recovering from multiple years of doom, digging out of a hole, repaying debt, taking care of underfunded pension and taking care of investors,” Heimlich said.

Profits for the top 10 airlines were about $ 7.3 billion in 2014 and should be in the range of $ 15 billion this year, said Cordle. That estimate could rise or fall depending on the fluctuations of fuel costs. The rapid drop in oil prices stood out in the fourth-quarter earnings reports of airline companies.

“Our earnings outlook is superb, if for no other reason then fuel costs are down dramatically year over year,” said Gary Kelly, chief executive of Southwest Airlines, in a conference call with analysts following its Jan. 22 fourth-quarter earnings report.

“We have significantly lower fuel cost and it drops straight to the bottom line for the most part,” Kelly said. While jet fuel prices have declined, air fares have not dropped accordingly, as was the case in times past. Operational efficiency and “capacity discipline” are among the reasons.

That could change, especially if some of the newer, smaller airlines get more aggressive in trying to expand market share.

Will Small Carriers Pare Rates?

Among them is discount carrier Spirit Airlines (NASDAQ:SAVE). Spirit offers ultracheap fares, but then charges passengers for services that other airlines offer for free, such as printing out a boarding pass and for carrying on a bag.

On its Feb. 10 quarterly earnings conference call, CEO Ben Baldanza said Spirit intends to offer its Bare Fares plus Frill Control product on about 35 new routes.

As to how aggressive Spirit would get on pricing, Baldanza suggested that would occur only to fill seats when capacity is low.

“When the largest input cost (fuel) drops, it makes it more economic to sell lower fares to fill marginal capacity, and that’s what we see happening, especially in off or lower peak periods in the time frame,” Baldanza said in the conference call. “There’s just more seats available to fill. And economically, they can be filled at lower prices.” During the fourth quarter, Spirit took delivery of seven new aircraft, bringing its fleet to 65. It plans 15 additional new aircraft this year.

Southwest is accelerating its capacity growth in the first quarter, aiming to add seats at a rate of 6% per year. It expects passenger revenue to grow in line with capacity.

“This guidance tempers the fear that aggressive capacity expansion could pressure the carrier’s air fares,” according to a research report by Trefis.

“There’s a tremendous opportunity in front of us from lower fuel prices,” said Delta CEO Richard Anderson in a Jan. 20 post-earnings conference call. “We will drive these savings to the bottom line with strong revenue growth and yield preservation regardless of fuel prices.”

As heard several times in the airline earnings conference calls, a top priority continues to be paying down debt.

“We expect to have our adjusted net debt below $ 6 billion by the end of this year and achieve a $ 5 billion target next year,” Anderson said.

Discipline Vs. Cheap Oil

Airline executives also made clear their intent to maintain fiscal discipline despite lower oil prices.

“Our perspective is that Brent (oil) was over $ 100 a barrel for nearly four years, and has been under $ 100 a barrel for merely four months. So we’re going to continue to run American as through we’re still operating $ 100-per-barrel oil,” said Doug Parker, American Airlines Group CEO, on the conference call Jan. 27.

The airline industry has also worked on steadily improving passenger service and comfort while improving business operations, driving more revenue while lowering costs. This includes deployment of onboard wireless services and an intense focus on automation, such as automated kiosks for ticketing. They are also upgrading passenger lounges and remodeling flight gate areas.

The carriers are also being careful not to repeat past mistakes.

They are “staying conservative with pricing and capacity,” said Heimlich. “If the U.S. economy stays healthy and fuel prices moderate, the biggest risk for U.S. carriers is more taxes and regulations.”

Airlines also are maintaining special fees, such as baggage, which are a cost-effective way to generate more money. The Transportation Department said the U.S. airlines are on track to have collected a record $ 6.4 billion in baggage fees and reservation cancellation fees in 2014.

Investors.com

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