US airlines:
Optimism for 2018 Jan/Feb 2018

2017 was the eighth consecutive year of healthy profitability for the US airline industry, with the nine largest carriers earning an aggregate operating profit of $21.6bn (13.1% of revenues). The combined net profit before special items was $12.2bn, 7.4% of revenues.

But it represented a second consecutive year of profit decline. Industry operating earnings fell by 17.2% from the year-earlier $26.1bn, mainly because of higher fuel prices, though expensive new labour contracts were also to blame.

The US airline industry became profitable in 2010, following a decade of steep losses, and in 2010-2016 recorded an aggregate net profit of $61.7bn (A4A data, see chart).

The reasons for the turnaround have been well documented: a decade of restructuring, many Chapter 11 visits, extensive consolidation, lack of new entrants, years of tight capacity discipline, new ancillary revenue streams and return-oriented management teams. Between late 2014 and mid-2017 US airlines also benefited from lower fuel prices.

US airlines are now regarded as having transformed into a viable, long-term business that can achieve financial metrics comparable to those of other high-quality S&P industrials. However, US investors still worry that the airlines could slip back into the bad old ways. Every time there is a mere hint of an airline stepping up capacity growth, a competitive skirmish developing or unit revenue growth not meeting expectations, airline share prices fall.

There were plenty of such scares in 2017, as a result of which US airline stocks vastly underperformed the S&P 500 Index. While the S&P rose by 20.5% in 2017, the NYSE Arca Airline Index was up by only 5.5%.

2018 has already seen major drama with US airline stocks. Initially many airlines benefited from up-beat RASM and earnings reports. Then on January 23 United dropped the bombshell: it would step up capacity growth to 4-6% in 2018 and probably maintain that rate in 2019 and 2020.

As a result, United’s share price fell by 15.2% and other airline stocks by 7-11% in January 23-25. The following week airline stocks got caught up in the turbulence that hit the global markets, which led to further price declines.

Analysts and airline CEOs were quick to play down the impact of United’s plans. Most feel that the move makes sense and is unlikely to provoke competitive responses. But investor sentiment has been dealt a blow, which analysts believe could linger on.

The biggest issue for US airlines in 2018 is likely to be higher fuel prices. After three years of WTI crude oil at $50-a-barrel or less, the past five months have seen the price rise to the low-to-mid 60s.

While higher fuel prices are likely to lead to higher airfares domestically (and fuel surcharges internationally), there will be time lags. Also, it may not be possible to fully offset the hike through ticket prices.

On the positive side, US airlines are benefiting from a promising macroeconomic outlook, robust demand for air travel in the US and internationally, improving RASM trends and labour costs being in check.

At this point, and assuming that crude oil prices will be in the $60-70/barrel range, analysts expect US airline pretax earnings to decline slightly in 2018, before bouncing back in 2019.

But tax windfalls resulting from the Tax Cuts and Jobs Act of December 2017 should significantly boost US airlines’ net earnings and EPS growth in 2018. Who will benefit the most?

Labour holiday this year

Hefty labour cost increases, resulting from new labour contracts (or, in American’s case, mid-contract pay increases), were the US airline industry’s biggest cost headwind in 2017.

This year, labour cost increases should be more in line with the rate of inflation. The exceptions are two US low-cost carriers. Spirit, the largest ULCC, has secured a five-year tentative contract with its pilots that will include a 43% average pay increase, improved benefits and $75m in ratification bonuses, increasing Spirit’s costs by $90m in year one.

JetBlue has been in negotiations with its pilots for a first contract for three years, following a vote to unionise in 2014. The union is seeking pay rates in line with those at other airlines. A deal seems likely in 2018, because the talks have been under federal mediation since last summer and the pilots have started picketing.

Fuel holiday over

The three-year slump in oil prices, which began when the WTI oil price fell from over $100 per barrel to the $50-level between August 2014 and January 2015 and included spikes to below $30, is over. Prices began rising in August 2017 and reached a high of $66-67 in mid-January, before retreating to the low-60s in early February.

Fuel was already a headwind for US airlines in Q4. In 2017 the airlines saw their average unhedged fuel price per gallon increase by around 21-22%, from $1.40 to the $1.70 level. This year the average price is expected to exceed $2 per gallon — a level last seen in 2015.

American’s CEO Doug Parker estimated in January that the carrier would face an additional $1.8bn fuel bill in 2018. United’s executives put the figure at $1.6bn. Few of the US airlines hedge for fuel these days.

Internationally, the problem may again be solved by fuel surcharges, which have already started reappearing at least in the Pacific market. Domestically, the consensus is that higher fuel prices will lead to higher ticket prices. However, several airlines noted that there is always a time lag (of 2-4 months or more) in passing such cost increases to customers.

A consensus of sorts is emerging that airlines will be seriously concerned only if/when crude oil prices rise above $70 Brent/high-60s WTI and stay at such levels for a period of time.

US airlines have a pretty good record of managing a high fuel environment. They were profitable earlier this decade when oil prices were well over $100 a barrel. And if relatively high fuel prices persist, it could accelerate the processes of retiring older aircraft and making mid-life aircraft more efficient by adding more seats.

Demand and RASM strength

In Q4 calls all US airlines commented about the strength of demand — something that has helped accelerate unit revenue growth in recent months.

Importantly, the improvements have been broad-based, with both domestic and international markets, as well as all different revenue segments, recording healthy gains. Even cargo — long the laggard — is now producing stellar results.

Several airlines noted that the international environment had not been this strong in years despite what has been dubbed the “Trump slump” — in the first seven months of 2017, international visitors to the US fell by 4%. However, outbound travel (which the US Big Three airlines are well positioned to capture), is booming — especially to Europe — and has amply offset the inbound decline.

American has performed especially well because it is still reaping benefits from the December 2013 merger with US Airways and catching up on the product front. In Q4 the airline saw its PRASM increase by 5.4% — the sixth consecutive quarter of positive growth. Revenues from corporate contracts recorded the strongest growth in eight quarters.

Every regional entity in American’s network saw positive unit revenue growth in Q4. PRASM rose by 5.7% in the domestic market, 7.7% on the Atlantic, 6.3% to Latin America and 1.2% on the Pacific.

The Atlantic result was the best American had seen since the merger and it was attributed mainly to “improved execution of LCC price matching together with strong premium cabin performance”. The UK led the way with double-digit PRASM growth.

The somewhat alarming reference to “LCC price matching” probably just meant better yield management. The strong premium cabin performance reflected a new Premium Economy product on international flights — both American and Delta began rolling it out in 2017, with United following in 2018. The US airlines are merely catching up with their European and Asian partners, which already offered a comparable premium product.

In Q4 American’s cargo revenues surged by 19.7% on both higher volume and higher yields, continuing a positive trend seen since mid-2016.

Delta executives described the overall demand environment as the “healthiest we’ve seen in years”. System PRASM was up by 4.2% in Q4. All of the regions saw PRASM increases, with the Pacific turning positive for the first time in 4-5 years. Atlantic PRASM rose by 7.4% on strong business class bookings and a foreign exchange tailwind. Delta said that its Basic Economy offering, which is aimed at tackling LCC competition, is now available in more than half of its European markets. In 2017 cargo revenues grew for the first time in six years.

Like American, Delta is seeing strong corporate demand and expects the momentum to continue, helped by new product initiatives aimed at premium travellers. The weaker dollar means that Delta is positioned to benefit from a tailwind from foreign exchange in 2018.

Domestically, though, US airlines have repeatedly failed to get fare increases to stick. That and United’s capacity hike announcement prompted JP Morgan analysts to reduce their industry PRASM growth forecast for 2018 from 2.5% to 2% in January. All of the six largest US airlines except Alaska are projected to see positive unit revenue growth in 2018.

Brighter economic prospects

US airlines are optimistic that buoyant economic conditions will help maintain strong air travel demand in 2018 and enable them to raise ticket prices without having to resort to capacity cuts.

GDP growth has picked up worldwide in recent months. In January the IMF raised its global growth forecasts for 2018 and 2019 by 0.2 points to 3.9%. That would be up from 3.7% growth in 2017 and 3.2% in 2016.

Importantly, the recovery is broad-based, with all world regions and both developed and emerging economies doing well. The IMF described it as “the broadest synchronised global growth upsurge since 2010".

The IMF also revised up its growth forecast for the US, in part to reflect the macroeconomic impact of the tax reform, which IMF estimates will boost US annual real GDP growth by 1.2 points by 2020. US GDP is now forecast to expand by 2.7% in 2018 and 2.5% in 2019 (up 0.4 and 0.6 points from earlier projections), following 2.3% growth in 2017 and 1.5% in 2016.

The corporate tax rate cuts and faster GDP growth should be positive for US business and corporate travel demand. The tax rate cuts may also mean that US consumers will have more money available for discretionary spending like air travel.

Capacity creep and hub bolstering

United is not alone in stepping up capacity growth; all of the top-nine US carriers currently expect to grow ASMs at a higher rate this year. JP Morgan estimated in a January 30 report that industry ASM growth would increase from 2.8% last year to 4.8% in 2018, before slightly moderating to 3.9% in 2019.

The higher rate is partly a result of the extensive flight cancellations in 3Q17 due to an unusually severe hurricane season in the Caribbean and Florida. For example, American expects 3% “actual” ASM growth but only 2.5% “schedule-over-schedule” ASM growth in 2018.

Also, all of the airlines have good reasons to add capacity. JetBlue is accelerating ASM growth from 4.5% in 2017 to 6.5%-8.5% in 2018 because it was hit hard in 3Q17 in the Caribbean and has good opportunities in its focus cities.

Southwest expects its ASM growth to accelerate from 3.6% in 2017 to “the low 5% range” in 2018, largely reflecting the retirement of its 737-300 Classics in September 2017 and recovery from last autumn’s natural disasters.

Alaska is slightly boosting its system ASM growth from 7.1% in 2017 to 7.5% in 2018, because it still has good opportunities to “connect the dots” following its acquisition of Virgin America. However, Alaska made the financial community happy by announcing plans to slow capacity growth to 4% in both 2019 and 2020.

Hawaiian is stepping up its ASM growth from 3.4% in 2017 to 5-8% this year as it enters into the “last phase of a strategy mapped out over a decade ago”.

The ULCCs are also growing at a faster pace this year: Spirit is projecting 23% ASM growth and Allegiant 11-15% growth, up from 16.1% and 10%, respectively, last year.

It all sounds very reasonable, but airline investors in the US are fixated about capacity growth outstripping GDP growth.

American and Delta both remain in line (with 3% and 2-3% ASM growth, respectively, in 2018), but United’s growth will far exceed GDP growth in the next three years.

United held a special investor meeting in New York to discuss its new strategy. The aim is to strengthen essentially the three mid-continent domestic hubs (Chicago, Denver and Houston), which suffered when United shrank by 8% in the six years after merging with Continental. Although United has strong international gateways, the profit margins of its mid-continent hubs are 10 percentage points lower than those of American’s and Delta’s inland hubs.

The plan is to improve connectivity and regain relevance at the three hubs by broadly restructuring them and adding new services.

United sees hub strengthening as critical to driving higher profits and closing the operating margin gap with its peers.

At the January event, United’s president Scott Kirby gave a master class on hub economics, reminding everyone why things like connectivity and hub dominance matter.

Equity analysts agree. In a January 23 note, Wolfe Research observed that hubs are key to US airline profitability and that it is critical that the carriers “truly dominate” their hubs. 

JP Morgan analysts wrote on January 30 that they had “long identified United’s paucity of hub dominance as a key contributor to sagging margins” and that the current plan to bolster hub connectivity comes “straight from the Best Practices handbook of Hub and Spoke Airlining, differing little from AAL and DAL efforts in recent years”. The analysts said that they remained convinced that “American and Delta will not lash out” and upgraded United’s stock from underweight to overweight.

Bernstein analysts considered in a January 31 note that it was “hardly a return to the bad old days” and upgraded both United and American to outperform.

Commentary from other airline managements also helped. American’s CEO Doug Parker stressed that investors needed to consider the type of growth in question. Growing out of a hub, where an airline has a “real strategic advantage” was the right kind of “smart, efficient” growth that does not result in yield decline or fare wars.

American, too, continues to strengthen its hubs. Its 2018 summer schedule will include 52 new nonstop domestic or international routes from its nine hubs. But all but five of the new routes will connect existing cities to new hubs — in other words, they are opportunities created by the merger.

Parker said that American would respond to competition where it made sense, but “it is always going to be around our core strategic assets” — meaning that American will continue to defend its hubs.

Even as there is agreement about hub-strengthening being the right move for United, there is scepticism about United’s ability to close the margin gap. The management presented similar plans in late 2016 and the margin gap only widened last year. Many believe that there could be another top-level shake-up at United this year.

Keeping ULCCs in check

The legacies’ hub-strengthening is negative for ULCCs because the implication is that the Basic Economy product, which is directly aimed at ULCCs, will be available in more domestic markets.

In a recent report, Cowen analysts noted two major differences between the US and European markets. First, the US legacies “vigorously defend their hubs and match low fares regardless of whether or not those fares make sense”. Second, “there aren’t many second-tier airports in the US”.

The latter helps explain why ULCCs like Spirit and Frontier took advantage of the legacies’ earlier shrinkage and began venturing into legacy hubs as they sought new growth opportunities.

United executives noted that the airline had been losing connecting passengers to discount carriers, so the efforts to boost connectivity at hubs are also aimed at reversing those trends. United would also continue to have an “aggressive competitive posture vis-à-vis ULCCs”. The following observation from Scott Kirby was indicative: “No-one chooses to fly on a ULCC if they can get the same price on United Airlines. Nobody”.

None of that was new; rather, United’s comments were merely a reminder that ULCCs will face an uphill battle to grow market share in the US. Although, if Southwest is included the LCC/ULCC share is already around 29%.

Another thing that may slow the progress of ULCCs in the US is higher costs. Spirit faces a significant hike in labour costs from the new pilot contract, which may make it less inclined to lower ticket prices.

Benefits from tax reform

Airlines are among the larger beneficiaries of the corporate tax reforms that were signed into law in the US in December, though the extent and timing of the benefit varies between individual carriers.

The airlines are benefiting from the reduction of the US corporate tax rate from 35% to 21% and a rule change allowing an immediate full expensing of capital investment (previously aircraft were depreciated over seven years for tax purposes).

Southwest is the clear winner, because it is a full US taxpayer and has significant ongoing fleet capex. The airline saw its 2017 income tax provision reduced by $1.4bn, which meant that it recorded a $237m tax benefit in 2017 and its net income surged to $3.5bn (16.5% of revenues). An estimated 23-23.5% tax rate in 2018 will also significantly boost Southwest’s net earnings this year.

Alaska, JetBlue, Hawaiian and Spirit are also immediate beneficiaries. All of them recorded sizeable reductions in deferred tax liabilities in Q4 and will benefit from the lower tax rates in 2018.

The Big Three airlines are not yet cash taxpayers, because due to earlier heavy losses they are still using Net Operating Loss (NOL) carry-forwards. But the NOLs will now last longer as the airlines can burn them at a lower taxable rate.

The Big Three will of course have lower tax bills when they become cash taxpayers in the future. That will not happen in 2018. Delta is expected to be the first to pay cash taxes in 2019/2020. Delta expects the benefit from the tax reform to be about $800m annually at its current earnings level.

According to Cowen analysts, American and United are not expected to pay cash taxes until after 2020. At year-end American still had $10.2bn of federal NOLs and $3.5bn of state NOLs.

Four of the airlines (American, Southwest, JetBlue and Alaska) followed the example of numerous S&P 500 companies and paid their employees a $1,000 cash bonus specifically related to the tax reform. Bonuses are tax-deductible and those booked in 2017 (and paid by March 2018) offered more in tax savings than if booked in 2018.

Otherwise, US airlines will use the tax savings to pay down debt, buy back stock, increase dividends and invest in the business. Delta also mentioned funding pension plans.

One question is whether US airlines will now order more new aircraft. So far only Southwest has done so, announcing in early January a “further investment in its Boeing fleet” specifically to take advantage of the tax reform legislation. The airline exercised 40 737 MAX 8 options for 2019-2020 delivery but deferred 23 737 MAX 7 firm orders.

The Big Three’s fleet plans always included some new aircraft orders. Delta made its long-awaited narrowbody decision in the fourth quarter before the tax reform was passed, ordering 100 A321neos with deliveries from 2020.

American’s hitherto industry-leading aircraft capex will decline from $4.1bn in 2017 to $1.9bn in 2018 now that the airline has completed its “accelerated fleet renewal programme”. But 2019 and 2020 will see higher aircraft spending ($2.8bn and $2.5bn) and American continues to have significant non-aircraft investments ($1.8bn in both 2018 and 2019).

But it will be interesting to see how United will facilitate the planned three-year growth spurt. The management projects total capex to decline from $4.7bn in 2017 to $3.6bn-3.8bn in 2018 but 2019 and 2020 seeing higher spending. United will continue to add used aircraft. This year’s capex will fund 24 new aircraft deliveries, opportunistic purchases of aircraft off-lease and continued investment in product, technology and infrastructure.