Low-cost airline carriers are vulnerable to significant declines if analyst growth expectations fail to pan out.
Compressed forward P/E ratios suggest institutional money managers (the real buyers and sellers) are more pessimistic than consensus estimates imply. Rising oil prices, economic weakness, and thin-margin business models are three key threats for the group.
The big-three low-cost carriers are:
- Southwest (NYSE:LUV) - The world's largest low-cost airline.
- Jetblue (NASDAQ:JBLU) - A dominant player on the Eastern Seaboard and in the Caribbean.
- Spirit (NASDAQ:SAVE) - Ultra-low cost carrier focused on the US Southeast, Caribbean and Latin America.
At current prices, 1-year forward P/Es represent significantly compressed valuations. This implies that active money managers are skeptical when it comes to analyst expectations for earnings growth in 2014.
The fact that buy-side investors are heavily discounting future earnings expectations helps to confirm our reservations on the group. There are three key sources of risk in play for low-cost airlines:
1) Stubbornly High Oil Prices
Jet fuel prices are a major driver of airline profit margins, particularly at low-cost carriers where price sensitivity is higher.
In 2011, when oil prices hit $110 per barrel, profit margins for LUV, JBLU and SAVE were all compressed significantly. For Southwest, the ramp in oil prices actually pushed profit margins into negative territory.
Supply disruptions in Lybia, Iraq and Canada have pushed current oil prices higher and U.S. refineries are processing crude oil at record rates, leaving little spare capacity. The risk that conflict in Syria spills over to larger oil producers in the Middle East inevitably increases the geopolitical risk premium of oil.
2) Economic Weakness
While the U.S. economy has demonstrated resilience this year, economic stability is sowing the seed for the Fed's tapering of its Quantitative Easing program.
U.S. monetary policy has turned a corner. Barring clear evidence of slowdown or the economy hitting "stall speed," interest rates will rise from historic low levels. This could impact low-cost carriers via middle-class belt tightening.
Evidence of slowing retail sales suggests that, while affluent Americans are spending freely, 'ordinary' Americans are still in trouble. Rising interest rates could further dampen middle-class spending and cut into travel revenues.
The economy slowing down would put pressure on middle- class consumers, resulting in a lose-lose scenario. (If economic stability is maintained, higher interest rates will pressure middle class consumers, and if economic stability deteriorate, job growth and consumer confidence will come under pressure.)
3) Vulnerable Low-Cost Business Model
The third problem is the inherent vulnerability of the low-margin business model, particularly for LUV and JBLU whose margins are below 5%. High jet fuel prices can cut directly into air carriers' profits, but the most obvious measure airlines can take when faced with a soft retail environment is to slash prices.
Reducing the quality of onboard offerings is a reputational risk LUV and JBLU have to balance with letting margins decline, while SAVE as an ultra-low-cost carrier has virtually nothing left to cut.
A good example of this vulnerability can bee seen by looking at the recent "turbulence" in European low-cost carrier Ryan Air's stock (NASDAQ:RYAAY).
RyanAir is one of the leading low-cost carriers in Europe. After giving a profit warning citing increased competition in the low-cost carrier space and weakness in forward bookings on Wednesday 9/4, RYAAY's stock dropped 11% on the day.
RYAAY's recent profit warning shows that low-cost carriers are not above economic realities and any slow-down for American consumers would make Wall Street's estimates unreachable, particularly as margins are eroded by high oil prices.
While large carriers face many of the same risks as low-cost carriers, low growth prospects have clearly already affected their valuations. There is little more compression to be witnessed in the forward valuations of larger carriers and it seems both the buy-side and sell-side agree on relatively bleak prospects for the group.
The large carrier group thus provides less opportunity on the short side as multiples already reflect relevant risks.
Are the low-cost carriers a good short at current levels?
Price action suggests mounting concern. The $XAL airline index has registered a potentially significant topping pattern on the weekly chart, with LUV, JBLU and SAVE similarly stalled in multi-month topping formations.
The Wall Street analyst consensus of 20-30% earnings growth year on year would be impressive for most any public company in this slow growth, stall-speed economic environment - let alone for airlines exposed to multiple external risks well out of their control.
Market participants are already skeptical of Wall Street's estimated growth prospects for the low-cost airline group. Should the group show weakness after the Fed's tapering announcement, low-cost air carriers should be an attractive short opportunity, particularly if oil prices remain high.
Based on strong potential for lowered 2014 estimates (assuming historical price earnings valuations), the big-three low-cost carriers could reasonably drop 20% from current levels. We are monitoring the price action along with the macro picture to identify attractive shorting opportunities.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.