Airlines Should Prepare For A Hard Landing

Includes: BA, CPA, LFL
by: Morningstar

by Neal Dihora, CFA

When compared against historical results, the most recent worldwide traffic data for the airline industry points to an upcoming slowdown. Pockets of strength remain in Latin America, Europe, and the Middle East, although the European vitality is a bit of an illusion as the continent is up against easy comparisons from the Icelandic volcano eruption that forced a large shutdown of airspace in April 2010.

The table below depicts revenue passenger traffic by region from 2003 through August 2011. The rebound that occurred in 2010 appears to have fizzled out in 2011.

Looking back at the prior rebound in 2004, the most current upturn was both weaker and may be of shorter duration. The industry is notoriously volatile and performance can change quickly. Heavy doses of uncertainty in 2011 are helping to push airlines back toward losing money.

The industry went through a gut-wrenching 2008 with losses totaling $26 billion, even as revenue peaked at $570 billion. The table below summarizes revenue, operating profit, and net profit from 2003-10. Shockingly, higher revenue does not translate into profit as the industry hit a new peak in profits in 2010 with lower revenue than 2007 and 2008. Such is life in the airline industry where capacity, competitive pricing, and customer demand patterns are too dynamic to pinpoint results with any level of confidence. With that caveat, we're going out on a limb to suggest that a reduction in demand is likely to result in lower profitability as projected aircraft deliveries continue to be very strong. This will lead to higher capacity and, should demand decrease, could pressure operators into lowering fares. Still, lower economic activity can lead to lower fuel expenses, helping to offset the impact to net income.

Aircraft Deliveries and Backlog Point to Strong Capacity Growth
The following table illustrates the total deliveries by Boeing (NYSE:BA) and Airbus, the main suppliers of commercial aircraft. It's not a surprise to see that North America dominates the installed fleet with 40%. However, it is interesting to note that Asia-Pacific is quickly catching up with Europe.

But does size matter for profits? Apparently not. Below, we review profitability by region, and Asia-Pacific dominates income generation. Strong demand and a lower cost structure, especially for labor, allow the region to deliver profits with revenue growth.

The current order books for Boeing and Airbus are very healthy, with unfilled orders of 7.423 aircraft. The two companies delivered 972 airplanes in 2010 and are expected to deliver more than 1,000 in 2011. With years of production on the order books, airline customers appear to see blue skies ahead as they will expand capacity by nearly 45% worldwide. The table below depicts the geographic breakdown of the current order books.

The Middle East, Latin America, and Asia-Pacific have exceptionally strong aircraft orders on the books. All three regions are aggressively expanding routes and quickly replacing existing fleets with more fuel-efficient aircraft. Still, we believe such rapid expansion into a declining demand environment will lead to lower profitability and potentially negative net income.

Stock Implications
Increasing capacity combined with faltering demand would lead to lower profits for many airline operators. We would generally avoid most airline stocks at this point as many of them are fairly valued. For example, LAN Airlines (NYSE:LFL) is a large operator based in Chile that would need a substantial pullback before piquing our interest. Copa Holdings (NYSE:CPA) is a fast-growth carrier operating out of Panama that has an outstanding track record. Still, weaker demand could put a dent into the stock.