This weekend, airline executives are probably having trouble suppressing their glee over the recent drop in oil prices. However, you wouldn't know it, based on the price action in airline stocks last week. Most major airline stocks dropped by 5-10% between Thursday and Friday. United Continental (NYSE:UAL) dropped by roughly 13% from its Wednesday close to its Friday close. The media blamed the selloff on Delta's (NYSE:DAL) announcement that it would be cutting capacity more than expected in the fall. This was particularly bizarre, given that Delta reasserted that demand for summer travel remains strong.
While the headlines out of Europe are obviously disturbing, the airlines are much better at matching capacity to demand today, relative to 2008 or 2009. In this vein, Delta's announcement should be comforting, in that it shows that the airlines are tweaking capacity proactively rather than waiting until they start losing money to cut back. United Continental made a similar move in March, cutting its full year capacity outlook by 100 basis points (with much of the decrease coming in the fall).
Furthermore, receding fuel prices provide significant leverage for airlines to offset weak demand. Jet fuel is the highest expense for virtually all airlines, and significant drops in the price of fuel can provide a substantial boost to profitability. Since the beginning of May, the spot price of jet fuel in New York has dropped by roughly 35 cents per gallon.
Considering that United and Delta each consume roughly 4 billion gallons of jet fuel per year, that implies an annualized savings of $1.4 billion for each of those carriers. Holding revenue constant, that could increase United's EPS by $3 and Delta's by nearly $1.50 (after profit sharing). Considering that many airlines trade at dirt cheap multiples today, this fuel price relief will likely boost airline share prices as the savings fall to the bottom line.
The purest play on the drop in fuel prices is US Airways (LCC). US Airways does not engage in fuel hedging, meaning that the full savings from lower jet fuel prices will immediately drop to its bottom line. By contrast, carriers that engage in hedging will find their fuel savings in the next few quarters partially offset by hedging losses. US Airways will also benefit disproportionately if fuel prices remain at current levels (or fall further) because the company survives on razor thin margins. The impact of lower fuel costs will have a disproportionate impact on its profit. (In other words, improving margins from 2% to 4% doubles profit, but improving from 8% to 10% only represents a 25% boost).
Another interesting play on lower oil prices is Allegiant Travel (NASDAQ:ALGT). Allegiant uses older jets (MD-80s and Boeing 757s) to lower its capital costs, even though these planes are much less fuel efficient than current models. While Allegiant has very high margins for the airline industry (unlike US Airways), the company will still see a significant benefit from lower oil prices. Additionally, the company has no exposure to Europe, and will benefit from its plan to add seats to its MD-80 jets (which will increase capacity at a minimal marginal cost).
Hawaiian Holdings (NASDAQ:HA) is another airline that will benefit from lower fuel prices, while having no exposure to Europe. The company has been expanding capacity relatively rapidly (approximately 15% per year), taking advantage of strong travel demand from East Asia to Hawaii. The increase in long-haul international flying has allowed Hawaiian to drive down its unit costs, while maintaining strong revenue performance. After a projected slowdown in PRASM growth due to the addition of two new markets in Q2 (Fukuoka and New York), the company is likely to see re-acceleration in PRASM growth in Q3 as these and other newer markets mature.
My top pick in the airline sector today is Hawaiian. It is a classic small cap value stock that has been flying under the radar for the past few years. After easily beating expectations in Q1, the drop in fuel prices this month has set the company up for earnings beats in the next few quarters as well. The stock has a very realistic chance to double in the next 12 months.
However, I think there are strong catalysts for the other stocks as well, so you really can't go wrong. My #2 pick is US Airways, as I think the combination of immediate fuel price relief, strong PRASM growth, and the potential for a merger with AMR Corporation (AAMRQ.PK) provides significant upside from current levels.
Additional disclosure: I may initiate a long position in LCC or DAL over the next 72 hours.