This latest earnings season has been, in our view, one of the most interesting ones that we have seen for some time because of the myriad of contradictory signals that corporations are sending. Investors have companies like Starbucks (SBUX) and Priceline (PCLN) beating estimates and saying good things about end market potential. And then investors have FedEx (FDX) saying a softening economy is crimping demand? Which camp is to be trusted? For some answers, we turn to a industry that, in many ways, is more defined by the economy than any other. And that industry is the airline industry.
Cyclicality: The Conventional Wisdom
Few sectors of the market are as unloved as the airline sector. Airlines are notorious for their capital intensity, cost uncertainty, and the idea that they are always at the mercy of global macroeconomic conditions. Conventional wisdom is that if the economy (both here and in the United States) is weak, airlines will feel the effect, for both corporations and leisure travelers will decrease their travel spending. And now that America's major airlines have reported their Q3 2012 results, we can examine their earnings commentary to see what they are saying about the state of business. Our review will cover 6 of the largest airlines in the United States:
- United Continental (UAL)
- Delta (DAL)
- Southwest (LUV)
- U.S. Airways (LCC)
- Alaska Airlines (ALK)
- Hawaiian Airlines (HA)
Collectively, these 10 airlines fly all across the United States, as well as most corners of the world. Their conference calls and operational results should yield insights into the state of the American and global economy, for if the conventional wisdom that airlines are fully exposed to macroeconomic stress holds, it should show up in their results.
United Continental has had a turbulent 2012, as its integration of Continental has been beset by setbacks and customer turmoil, though its issues have not been as extensive as those at American. And while Q3 was not as turbulent as Q2, there were still issues at United. For Q3 2012, United posted pro forma EPS of $1.35 on revenues of $9.909 billion, missing consensus estimates on both the top and bottom lines. EPS missed by 12 cents, while revenue missed by $60 million, dropping 2.6% from 2011 levels.
United posted strong results in the Pacific, with passenger revenues up 11%, outpacing the industry's gain of 9%. However, strength in the Pacific was more than offset by weakness in all other geographies. Atlantic revenues were down 8%, Latin American revenues down 6.8%, and American revenues were down 5.8%. On the company's Q3 earnings call, Chief Revenue Officer James Compton stated that,
We've been affected by the economic challenges in Europe, and the majority of our previously announced fourth quarter capacity reduction is to our European service. One of the most important benefits of our merger is our ability to reduce capacity in weaker markets like the Atlantic and take advantage of stronger markets like the Pacific, as economic conditions change around the world.
United is working to mitigate the stress in its European business, which makes up the majority of its Atlantic revenues (United, like Delta, breaks down revenues in this manner each quarter), by reducing capacity, while focusing on its stronger markets, especially the Pacific market.
United's results indicate that its European business is under pressure. But the company did not mention any other notable economic weakness, and said that its domestic operations continued to see pressure due to United specific issues. The company did not attempt to pin its underperformance in the United States on a weak economy, a refreshing level of candor.
For Delta, 2012 has been a continual of the company's core mission since 2009: deleveraging its balance sheet. Delta has a seeming obsession with paying down its debt, with more than $5 billion in debt retired since the end of 2009, including $247 million in Q3. Delta posted pro forma EPS of $0.90 on revenues of $9.923 billion, missing consensus EPS estimates by a penny, and revenue estimates by $50 million.
While Delta did miss estimates on both the top and bottom line, the company's management team was upbeat on its Q3 conference call, with good things to say about the state of business. Delta has been gaining share in corporate travel, and on its call, explained that it expects that share to remain, even if some of it was caused by operational issues at American Airlines. The company noted that the corporate travel market remains stable for the time being, and that it is not seeing worrisome trends emerging. Detla's Asian revenues (on a unit basis) were up 6% in the quarter, underperforming the industry. When pressed about what the source of this underperformance was, Delta's President, Ed Bastian replied that,
We got a lot of new capacity in from the over flights and the stage link was up substantially in the quarter. I think that would be the primary differential, and then there's also a lot of capacity in Japan. So as we move forward with ANA and Jal, we are the largest carrier to Japan so there is a lot of pressure with new frequencies to New York, new frequencies to Seattle, new frequencies to San Diego and San Jose offered by the Japanese carriers as they complete their restructuring..
Delta's revenue growth of 3% in Latin America represents a deceleration from prior quarters, and the company attributed that to capacity growth for the market as a whole, not a dropoff in travel demand. Both Lan and other South American airlines are expanding in that region, putting pressure on Delta and other carriers. Delta's comments regarding its performance in Europe were of particular interest. For Q3, Atlantic revenues were down 2%, but Atlantic unit revenue was up 3%. Given the macroeconomic stress in Europe, analysts pressured Delta's executives repeatedly on the state of its business there, given that Delta is one of the most internationally exposed airlines. In our view, the response of Glen Hauenstein, Delta's VP of Revenue Management, to these questions drove home a crucial point that all investors need to keep in mind: investing needs to be done based on fundamentals, not headlines. Hauenstein stated that,
I think again this is similar to a comment I made in last quarter, is the headlines don't match our results. And what we see through the winter months is actually some very positive signs in terms of European command, the market responds to the capacity discipline. So we're very optimistic as we run through what's historically the winter odysseys and the weak five months of the year and we're going to post very favorable improvement in unit revenues despite not only the economic headwinds but the headwinds of the currency on a year over year basis. So we've mitigated, it looks like we're going to mitigate both of those and the demand is actually moving both ways, so European multinationals who are having trouble doing business in Europe are actually coming to the U.S. to do business, and so there's lot of dynamics that are appealing in that I think.
Investors assume that as an airline, Delta's business will fall apart in Europe due to the macroeconomic stress that is occurring there. Yet that is not the case. Delta's international presence is proving to be a benefit in these times, as European corporations move to the United States to conduct business, and they are choosing Delta for their travel needs. The panic that is occurring over the economic situation in the markets has certainly had an effect on Delta's stock price. But the economic situation in Europe has not had a material effect on Delta's underlying business.
As a domestic airline, Southwest's results will surely give insight into what is going on in the American economy. After all, Southwest made its move outside the continental United States on November 1, announcing service to Puerto Rico. Southwest, more than any other airline, has historically been held up on a pedestal, owing to its consistent record of profitability. Southwest is the only Tier 1 airline (consisting of United, Delta, U.S. Airways, American, and Southwest) that has not filed for Chapter 11, and investors look to it as a relative beacon of stability in what has historically been a very volatile industry. However, Southwest's Q3 results and commentary belie that notion. For Q3 2012, Southwest posted pro forma EPS of $0.13 on revenues of $4.309 billion, mathcing consensus EPS forecasts and missing on revenues by $50 million.
Southwest's revenue for Q3 was essentially flat compared to Q3 2011, falling by 0.05%. While SOuthwest's revenues did not grow year over year, they did not deteriorate materially. In a way, this embodies much of what is going on in the domestic economy; we are not seeing a deterioration, but we are also not seeing meaningful improvements (some sectors, such as technology and healthcare are exceptions to this trend). Southwest's conference call commentary, however, was pessimistic, with the company taking a pessimistic stance about the state of the domestic economy. CEO Gary Kelly, responding to a question form Morgan Stanley regarding demand trends in this "GDP cycle" relative to other "sluggish environments," stated that,
I think really, this period since '08 is unlike anything we've ever seen. And the oil markets, it -- I mean, it's really the same story for the economy, for travel demand and for the oil markets. They're extremely volatile. And I think the bottom line answer to your question is I don't think we can be sure that September is just a blip. It -- September's performance [Southwest had a weak September, but a good October] is inconsistent with what we saw in June. On the other hand, we did have some interesting comps in July and August, but we were also off our plan in those 2 months a little bit as well. But I looked back at our earnings plan for the year again this morning, we were ahead of plan as of June. And now all of a sudden, 3 months later, we find ourselves pretty significantly behind plan for the year, so that's how fast things have turned on us and why it makes it really tough to predict from here. But we all know the political uncertainty. We all know the fiscal issues that the country faces and the debt, and the elections are upon us. And I don't think any of us can predict exactly where the economy is going to go from here. I think all the economic signals, as we see them, are very mixed. And as I look at our trends compared to everybody else, I don't see any difference in trends. So it's nothing unique to Southwest.
Southwest's commentary, given its perception as the airline with the most credibility on Wall Street, would seem to carry more weight. If Southwest, the airline industry's bellwether, is pessimistic about the domestic economy, then the domestic economy must be faring poorly. However, results from other airlines seem to contradict those results, as do Southwest's own passenger revenue statistics. Delta grew its domestic passenger revenues by 4% in Q3. And U.S. Airways grew its passenger revenues by 2.3% in Q3. Southwest's own passenger revenues grew by 0.297% in Q3. If the assumption that Southwest is the most competent airline holds true, then it should be outmatched in terms of revenue growth in such an economic environment. If U.S. Airways, the only Tier 1 airline to have the privilege of filing for bankruptcy not once, but twice can grow its passenger revenues by over 2% in this environment, shouldn't Southwest be able to do more? Southwest's results seem to go against what the rest of the industry is saying. To see whether or not Southwest's pessimism about the economy is warranted, we turn now to U.S. Airways.
For Q3 2012, U.S. Airways posted pro forma EPS of $0.98, beating consensus estimates by 6 cents on revenues of $3.533 billion, which met estimates. U.S. Airways' Q3 conference call contained several items of interest, even though the company began the call by explicitly stating that it could not talk about American Airlines or the possibility of a merger, even if that was what analysts really wanted to hear. Because of that, analysts channeled their questions toward the company's performance, which, for our purposes, set up an ideal situation.
U.S. Airways was pressed by Maxim Group as to what it can do to manage a downturn in the economy, given that the company is somewhat more constrained in its ability to reduce capacity (historically one of the few levers that airlines have in managing themselves in a weak demand environment) relative to its competitors. Scott Kirby, U.S. Airways' president, responded by saying that,
We have pretty limited flexibly to reduce capacity. We're near our minimums on both utilization and fleet size. And because of that, we don't have a lot of ability to dramatically reduce capacity. That said, while I think there would be an industry capacity response to a slowing economy, that would benefit us as well, even if we couldn't meaningfully reduce capacity. And I think this industry, this went to an earlier question about structuring and restructured industry, has demonstrated in the past few years in adverse macro situations, whether it was a weak economy or high fuel prices, that we've been able to respond as an industry. And US Airways is part of that industry and I think we do well. To your question, or I don't know if it was a question, but the comment about the economy for next year, while we don't have a necessarily a better crystal ball than anyone else, but we do see a strong leisure demand. And historically, that's been a pretty good indicator of where the economy is headed. It's more of a leading indicator when leisure demand starts to weaken, that's indicative of consumer spending, retail sales all starting to weaken as well. And leisure demand has held up quite strong for the past several months. So using our internal data, and would feel reasonably good about the economic outlook for the fourth quarter and into 2013.
Leisure travel has held up well in 2012, something confirmed by earnings reports from both Expedia (EXPE) and Priceline. Leisure travel is a discretionary item, and for many consumers, it is something possible only when they have a sense of economic security. If you are worried about losing your job soon, would you be spending money on a vacation? U.S. Airways, like Delta in its European business, isn't seeing the kind of weakness in its underlying performance here in the United States that headlines would suggest. U.S. Airways is confident about its outlook for Q4 and 2013, contradicting what Southwest has said on its earnings call. Furthermore, U.S. Airways is optimistic about the industry as a whole, with executives saying that they are seeing more rational decision making across the entire industry. Historically, the level of competition in the airline industry has damaged every company involved, as companies chased market share at the expense of profit and shareholder returns. President Scott Kirby stated that,
Just management teams that, while this is probably one of the most competitive industries in the world, are more rational and don't do things that are going to cause the airlines to lose money. You see that in capacity allocation decisions, pricing decisions and again this still is an incredibly competitive industry, still have margins well below what other industrial companies earn. But an industry that seems to have management, by and large, that's focused on shareholder returns. And I think some of that's been driven, frankly, by guys like you sitting on these calls and airline management teams getting beat up about shareholder returns and doing things to maximize shareholder returns as opposed to market share-driven metrics. And that message has gotten through to the industry and an industry that's focused on that. And because of that, it's [margins] outperforming what's happening with GDP.
Destructive competition benefits no one in this industry, and from U.S. Airways' vanatge point, there is an increased level of rationality in the industry, where profits and shareholder value are now bieng put above being the as large of an airline as possible, no matter the cost.
Alaska Airlines is an airline that is almost completely domestic (its international presence extends to Mexico and Canada, and for some, those markets are not truly considered to be international). The company's pro forma EPS for Q3 2012 came in at a record $2.09, beating estimates by a penny. Revenues of $1.2722 billion matched estimates, and grew by 6.2% in total. Passenger revenue itself grew by 6.9%, with the difference in growth rates being driven by a 1% drop in freight and mail revenue (that 1% drop is equal to just $300,000 in revenues).
Alaska flies mainly in the western united states, with California, Washington, and Oregon serving as its three largest markets, giving Alaska a relatively high level of insight into their economies. On its Q3 conference call, CFO Branden Pederson stated that,
We would once again characterize the demand environment as stable. Both leisure and business traffic seem to be holding up despite continuing concerns at the macro level. As we look to the fourth quarter, advanced booked load factors are up about 2.5 points for October, 1 point for November and December is currently down 0.5 point.
Alaska, like U.S. Airways, is not seeing weakness in its business as a result of macroeconomic stress. But, given that December advanced bookings were stated as being down 0.5% compared to 2011 levels, analysts were understandably nervous. Could this be a leading indicator of a weakening domestic economy? Andrew Harrison, Alaska's Vice President of Planning & Revenue Management, replied that the 0.5% drop in advance bookings does not dent Alaska's optimism regarding the fourth quarter. Harrison stated that,
As we look forward and look at -- October is up 2.5 November 1 and December down just a 0.5 point, that feels right to me personally. We have often seen further out, especially when you have a lot of holidays in the December period. The holidays are actually -- both Christmas and Thanksgiving, are all booking up solidly and normal. The one thing to also remember is our trip length is going to be up 4.3% also in the fourth quarter. But overall, other than as I shared earlier, recovering a little bit from, I'll just say, lack of understanding of the seasonality of Hawaii and California, so we're going to bring that in a little bit more. So I think some of these you'll see improve. But overall, we feel pretty solid about the fourth quarter.
We expect more color on December demand when Alaska releases its operational results for November in about a month, but we do not think that Alaska will display material weakness. Alaska Airlines has a management team that has led the industry in terms of being proactive in responding to changing industry conditions, and the company has launched a $250 million buyback (Alaska is one of the few airlines returning capital to shareholders), which represents about 9.1% of its outstanding shares, based on current prices. If Alaska was not confident about its potential and the state of demand, would it be sending cash out the door?
Hawaiian Airlines posted pro forma EPS of $0.77 for Q3 2012, beating esitmates by 9 cents on revenues of $549.322 million, which missed estimates by $4 million. Hawaiian is focused on the western U.S. market, as well as the Pacific market, and has only recently begun to expand to the east, with service between New York and Hawaii only since June 2012. Hawaiian has been focusing on the Pacific market for growth, with service to Japan, South Korea, Australia, New Zealand, and the Philippines.
Hawaiian, unlike the other 5 airlines that we have profiled, was not pressed by analysts regarding macroeconomic factors to the degree that its peers were pressed (perhaps Q3 2012 revenue growth of 20.5% and pro forma EPS growth of 30.5% were strong enough to quell concerns about the economy's impact on Hawaiian). However, the company did make a comment regarding its views on the economy. CEO Mark Dunkerly, while answering a question regarding excess cash and Hawaiian's plans for it, stated that,
We are clearly mindful that in an environment where people are talking, I mean headlines about macroeconomic news or very sort of uncertain, although we have seen none of that in our marketplaces. We wanted to make sure that in an event that there is a dip that we have really everybody has been expecting for the last four years come about that we have a cash cushion that means that we are in a stronger position in relative terms than our competitors.
Hawaiian, like most of its peers, is not seeing any material weakness in the economic picture, and its results serve as proof. Hawaiian is primarily a leisure airline, and as such its results are a decent gauge of overall demand for leisure travel, something that U.S. Airways has also said is holding steady. That assessment is confirmed by Hawaiian's results, for if there was material weakness in the economy, it should have showed up in Hawaiian's results.
Investing based on headlines alone is a surefire way to lose money, and we have never been believers that headlines or economic statistics can tell the full story of how an economy is doing. But the performance of an entire industry can. And in general, America's airlines have had good things to say about the state of their end markets. Southwest was a notable exception, but we believe that it is possible that the company is masking some deterioration in its competitive position by blaming the economy. Southwest has said that what it's seeing is not unique to it. However, results from Delta, U.S. Airways, Alaska, and Hawaiian beg to differ. And United was frank about the fact that its weakness was caused by operational missteps that it is working to mitigate. It is true that most airlines missed estimates for Q3. But, if the domestic and global macroeconomic picture was deteriorating materially, we would expect that the executives of these airlines would say so. But, as the conference calls of these 6 airlines have shown, most of them are positive on the state of demand for travel, which, in our view, implies that the macroeconomic picture, while certainly not where it should be, is not deteriorating.