On January 3, 2019, Delta Air Lines (DAL) reported its operating performance for December, as well as updated commentary on the fourth quarter of 2018. This news sent the sector skydiving, with Delta, American (AAL), Spirit (SAVE), and Alaska (ALK) all down more than 5%.
From the beginning of October until the end of trading Thursday, airlines marginally outperformed the broader markets. While I wouldn't consider this much of a feat given the widespread losses, I do believe that airlines remain an investible industry at this juncture. I personally hold the belief that it is possible to profitably invest in the airline industry, though it requires timing, hedging and stock picking.
There are several macro-forces at play, but the most critical are the global economy and the eroding price of oil. Delta's Thursday update, despite the sharp reaction from equities, illustrate possible tailwinds for the industry as a whole in 2019.
The overall demand environment remains healthy with strength in both business and leisure segments throughout the quarter. While close-in yield momentum continues, the pace of improvement in late December was more modest than anticipated (Investor Update)
While we must be cautious and not immediately extrapolate Delta's guidance across the entire Airline industry, there are several important nuggets to digest. Firstly, demand remained strong. While this is positive, the warning regarding close-in yield (flights booked close to the flight date) is slightly worrisome. Does this mean that the Holiday period was weaker than expected? Not necessarily. But it almost certainly means that there is increased pricing pressure and competition among airlines.
Possibly contrary to one's intuition, close-in bookings are higher yielding than advanced bookings. These fares, often purchased for business travel, are commonly more expensive than those booked farther advance. Thus, slowing close-in yield momentum growth is a sign of lower revenues (and margins).
This problem may be limited to just Delta, or even to just business travelers. We do not know for certain without any further data, but any price war is terrible for airlines. When fuel prices decrease, investors believe that these savings will carry straight to the bottom line. However, this sometimes isn't the case: airlines often compete away any fuel savings. Additionally, the soft PRASM (or "TRASM") reported also lends to the idea of increased pricing pressure. Hence, these fears of increased price pressure may have wiped away any expected gains that might have been seen from savings in fuel expense (I will get to this later).
United States vs. Global Economy
Even if there is increased pricing pressure, didn't Delta report that demand remained strong? While this is true, decreasing margins is extremely troubling for the industry. The picture painted by the soft PRASM data as well as poor close-in yield momentum growth is exactly the opposite of what investors want. The question really is whether this is a global issue...
There are many concerns that the global economy is slowing down, from China weakness to political issues in Europe. While the data is showing a deceleration of growth internationally, US Consumer confidence remains near its decade-high and the US economy remains healthy.
Data reported by Delta is in line with these assumptions. RPM (Revenue Passenger Miles) for its domestic routes grew by 4.9% in 2018 compared to just 1.1% internationally, which showed losses in its Latin America and Pacific Routes. This domestic focus showcases the strength of the US Consumer and high demand (virtually all US Airlines are increasing this ASMs).
Other Global Concerns
I believe that the travel advisory to China also added to the airline sell-off. Anything that could possibly disrupt international tourism is an obvious headwind for airlines. This is the case for China in particular, which has the largest global outbound travel expenditures at $257.7b in 2017. This news especially impacts Delta as it made a $400m investment in China Eastern Airlines. I believe that carriers with a focus on the Americas are located in the most favorable operating environment.
Non-fuel unit costs are expected to be down approximately 0.5% year over year as cost control actions in addition to benefits from Delta’s fleet transformation and One Delta initiative are being realized... Fuel price per gallon is expected to be $2.38 - $2.43, approximately 10 cents below initial guidance. Timing of inventory purchases and the Monroe refinery maintenance turnaround offset a portion of the benefit from the decline in market fuel prices (Investor Update)
To me, this was the worst part of Delta's report. Delta is an interesting case given the company owns a refinery and hedge against increases in oil. This means that it was not able to reap the benefits of lower prices.
One big catalyst for 2019, in my opinion, is the low price of oil. However, many of the major airlines (Delta included) already purchased fuel reserves, and were not able to reap the full benefits just yet. What is concerning is the fact that Delta did not allude to any future benefit from the suppressed price of fuel. I believe that smaller carriers, especially those which are not hedged, will have the best flexibility and be able to reap the most benefits from cheap fuel.
I like domestically focussed, low debt, non-hedged airlines for 2019. There are a lot of global issues, rising interest rates, and airlines that are hedged will not benefit from the current decline in fuel prices. I believe that Hawaiian (HA), Alaska, Southwest (LUV), and JetBlue (JBLU) are all worth a look (though some do hedge). While this article is not designed to discuss airline valuations, it is clear that as a sector its valuation is severely depressed.
Author compiled data from research for JetBlue article. JBLU is highlighted and placed in the center given the fact that I do not believe it should be grouped with the LCC (left) or Legacy (right) carriers.
While it would be completely fair to argue that Delta's stock overreacted, and its shares are significantly undervalued, I am still cautious. If a global slowdown is coming and there is an increase in competitive pricing, all airlines will be susceptible.
With fuel benefits likely to come in 2019, I believe that airlines offer an interesting opportunity for investors. While riskier than many would admit, Delta provides a strong balance sheet and large profits at a cheap price for an industry leader. I believe that it is important to pick and choose your spots in the sector; I personally believe that there are better investments than Delta, though I can completely understand an investment in the company. As a whole, I believe that airline stocks overreacted to Delta's news as there is not enough data to support these bearish valuations. However, a strong stomach is necessary for the turbulent ride ahead.
Disclosure: I am/we are long JBLU. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Long JBLU, Short AAL