Airline Stocks A Buy In 2016?

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2015 is likely to become the most profitable year ever for the US airline sector. Combined, the airlines are on track to book a record net income of $18 billion. A large part of the profit will be recorded in the last month of the year. Analysts are forecasting a record profit of slightly more than $ 4 billion. This is more than 40% higher than last year when US airlines booked a net income of $ 2.8 billion. Still, the sector had a sluggish year on the stock market. Just shortly before the Christmas period, the Dow Jones Airline Index was down 5% for the year. However, that’s still better than the Dow Jones Transportation Average which is down over 18% for 2015. Nevertheless, measured against the Dow Jones Index which lost a small 3% during the same period, the sector was a underperformer.

That’s all behind us and now we should asses what the future will bring us. One of the major factors that drives airline margins higher, are lower fuel costs. Currently the Gulf Coast jet fuel price stands slightly below $1.00 per gallon. This is a multi-year low, in fact even lower than during the financial crisis of 2008-2009. The last time jet fuel prices were below $1.00 per gallon was in 2004. Obviously a large part of the decline in jet fuel prices can be attributed to falling oil prices. The question is whether oil prices have seen the bottom. Furthermore, airlines tend to hedge their fuel price exposure. That means most of them are not able to benefit to the full extent of lower jet fuel prices. Nevertheless, analysts at Deutsche Bank estimate that in 2016 the sector will see an 11% decline in full expense. This is quite significant, since the total amount will drop from $30.2 billion to $27.0 billion. Reuters estimated earlier this year for European airline carriers that fuel accounts for 46% of Ryanair’s operating costs, 33% for British Airways and 21.5% for Lufthansa. The table below shows the impact of a rise in fuel costs on earnings per share (source: Deutsche Bank).

Next to fuel costs, US airlines have to cope with another cost issue: wages. Since the airline industry is relatively labor intensive, rising wage inflation is an important factor determining profitability. Deutsche Bank counted 40 union labor contracts that either open or are up against their amendable date in the first half year of 2016. Under normal conditions this wouldn’t be too much of an issue, but the problem is that the larger part of the contracts were signed when the industry was in a state of financial distress. New agreements will be much more demanding for the airlines. Next to that, with unemployment at low levels, risks for elevated wage inflation are feasible.

But which airline is the most promising? From a ratio-perspective, there are no real bargains to be identified. Most airlines have a somewhat comparable price/earnings-ratio of between 7-11, with the larger airlines a lower valuation. This is certainly not expensive and offers upward potential. That said, investors should realize that American Airlines (AAL) has a sizable exposure towards Latin America. Roughly 15% of its revenues comes from the LatAm region. With the current developments in Argentina and Brazil, this is something to track. Alaska Air (ALK) looks most expensive with a price/sales-ratio of 1.8 where other airlines are in the range of 0.8-1.1. American Airlines and United Continental Holdings (UAL) are somewhat cheaper at a p/s of 0.6. An interesting play is JetBlue, a growth airline. Nevertheless, fuel cost sensitivity could be a cause of concern if prices rise dramatically. But as a whole, the sector looks attractively valued to outperform the transport sector once again in 2016.

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