(ticker: AAL) was the worst-performing airline in 2018, with a 38% fall in hits share price. A weaker performance in terms of revenue versus its peers was the main reason the stock lagged behind.
Thursday morning, American’s woes continued. The airline cut its 2018 earnings forecast from a range with a midpoint of $4.75 per share, to $4.50 per share. Weak revenue was, again, the culprit. Fare growth in the fourth quarter came in about 1% below what American’s management had initially expected.
That update sent American Airline shares down 9% in morning trading, while the
Dow Jones Industrial Average
was off 0.3%.
This isn’t the first poorly received update from airlines this year.
Delta Air Lines
(DAL) plunged 8% after it updated its guidance on Jan. 3. Delta said it expects prices to rise 3% in the fourth quarter, rather than 3.5%. That might seem small, especially with oil prices plunging, but investors are very, very wary about the outlook for fares.
JP Morgan analyst Jamie Baker has a saying that RASM—an industry acronym for revenue per available seat mile—equals multiple. RASM depends on pricing, and Baker’s saying highlights that investors won’t pay up for airline stocks until the price of seats is rising.
Clearly, guidance cuts are never a good thing, but investors should remember that the oil-pricing environment was extremely challenging for airlines in the fourth quarter. Oil prices dropped 38%.
That level of volatility can make margins unpredictable. Jet fuel is one of the largest expense items for all airlines. At American, fuel expense has ranged from 15% to 25% of sales over the past few years.
Thursday, Baker actually increased his 2019 airline earnings estimates by an average of 18%. The problem is that his estimates are rising because of falling oil prices, not because of strong pricing.
Baker raised United Continental Holdings (UAL) to Overweight even though he worries that guidance from United could be disappointing, just as that from Delta and American was. Still, with a targeted valuation of only 7.5 times 2020 earnings, his price target for United stock is $95 per share, implying a gain of 13%.
Delta Air Lines (DAL) is scheduled to report earnings next week, the first airline to do so. Investors will carefully watch the guidance Delta offers on first-quarter pricing. Baker expects guidance for first-quarter RASM to call for an increase of between 1% and 2%.
That would be a deceleration from the fourth quarter and may spook investor further. But investors should focus on margins, rather than ticket prices. They have to remember that Delta’s revenue guidance will have to factor in the fact that the price of oil is expected to average $50 to $60 per barrel in 2019. Oil averaged $67 per barrel through the first three quarters of 2018.
Lower revenue guidance doesn’t have to mean worse earnings per share if costs are falling.
Now, Delta trades for only 7.2 times 2019 estimated earnings. American trades for 5.7 times. Those valuation multiples are low and at levels not seen since 2016, just after the last time oil prices crashed.
Airlines illustrate the dilemma of investing in a cyclical industry in a down market. How cheap is cheap enough? Pricing is decelerating and operating margins are down, but even with those problems, the margins seen in 2018 would have been strong ones for airlines in just about any other year before airline restructuring took place.
All the bankruptcies and combinations during the early part of the century dropped the number of legacy carriers from six to three. America and US Airways got together. Delta and Northwest combined. And United and Continental are now one.
Even with the improved operating performance and better industry structure, all airline stocks trade for less than 10 times
estimates for 2020 earnings. Airlines just can’t get any respect.
Sometimes, we feel like a broken clock, saying similar things, but only occasionally proving to be correct. With valuations depressed and oil stabilizing, airlines look attractive to Barron’s. We recommended Delta as one of our top picks for 2019 in December.
Investors just have trouble shaking the idea that airlines lose money in a downturn and eventually go bankrupt. But Delta’s 2019 margins are expected be 14%, and its current free-cash-flow yield is nearly 8%. If investors could ignore the fact that this is an airline, they might feel better about the operating performance.
Write to Al Root at email@example.com