Tuesday, May 26, 2015

Cheap Oil Just Might End the Airline Profit Orgy

Low fuel prices tempt carriers to add seats. Are they asking for trouble?
Trudge aboard a packed plane with your pricey ticket and you can see why the industry is ecstatic. Brent crude remains around $65 a barrel, Americans are primed to travel, and the airlines’ earnings are sizzling.

What could possibly go wrong?

Amid the current profit bonanza, some investors and analysts are worried (or annoyed) that the industry is risking its longer-term profitability by flying too many seats in North America. In other words, they see backsliding after years of discipline and pledges by executives that a lost decade of red ink had taught them hard lessons about growth and market share grabs. 

Tempting the airlines to goose capacity: cheap oil. Jet fuel this year has cost them 31 percent less per gallon than in the same period in 2014, the Bureau of Transportation Statistics reported on Monday. Most of that savings has gone straight to profits; airlines haven't cut fares or eased fees. But are executives, giddy on the fumes, compromising future earnings with the buildup of capacity in the United States, one of their only consistently profitable markets? Expanded flying this year could yield an ugly hangover in 2016.

“To me, this is all the beginning of the unwinding of this great domestic market story of capacity constraint,” said George Ferguson, an airline analyst with Bloomberg Intelligence. “Management nature is to want more. The board always wants more. The CEO always wants more. ‘Go find me growth.’"

When times are good, there’s almost no cost to scheduling a few extra flights here and there. In the second half of the year, U.S. airlines will increase capacity by about 3 percent, led by JetBlue, Alaska, and Virgin America, even as the legacy carriers plan dramatic cuts in parts of Asia and Latin America, where a strong dollar and weak economies have dented profits on some routes. Domestic capacity is exceeding growth in U.S. gross domestic product for the first time in eight years, Wolfe Research reported last week in a client note bemoaning a lack of restraint.

This capacity creep, coupled with investors' fear that airlines may have hit the top of the current profit cycle, has left the Bloomberg U.S. Airline Stock Index down 3 percent so far in 2015. Shares of American, the world’s largest airline, have lost more than 8 percent, with United and Delta stock prices each declining more than 6 percent. “Lessons Unlearned,” read the top headline in a recent issue of the trade journal Airline Weekly. 

Not all the capacity growth comes from adding flights; airlines are swapping larger aircraft into some routes and adding seats to many jets. United is moving some Boeing 777 widebody planes from international service to fly on domestic routes from its hubs. And American President Scott Kirby has said the industry's effort to swap out smaller jets for larger and to add seats on planes is a one-off event that doesn't signal longer-term plans to boost capacity even further.

Airline profits will be robust again this year. U.S. carriers amassed more than $3 billion in the typically slow first quarter and will do even better this spring and summer. They should weather downturns better than ever. The industry has radically restructured itself into four large carriers, plus a half-dozen smaller carriers, and those permanent changes are expected to protect income during recessions. American Chief Executive Officer Doug Parker is now being paid only in stock, so confident is he that the good times will be silly good and the bad times won’t be so harsh.

But much of the airlines' current financial bonanza is due to years of keeping seat supply below customer demand, as measured by U.S. economic growth, helping to bolster fares and widen profit margins. Historically, demand for air travel grows at 1.1 times gross domestic product, says Raymond James analyst Savanthi Syth. Today, airlines are setting capacity growth at about 1.5 times GDP, she says, reversing a trend of many years toward keeping seat growth below demand. That strategy won't work forever. “What they did for the last four years is not sustainable. … You can’t continue to undersupply the market,” she says, because profit margins that grow fat inevitably inspire new competitors. “If there’s demand, then somebody is going to come in and fill it.” 

Syth points to Southwest, which expanded voraciously to all corners of the U.S. and now accounts for roughly 20 percent of U.S. capacity. Southwest stopped expanding for about two years as it integrated AirTran Airways, which it acquired in 2011. It is now firmly back in the growth business, with seat-miles (the industry's measure of capacity) rising almost 7 percent this year over last, and an additional 5 percent increase planned for 2016—most of it driven by the end of flight restrictions at Dallas Love Field, growth in New York and Washington, D.C., and the airline’s increase in international flying.

“Southwest is the wild card,” said Syth, who doesn't believe that the industry as a whole will oversupply the U.S. market. “Will Southwest pull back their plans and maybe park aircraft if supply seems to be outstripping demand?”

Southwest, whose fleet is nearing 700 jets, has "great opportunities that we have been investing in ... over the last five years, and now we want to take advantage of them," CEO Gary Kelly said last month, responding to questions about the company's capacity expansion this year and next. "The peak in the growth rate is here in 2015, and it begins to diminish next year, and then it diminishes, growth-rate-wise, again in 2017."  

Cheap fuel also tempts airlines to add seats and use planes more each day because increased flying lowers unit costs. Expensive items such as airplanes, ground equipment, and employees become more productive as they are put to more use. This math becomes even more appealing at a time of high demand, when fares are strong and it's all but free to expand “marginal flying” at off-peak times. Add it up and the profits start to look like cash flying out of an ATM machine.

“Airline executives probably saw an opportunity to make more money at higher margins than they ever dreamed of making, and they got complacent,” Wolfe Research analyst Hunter Keay wrote on May 8 in a note titled “Airline Bulls: Pray for Higher Oil Prices.” Keay is a longtime critic of airlines' use of GDP growth as a guide to capacity planning. As a result of the capacity growth this year, he wrote, “high oil is literally the only thing we can rely on to force airlines to behave in ways that make their stock prices go up over the longer term.”



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