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Airlines Looking More Attractive

We think investors are overlooking the solid air traffic growth forecast for 2017.

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In December, we cautioned that airline stocks across the major network carriers ( United (UAL),  American (AAL), and  Delta (DAL)) and  Southwest (LUV) looked fully valued to slightly overvalued. However, we thought investors might find a more attractive entry point as a result of fare headwinds in the first half of 2017 combined with higher costs. Our thesis has begun to play out: Airline stocks have sold off on the back of deteriorating unit revenue guidance and are now trading at an average price/fair value estimate of 0.96 compared with 1.09 in December.

Among the U.S. airlines we cover, United looks the most attractive from a valuation standpoint, followed by American and then Delta. We like United’s new management team and believe that the turnaround story at the Chicago-based carrier has not yet played out. The stock is trading at a 0.89 price/fair value. On the other hand, Southwest continues to look slightly overvalued at a price/fair value of 1.11. Investors seem to be ascribing a premium to Southwest based on its historical performance without recognizing fundamental changes in the carrier’s business model and in the business model used by its peers.

All the bad news over the past few weeks notwithstanding, we think air travel demand should remain firm over 2017, resulting in an improving outlook for the airlines. While the recent downward pressure on oil prices could exacerbate near-term fare weakness as airlines give away cost savings in the form of lower ticket prices, we think decreases in fuel prices should still be viewed as a positive over the mid- to long term. Corporate tax reform could also be another positive for the U.S. airlines--particularly after their net operating loss carryforwards burn off in 2018-19--due to limited overseas earnings and high effective tax rates. With these potential catalysts on the horizon and the sell-off underway, we think investors should give airline stocks another look.

Year to date, the major U.S. network airlines are down between 7% and 11% versus a gain of 3.9% for the S&P 500; only Southwest is up (by 5.8%). Airline stocks have struggled to keep pace with the market over most of 2017, but a sell-off began gathering steam March 3 as January traffic statistics came in and then accelerated following downward guidance revisions by several airlines. On March 8, Delta announced that unit revenue would be flat year over year in the first quarter of 2017 versus previous guidance of 0% to up 2%, and operating margins would come in around 10.5% versus previous midpoint guidance of 12%. Then on March 10, Southwest guided to a year-over-year decline in unit revenue for the first quarter compared with prior guidance in which management was hoping for flat unit revenue performance. United topped off the bad news, revealing 100- and 50-basis-point increases in domestic and international 2017 full-year capacity expansion guidance, respectively. Winter storm Stella’s arrival on the heels of this news didn’t help matters. Finally, the recent weakness in oil prices confirms our view that fuel prices will remain low for the airlines thanks to significant U.S. supply. While depressed oil prices contain growth in a major expense line item for the airlines, it may also augur further pressure on fares over the near term.

Despite all the negative momentum, we think investors are overlooking the solid air traffic growth forecast for 2017 and still-prudent capacity management by most U.S. airlines. In January, air traffic increased a relatively solid 3.4% year over year, and although United has raised its capacity guidance, other airlines are staying with their original capacity expansion plans. Barring any shocks, we think the current economic environment will support enough air traffic growth for a unit revenue recovery toward the back half of 2017, and over the midterm, lower fuel prices will keep a key expense down for the airlines, which have now largely eschewed fuel hedging.

Chris Higgins does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.