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Taking a Fresh Look at the Airlines

Although we've raised our estimates, the carriers still look fairly valued.

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Consolidation has driven roughly 80% of U.S. domestic market share into the hands of four major carriers, partially alleviating the excess supply issue that historically plagued the airline industry and improving margins. The emergence of loyalty programs also helped push margins to new heights. By switching loyalty programs from distance-based point systems to revenue-based systems, airlines structurally changed the economics of credit card partnerships and generated a windfall of income. Despite the success of credit card partnerships, we question whether the programs will continue producing robust growth. We’re also unsure if the improved core airline business can endure a full cycle and consistently generate returns above its cost of capital; our concerns are particularly pronounced for American and United, while we remain more bullish on Delta’s and Southwest’s passenger operations.

On the back of secular changes, all four carriers cleaned up their balance sheets and logged record profit margins during 2015. We don’t expect any of them will revert to the days of operating at a loss, but we also don’t expect operating margins will return to their 2015 peaks, when fuel prices collapsed and fares were elevated. Instead, we assume operating margins will expand through our normalized period after falling from 2017 to 2018, as carriers realize modest improvement in yields through constrained capacity growth and drive revenue growth through ancillary channels.

Fuel and labor account for about 50% of the U.S. major airlines’ operating expenses, and while our bearish forecast for $60 a barrel normalized Brent should help margins, we think structurally higher operating margins means unions will demand higher pay and pilot contract negotiations early next decade will probably result in healthy compensation increases. At the same time, loyalty programs won’t replicate the double-digit revenue growth from the past three years through our midcycle, but we do expect each carrier will rely increasingly on income from loyalty partnerships. We estimate loyalty program operating margins over 60% and believe these programs account for more than 30% of operating income at most airlines. We don’t foresee economics for these programs changing, but our weaker growth assumptions are based on carriers and their partners saturating cardholder markets.

Over the past 10 years, Delta has cleaned up its balance sheet, reached an investment-grade credit rating in 2015, and produced several years of returns above its cost of capital. The carrier has benefited from its lucrative loyalty program, Delta SkyMiles, logging estimated profit margins of 60% and growth over 12% annually after changing its point accrual system from distance-based to revenue-based in 2014. We think traces of the intangible moat source in its core airline business have now become visible thanks to consolidation. Delta benefits from high connectivity between hubs and regional airports, as well as dense regional connections along the Eastern Seaboard in particular. Delta expects to boost its advantage by converting a substantial portion of its small regional jets (50-seaters) and medium-size aircraft (MD-88s) to larger planes. The carrier expects small regional jets will decline to 2% of total aircraft in 2023 from 7% in 2017, and midsize aircraft will shrink from 35% of its fleet to 15% in 2023. We expect the benefits of rolling up markets into bigger planes will translate into higher margins and prove durable through our midcycle period, thanks to Delta’s unique network structure and dominance at Atlanta, which we don’t anticipate changing. Although we don’t award these airlines a moat, we believe improved core airline operations and lucrative loyalty programs will allow carriers like Delta to log profits through our 2022 midcycle year. We model operating margin expansion of 170 basis points from 2017 to 2022 for Delta. The shares are currently trading slightly below our $62 fair value estimate.

For years, Southwest has operated profitably because of its well-executed low-cost strategy, which includes a distinct company culture, short-haul flying, fleet commonality, and point-to-point flying between secondary airports. Recently, short-haul growth opportunities began drying up, pushing the airline to expand internationally and open long-haul domestic routes. The carrier is also pursuing more price-inelastic travelers who typically prefer network carriers. Southwest plans to bolster its presence in California in the immediate future by opening routes to Hawaii. We anticipate top-line growth will peak in 2019 thanks to the California capacity adds, coupled with the initiation of routes between California and Hawaii, beginning at the end of 2018 or in early 2019. Nonetheless, we think long-haul routes are likely to weigh on margins. Gradually turning away from a no-frills product and choosing to pursue travelers higher up the cost curve will inflate costs as Southwest adds amenities to lure travelers from legacy carriers. Although this strategy will generate higher revenue, we expect this growth won’t be margin-accretive. Although we’ve raised our fair value estimate, a risk-adjusted price/fair value ratio of 1.0 leaves Southwest shares fairly valued.

Of the four domestic carriers we cover, American had the most concerning balance sheet, with total debt/EBITDA of 3.7 times in 2017, a step above Delta’s 1.3 times and United’s 2.5 times. Because of this leverage, we assign American a very high uncertainty rating and expect a wider range of outcomes in our bull and bear cases. We believe American’s network optimization and growth initiatives are paramount for the success of its loyalty program and its ability to clean up its balance sheet. American expects over $4 billion in revenue and cost improvements through 2021. Because the carrier has already claimed many benefits from its premium and basic economy roll-out, we expect moderate gains from revenue initiatives going forward. We also anticipate American will benefit from deepening feed routes into its domestic hubs and cutting unprofitable routes like Chicago to Shanghai. The shares are currently trading just below our $44 fair value estimate.

United is devoted to expanding domestic capacity after years of dialing back growth for margin expansion. In shifting strategies, United aims to improve network breadth, increase daily flights to spokes from hubs, and take advantage of the benefits of upgauging. With this strategy, United expects to increase system capacity by 4%-5% a year over the next two and a half years. Moreover, United aims to catch up with Delta and American by offering nonstop service to more regional markets. While we anticipate United’s revenue growing at more than 5% on average through 2020, we expect this growth to weigh on profitability. We forecast an average operating margin slightly above 9% over 2018-20, about 60 basis points lower than the 9.7% operating margin United recorded in 2017. We believe capacity growth will adversely affect passenger yields, especially considering that lower oil prices will allow competitors to bid away attempts to increase fares. Further, as United enters more regional markets, it should naturally see improved unit revenue; however, this is limited by the carrier’s use of 50-seat jets. When tying these assumptions with our lower demand forecast, we expect operating margins will decline from 9.6% in 2019 to 8.1% in 2022. United is currently trading slightly above our fair value estimate.

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