As the Dow Jones US Airline Index has declined almost 10% this past week, airline stocks can be bought on dips – assuming investors believe that the US economy is improving
It is only befitting that the stocks that rallied the most when the stock markets were up were the ones that moved down the most when stock markets declined. The Dow Jones US Airline Index (DJUSAR) was the best performing index last year, recording an increasing of more than 86%, and so far into 2014, it is up over 32%. In comparison, the S&P 500 Index (SPX) is up less than 5% year-to-date.
Over the past week, the airline index has dipped nearly 10%, while the S&P 500 declined close to 1%. We try to understand why airline stocks have fallen more than the broader market has, and evaluate if this represents an opportunity to buy airline stocks on dips.
What Caused The Sharp Decline In Airline Stocks
To understand why airlines stocks are down as much as 9% over the last week, we need to take a look at some fundamentals and attempt to uncover investors’ sentiments. Airlines are one of the primary beneficiaries of economic growth, as leisure and business travel tend to pick up pace. Airlines stocks soared last year as nearly 2.7 billion passengers flew around the world, and the airline industry’s profitability went up to almost $13 billion.
Now that US stock markets are on a downward trend, airlines’ stock prices are falling. The recent decline in airline stocks can be attributed to some geopolitical events, and soft economic data coming out of the US. While the crisis in Ukraine did not result in much activity in global markets, recent developments in Iraq have significantly affected the price of crude. Iraq is the second-largest producer of oil among OPEC nations, trailing only Saudi Arabia. The latest figures put Iraq’s oil production at 3.2 million barrels per day, with exports of close to 2.5 million barrels per day.
Uncertainties and political mayhem in Iraq has caused crude prices to rise in the past week, as security conditions worsen in the war-torn country. The front month price of crude is more than 4% higher – the largest increase since July 2013. And with Brent crude prices rising, we can expect jet fuel prices to follow suit. Over the last four quarters, the spread between jet fuel and Brent crude prices has averaged around $0.40.
While a rise in fuel prices can potentially cut into airlines’ profitability margins, airlines have historically been able to pass on rising fuel costs to passengers. In the short term though, investors’ sentiments could sour, sending airlines’ stock prices lower, as seen recently.
Apart from rising expenses due to appreciating fuel prices, economic indicators coming out of the US are also causing investors to rethink their outlook on the country’s growth potential. While unemployment levels have been steadily declining, an increasing number of experts are worried over the uneven growth between full-time and part-time employment. There is also a concern that the types of jobs being created are at the low-end of the pay-scale.
The latest initial jobless claims data (released yesterday) showed an unexpected rise in new claims, while the retail sales report missed expectations for the second month in a row. An increasing number of analysts and money managers have now adopted a cautious rhetoric on the market, as new data failed to uplift confidence levels.
Valuation of Airline Stocks
Delta Air Lines Inc. (DAL) was the best performing stock among peers last year, soaring in value by nearly 125%. Even though Delta’s revenues increased only 3% year-over-year in 2013, its bottom line improved over 70%, as the company was able to generate higher ancillary revenues while reducing costs. The stock is down over 7% this past week, after shedding nearly 5.5% during yesterday’s session to become the top loser for the day on the S&P 500.
The only airline stock that is down more than Delta in the past week is United Continental Holdings Inc. (UAL), which has fallen nearly 10%. The significant declines for both Delta and United Continental are not surprising, since the companies have betas of 1.45 and 1.55, respectively, which are higher than the average of the industry’s beta of 1.05.
Based on the 2014 forward price-to-earnings multiple, Delta’s stock is currently trading at a 22.7% discount to the S&P 500, and a 7.5% discount to the industry’s average. Similarly, United Continental and American Airlines Group Inc. (AAL) are respectively trading at discounts of 32% and 53% to the broader market, and at discounts of 18.5% and 44% to the industry’s average.
We had identified Delta as the best airline play in October last year. Since then, the stock has risen over 50% and we continue to be bullish on the company.
If we believe that the overall softening in the US economy and the worsening security conditions in Iraq will cause oil prices to rise further, we will re-evaluate our stance on the airline industry. Based on the current prospects of the industry for the year and present airline stock valuations, we continue to have a positive outlook on the industry in general, and on Delta Air Lines in particular.
You can also read Bidness Etc's financial analysis on airlines such as Delta Air Lines.
Do you agree with our analysis? Let us know your views in the comments section below, and our analyst will reply to you shortly.
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