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US airlines’ big test


Investors wonder whether airline revenue will remain stagnant as fuel costs rise.

Fuel prices have been ticking up and US airlines may be about to face a huge test of the durability of their strong profitability. The investment community has been notably skeptical that airlines can pass the test.

If fuel prices continue to rise, will US airlines’ profitability disappear? With US airlines’ unit revenue performance consistently down year-over-year and overall revenue flat, recent profitability has undeniably hinged on lower costs, which have hinged on lower fuel prices. Airlines for America (A4A) chief economist John Heimlich reported last week that mainline US airlines’ first-quarter operating revenue was flat year-over-year “as 6.7% lower fares offset 6.2% traffic growth.” He noted that airlines’ first-quarter operating expenses fell 1.5% year-over-year as lower fuel costs offset higher employee wages and benefits. In fact, Heimlich said, fuel was the only expense category that saw a year-over-year decline in the first quarter.

Crude per barrel oil prices are sitting at around $48, slightly down from earlier this month but way up from a low of $33 in January and generally trending up. Delta Air Lines last week preemptively lowered its second-half 2016 capacity growth, citing rising fuel prices.

US airlines have been frustrated by the lack of lift in their stock prices, believing the stock market is significantly undervaluing the industry. “The long-term prospects of the stock are not reflected in the near term,” American Airlines chairman and CEO Doug Parker said on the company’s first-quarter earnings conference call.

But investors look at the sluggish revenue environment and rising fuel prices and wonder: Will revenue rise along with fuel prices? Or will revenue remain stagnant as fuel costs rise, thereby unmasking the industry’s profitability as merely a function of low fuel prices?

American president Scott Kirby believes there is a strong correlation between fuel prices and revenue. Low fuel prices mean lower revenue, but he believes the opposite is also true. “You wind up with less capacity when oil prices go up and [ticket] prices go up,” he explained. (According to Heimlich, US airfares are at their lowest point in at least six years “whether you include ancillary fees or not.”)

So, if fuel prices go up, capacity will be kept in check, airfares will rise and so will revenue, right? “If you believe it, it’s an easy investment” to buy airline stock, Kirby said. “If you don’t, it’s not.”

Parker and Delta CEO Ed Bastian are insistent that the US airline industry has fundamentally changed. Sure, low fuel prices are a bonus, but the “new” post-consolidation, post-bankruptcy restructuring US airline industry is built to be profitable no matter what the circumstances, they believe.

Bastian has pointed out that per barrel oil prices averaged $55 in 2005, nearly identical to 2015’s $54 average. Yet the industry bled red ink in 2005 (Delta alone incurred $10 billion in combined net losses in 2005 and 2006).

“A lot of the [restructuring] work [US airlines have] done over the last several years is to allow them to be able to respond quickly to changes in fuel prices,” particularly by making “tweaks of [aircraft] delivery schedules and tweaks of … growth plans,” Heimlich said.

“If I were a short-term investor, I would be focused on tomorrow’s revenue,” Parker said. But Parker and his brethren at other US airlines say they are fanatically focused on the long view and believe investors in for the long haul will be handsomely rewarded.

US airlines love low fuel prices, but a rise in energy costs may actually be what they need to prove their durability to the stock market.

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