Why high-flying airline stocks have hit an air pocket

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Airline executives took a pummeling from a Capitol Hill panel on Tuesday, as lawmakers lambasted them for too often making flying an ordeal. “We’re sick of it,” one congressman thundered. Passenger anger is among the reasons that once-climbing airline stocks have flattened out or dropped lately. 

For years, when they were losing money, airline shares had a sign around their neck: “Investor beware.” But nowadays, the sector is making money, so its shares began gaining altitude — until early 2017, when their ascent halted. Videos of a bloody-faced passenger being hauled off a United Airlines flight on April 9 crystallized long-festering customer dissatisfaction and have helped sour investors on the industry. 

Passenger unhappiness, along with so-so earnings due to expensive labor pacts and fuel cost increases, plus overcapacity, are to blame for creating the air pocket, causing some investors to rethink their euphoria over the industry. Despite improvements in profitability, many mutual fund managers still “don’t think it’s a good business,” said Craig Hodges, CEO of Hodges Capital Management, which sponsors funds. 

Look at the exchange-traded fund that tracks the air carriers, US Global Jets (JETS). After a healthy run-up of almost 20 percent in 2016, it  began to flatten out and peaked in late February. Since then it has slipped 0.6 percent. 

From their winter highs, the two largest domestic carriers, No. 1 American Airlines (AAL) and No. 2 Delta Air Lines (DAL) are down by double digits, 13 percent and 7 percent, respectively. The next two major airlines, United Continental Holdings (UAL) and Southwest Airlines (LUV) are off 3 percent and 2 percent, respectively. “Positivity is declining,” said analyst James Corridore at research firm CFRA.

Of course, these travails were nothing like what the industry encountered in the past. Before airlines were deregulated in 1978, prices were set at a high level, and air travel was civilized. Then came a chaotic explosion of low-cost carriers like People Express and fares plummeted. So did the fortunes of many of the upstarts and also the legacy airlines like Eastern Airlines. 

But then there was a consolidation: Numerous competitors vanished from the skies and landed in bankruptcy court. The seven majors left in 2000 shrank to four by 2015, owing to a spate of mergers. What also shrank were passenger services like free food and checked bags. Nevertheless, the sector began running regular profits.

So enticing were the prospects for air travel that Warren Buffett, who previously had disdained airlines, began buying their stocks two years ago. The legendary investor’s holding company, Berkshire Hathaway (BRK.A), now holds positions in all four of the industry leaders. “Buffett was the proof” to investors that airlines were fitting investments, money manager Hodges said. 

Despite their bull run, airline stocks have never been able to shake the underlying doubts among a part of Wall Street that Hodges pointed to. Their price-earnings ratios, which gauge stocks’ affordability, are below-market. Among the majors, p-e’s run from Delta’s 9.3 to Southwest’s 17.5. The broad-market S&P 500’s p-e is 24.2.

Fueling that skepticism of late:

Passenger animosity. At the U.S. House Transportation Committee hearing on Tuesday, Chairman Bill Shuster (R-Pennsylvania) warned airline executives that “something is broken” in industry customer service and that they had better “seize the opportunity” to fix it. Otherwise, he said, Congress might clamp down on them and “you’re not going to like it.”  

The United incident, where the passenger was dragged off the flight after refusing to surrender his seat to an airline employee, caused a public uproar — and became a perfect symbol of the discomfort and the indignities that many passengers grouse about. 

At the hearing, United CEO Oscar Munoz apologized for the violent treatment that customer David Dao suffered — he has reached an undisclosed legal settlement with the company. And Munoz outlined a series of steps the airline has taken to avoid a repeat, such as drastically increasing the payment it will offer to bump a passenger, up to $10,000. 

Plus, as Munoz and other industry executives argue, the industry has improved service in several key areas. Involuntary bumping and mishandled baggage reports were down last year, for instance. 

Fine, but the list of customer woes remains long. The proliferation of fees has spread like a storm front — for seat selection, for checked baggage, on and on. House Committee Chairman Shuster chided Munoz for United’ collecting $800 million in fees to change flights. “That’s a lot of money,” he said.

Another committee member, Rep. Michael Capuano, D-Massachusetts,, recalled blighted playgrounds in his youth that worn-down citizens had learned to accept. By the same token, he said, air travelers have succumbed to “lowered expectations.” American got into trouble recently when a flight attendant was accused of hitting a mother and the child she was carrying with a stroller. 

Indeed, consumers rate airlines as one of their least-liked industries, a recent survey from the American Customer Satisfaction Index found.   

Overcapacity. A lot of passenger peevishness stems from crowding. The total number of domestic passengers topped 700 million last year, an almost 20 percent increase since the end of the Great Recession. Airlines, especially the majors, like to squeeze as many people as they can onto their aircraft. 

Cabins have been reconfigured to fit in more seats, shrinking legroom by three inches in recent years, as measured by the Atmosphere Research Group, a travel industry consulting firm. Most planes are flying nearly full, averaging 84 percent of capacity last year. 

Overbooking is one strategy that the industry has adopted to ensure that planes are as full as possible. The airlines view this practice as buffering themselves from trip cancellations and transfers to other flights as people change their plans. And they argue that this practice has helped keep down fares.

What that translates to is that, in aggregate, the airlines’ capacity additions too often have outpaced the number of fliers, even though that doesn’t seem to be the case when you’re jammed into a plane like a herd animal. “There’s more capacity than the market demands,” said consultant Bob Mann of R.W. Mann in Port Washington, New York. “They can fit more people in the same tubes.” 

Blah earnings. Profit margins are on the downswing among many airlines, at least for the moment. At United, for instance, the margin slid to 2.3 percent in the first quarter, versus 8.4 percent in the year-before period. For all four of the majors, first-quarter earnings all had slides ranging from Delta’s 30 percent to United’s 70 percent.

One factor is falling fares: Thanks to competition from low-cost rivals, especially on transatlantic routes from the likes of  Icelandair, fares have tumbled 17 percent in constant dollars over the past two decades, and last year alone they plunged 8.5 percent. 

Another factor is that fuel costs have escalated, with crude oil rebounding to around $50 per barrel lately from below $30 a year ago. Granted, that $30 level was abnormally low, so the bounce-back was enough to jack up United’s fuel costs 28 percent last quarter. 

Then there are labor costs, which are escalating after the red-ink years when carriers endured trips through bankruptcy court and airline unions had to make concessions. Last year, Delta and United forged new labor pacts that pumped up their crews’ incomes considerably. Delta inked a four-year contract with its pilots that gave them a 30 percent raise, while flight attendants signed a five-year deal that increased wages from 18 percent to 31 percent, depending on seniority. 

That posed a quandary for American, whose contracts don’t come up until the end of 2019, which meant savings in the interim but a lot of worker discontent. So to keep employees happy, the company agreed to an interim 8 percent increase for pilots and 5 percent for flight attendants. When that came to light with American’s earnings release on April 27, the carrier’s stock fell more than 5 percent. 

What’s the outlook for airlines stocks? Most likely, an eventual recovery, assuming no economic downturns, which always suppresses air travel and industry performance. Growing capacity and expected better profit margins by year-end means “stock prices could follow,” said Helane Becker, an analyst at investment firm Cowan and Co.

That still leaves customer dissatisfaction as a drag on the stocks. As Rep. Duncan Hunter, R-California, asked the airline executives at the hearing: “How much do you hate the American people?”  

Source: CBS News – Moneywatch

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