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Analysts at loggerheads over six-month outlook for US aviation


The second quarter is coming to a close and airlines have signalled the double-digit growth in unit revenues they have experienced since last year is slowing. Even so, the second quarter is expected to be good for the US industry as is the third.

However, what happens after that depends on whether or not you think the economy is going to grow and judging from analysts and economists who have all been sharpening their pencils as the quarter closes, that is about as clear as mud. From early reports, it appears higher fares have grounded some economy passengers while business demand remains robust. It also looks as if Delta’s USD1 billion investment in its front-of-the-airplane products as well as its aggressive sales efforts in the corporate arena have paid off since its unit revenues are rising at a greater rate than its peers. American, on the other hand, is catching a lot of heat, so much so, analysts seem to be calling for new management.

Wither the economy

Maxim Group Analyst Ray Niedl suggests the economy is really slowing down. Economists are mixed in their predictions. In fact, they are all over the map. They point to the fact that consumer spending for May did not grow over April, the first time that has happened since the beginning of the recession.

Speaking to Yahoo Finance’s Breakout, Mr Niedl said that falling fuel, coupled with the fare increases imposed earlier this year should result in “earnings magic”, particularly for the smaller niche players with lower cost structures, such as Copa. “Copa is king,” he said citing its earnings growth of 20% despite the stubborn recessionary environment.

Copa Airlines Share Price

He also likes Spirit, although he called it a “bottom feeder,” offering extremely low fares and fees for everything from a carry-on bag to printing out a boarding pass at USD5. In fact, it is business models such as those at Spirit and Allegiant that will keep economy passengers flying, even if they are not flying legacies or LCCs.

Spirit net income, profit loss (system)

Seeking Alpha author Doug Short seems to agree with Mr Niedl on where the economy is going having reported that consumer confidence, which continued to drop in June, is at its lowest since last December owing to continued pessimism for the short term – that is, over the next six months. It should be higher, he said, when compared with other recessions at 25 months. Indeed, he likened it to the 1990/91 recession, saying confidence took 36 months to recover because, it too, was a jobless recovery.

But other economists are seeing pent-up demand increasing as the economy stumbled on fuel prices, weather and supply-chain problems. Others say that the consumer numbers are usually lagging indicators and confidence should pick-up in the next couple of months. Indeed, the drags on the economy – high oil, manufacturing delays from the Japanese earthquake, severe weather in the first and second quarters – are fading, ushering in spending to satisfy that pent-up demand. An Associated Press survey of economists says the uptick, however, will be modest but will include a second-half rebound benefitting from reconstruction after tornado and flood disasters.

Perhaps the best nugget came from Motley Fool author Morgan Housel who said: “Of the past 10 recessions, at least six have seen a major slowdown in the middle of what became an otherwise solid recovery.”

One can only hope he is right and consumers will resume normal spending despite the fact they can no longer leverage their homes to do so. In fact, credit has become much harder to come by for everyone, not a happy prospect given the fact that the economy has been fuelled by not much more than consumer credit since the 1980s. But, he also indicated 2011 is looking a lot like 2010 when the economy and stock market roared only to fizzle in the back half of the year.

Economists surveyed by AP disagreed calling the first half dismal because of weather, the Japanese disaster and high fuel prices, saying that the economy is due for a hefty increase in the back half.

Analysts are just as mixed as economists as some cite lower fuel costs for recommending airlines.

Investor updates

Fuel prices prompted JP Morgan analysts Jamie Baker to increase earnings estimates for the industry by 20% with an additional 30% next year. In a recent research note he suggested the lower fuel prices would yield USD3.5 billion in annualised benefits for the US industry. He is clearly bullish on the sector and criticised the financial community for not changing forecasts on declining fuel.

Delta, American, Hawaiian and United issued their respective investor updates this week pointing to the slowing revenue growth.

American reported unit revenues would only rise 4-5% in the second quarter year on year citing weather – hailstorms which cost it USD60 million in reduced revenue – for its forecast. It also cited the continuing impact from the Japanese earthquake. It also said that, despite fuel price moderation, it was paying USD3.13 per gallon compared with USD2.37 in 2Q2010.

Similarly, United said unit revenue was up 3-4% in June year on year and down significantly from the 14-15% experienced in May year on year. The company kept capacity at a 1% growth rate for the second quarter compared with the 0.8-1.8% it guided to in April. PRASM, it said, would be up between 8.3% and 9.3% for the second quarter.

Barclays Capital described United’s announcement as disappointing, adding that the softening economy will take its toll. It had expected June RASM at about 11% growth compared with the anaemic 8.3-9.3% United expects and cited the impact of the joint venture income reconciliation and frequent flyer adjustments.

“Our forward estimates reflect revenue deceleration on declining fuel and a recent softer economic climate,” said the company in a research note. “We now believe that deceleration developed earlier than expected, though recent feedback from DAL suggests less deceleration.”

Delta expects a solidly profitable second quarter with an operating margin between 6.5% to 7%, saying higher revenues have offset much of its USD1 billion higher fuel bill. It expects cargo and other revenues to finish the quarter at between USD1.2 billion and USD1.3 billion. Unlike its counterparts, it was expecting to be in double digits for unit revenue at about 10% with strong yields offsetting declining load factors. Fuel prices, it said, will be 3 cents higher than predicted at USD3.23 per gallon in the quarter and 91 cents more than in the year-ago period.

It reported that the Japanese earthquake continues to affect the carrier which took a USD125 million hit in the second quarter. Consolidated CASM ex fuel will come in having risen between 4.5-5.5% for the second quarter. In addition, it expects maintenance expense to be USD250 million lower for the second half compared with the first half. It is also taking out 70 of the 140 aircraft set to be removed from the fleet through 2012.

Its fuel price is expected to moderate further in the third quarter to USD3.03 per gallon although non-fuel unit costs will be higher than planned on increased maintenance costs coupled to lower capacity than plannedIn an effort to reduce costs it continues to forecast a 4% drop in capacity post-Labor Day with domestic down 1-3% and international down 4-6%. It is dramatically reducing trans-Atlantic capacity along with its SkyTeam partners between 7-9% with Delta dropping such capacity by 10-12%.

Hawaiian expects its metrics to be unchanged from guidance provided during its Q1 conference call. It said unit revenue is to rise between 3% and 6% during the second quarter to 11.28 cents, well ahead of its flat to up 3% CASM ex-fuel expense of 8.66 cents. Capacity will be up a whopping 20-22% on its Asian expansion taking advantage of Japanese and Korean tourism to the island state.

It is pegging fuel costs between USD3.30-3.35 per gallon on a 18-19% increase in fuel consumption, also on its Asian expansion. However, Dahlman Rose analyst Helane Becker indicated she is seeing a bottom in Asia Pacific traffic, according to this week’s research note. She thinks Hawaiian will benefit from the capacity cuts imposed by other carriers after the earthquake as traffic from Japan returns.

Dahlman Rose is predicting Hawaiian will break even in the second quarter.

American impatience

During the upcoming earnings calls expect more impatience with American Airlines to be expressed by analysts just as they do each quarter. Several analysts over the past year have broadly hinted at a need for new management and as the months have progressed it is clear they are no longer buying American’s line about its higher costs resulting from the fact it was the only carrier to avoid bankruptcy. They are also not buying that the rest of the legacy carriers’ labour costs will rise to meet American’s. That leaves its international joint businesses as the only hook on which to hang its future since it has indicated that, and its cornerstone strategy, would make the difference.

American Airlines share price

They criticise the carrier’s capacity planning. Avondale Analyst Bob McAdoo is among the company’s critics saying it would help a lot if American were to concentrate on bringing its losing markets at least to break even which, he suggested, would add USD1 billion in revenue annually. Failing that, the company should just shed these loser markets. He clearly is not a convert to its cornerstone strategy and questions its market decisions

“Its 10 worst markets lose USD450 million per year,” he said. "American's problems are clearly fixable, either by this management or by some other."

It should be noted USD450 million is about what it lost in the first quarter. It has lost money in nine of the last 10 quarters and hasn’t seen a profit since 2007. While its peers lost money, too, during the recession, they have managed to pull out and become profitable last year and are expected to be profitable this year.

American net income, profit, loss (system)

“Recent pronouncements raise questions about management's grasp of its situation,” he went on to write. “Far more important than silencing the pointed questions from analysts and investors, AMR needs to change the direction of the company. Waiting for the other airlines to sign generous labour contracts does not fix AMR. Hoping your competitor will take a particular action is not a strategy. Although labour costs per ASM are higher than at the other legacies, labor costs are not the big driver of American's weak results.”

Mr McAdoo cited such high-profile markets as New York-London, which brings into question its insistence on providing a shuttle service as part of its joint business with British Airways. The top 10 list of worst markets includes New York-California, said Mr McAdoo, along with Chicago international service to Delhi, Beijing, Shanghai as well as Miami-Buenos Aires. New York-Los Angeles loses USD70 million annually with 10 daily flights while USD54 million is lost annually on the five daily departures to San Francisco.

“Since 2000, when American had similar service levels, its average fares in these markets have dropped from USD397 to USD279 as its principal competitors have shifted from United and TWA to JetBlue and Virgin America,” said Mr McAdoo. “United has chopped capacity and maintained its fare levels, but American apparently prefers to maintain market dominance.”

The rest of US legacies have switched from a focus on market share to a focus on profitability, clearly something American has yet to do. American is also in the midst of fare wars with both JetBlue and Southwest.

He criticised the fact it rolls out far too much capacity in its markets limiting its ability to raise revenues on constrained capacity as its peers have already done. Mr McAdoo compared Chicago-Heathrow noting American has almost twice as many seats in the market as United, resulting in RASM of 8.7 cents to United’s 10.9 cents. He also noted that American undercuts its own non-stop London fares at Dallas and Los Angeles by routing passengers to the Chicago-Heathrow flight.

Mr Baker cited the drop in fuel prices has been good for American but he has been the company’s harshest critic during earnings calls almost pleading with management to indicate it has something else up its sleeve. Invariably, he is disappointed, and the last time he likened American’s actions to Einstein’s definition of insanity – continuing to do the same thing and expecting a different result.

Maxim’s Mr Niedl continues to have shaky faith in the company saying it has a strong brand. "But pretty quickly they're going to have to come up with new ideas, either this management or new management, on what to do."

Not so for Seeking Alpha’s Brian Nelson who analysed whether or not American’s equity is worthless.

“For AMR's equity to be worth anything, the firm would need to generate a discounted enterprise free cash flow stream (ie free cash flow to the firm) that amounts to more than USD41 per share (or about USD13.7 billion),” he wrote in a 19-May article.

However, given its free-cash flow record, Mr Nelson said, “if we value AMR's operating assets through a standard mid-cycle perpetuity function, we're looking at about USD6 billion to USD7 billion in value (assuming a very generous 10% discount rate, given AMR's risk profile) – not even close to the USD13.7 billion equity investors need to break even.”

He did outline a saving scenario for the company suggesting a permanent drop in fuel to perhaps USD70 and global economic growth to pre-Great Recession levels could result in AMR stock going to USD20 per share instead of about the USD5.60 as of yesterday. Mr Nelson said breaking out Eagle (something it has not been able to accomplish despite three years worth of effort) and its frequent flier program might mean higher valuations. Still he reiterated such actions does nothing to change the fundamental problems with the company.

“AMR's equity is not worth zero per share given the concept of option value,” he concluded. “But with a break-even, mid-cycle enterprise free cash flow number that's north of about USD1.4 billion (assuming very generous discount rates, given its competitive position and well-documented risks of the airline industry), AMR has some work to do to deliver any value to shareholders.”

And that just about sums up how its analysts feel.

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