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Analysts optimistic about US airline industry

Analysis

In the wake of record-breaking third quarter results and strong 4Q indications, CRT Capital Group Michael Derchin and JP Morgan Analyst Jamie Baker are giving good marks to the prospects of the US airline industry in research notes. The most surprising item was Baker's approval of American Airlines, after taking AMR executives to task during the first quarter conference call when he expressed grave doubts about its corner-stone strategy and its estimates for the joint business over the Atlantic. Indeed, he bluntly asked AMR Chair Gerard Arpey whether that was all he had. Arpey's response was patient but determined.

Summary
  • Analysts are optimistic about the prospects of the US airline industry based on strong third-quarter results and positive indications for the fourth quarter.
  • American Airlines, previously criticized by analysts, is now seen as a top equity pick due to expected improvements in labor costs and trans-Atlantic relationships.
  • The industry is expected to close the labor cost gap, starting with United and then US Airways.
  • American Airlines' stock rose after Standard & Poor's raised its credit outlook, citing improved operating performance.
  • Analysts predict that American Airlines will turn a significant margin corner in 2011, with potential equity upside exceeding other US airlines.
  • Overall, the industry is expected to post higher profits in the fourth quarter, driven by strong advanced bookings, pricing power, and lower unit-cost escalation.

See related report: American Airlines widens net loss to half billion

Baker, who called American its top US Airline equity pick, recently said that he saw AMR's headwinds - higher labour costs which is estimated to cost it USD600 million annually and being last to immunise relationships across the trans-Atlantic - as turning into tailwinds. Baker pointed to AMR's argument that the industry will ultimately close the labour gap, saying it would come first from United and then from US Airways.

AMR's stock rose after Standard & Poor's, citing improve operating performance, raised its credit outlook

"AMR's recently immunised alliance partners should drive RASM momentum in 2011," he said. "And 10% Latin supply growth is moderating while Pacific supply is worsening, suggesting RASM relief for AMR and pressure for DAL/UAL. We expect AMR to turn a significant margin corner in 2011, as alliance immunity, rising industry labor costs, and a shifting Latin/Pacific supply dynamic reverse its multiyear relative margin decline. Based on our theoretical analysis, if AMR relative margins can perform in line with the industry from here, upside equity potential is expected to exceed that of all other US names we cover. If relative margins can narrow their gap to the industry, potential equity upside is still great."

Baker retained his disappointment in the fact that American is not more aggressive, he concluded: "In our view, that doesn't stop us from identifying where potential equity upside is greatest. We think we've found it."

Derchin agreed pointing to higher total industry profits in 4Q2010 and raising 2011 estimates for AMR along with Southwest, Delta and JetBlue. However, he dropped estimates for AirTran, Alaska and US Airways, adding Southwest would be down a penny in 4Q. Delta is expected to increase profits by 21 cents, he said, adding JetBlue would jump by 5 cents per share. He is also expecting profits for United Continental Holdings but did not expect American to make a profit in 4Q2010.

Derchin, who indicated the industry would post net profits of USD269 million in 4Q2010, more than double his previous estimate, cited the stronger than expected 3Q earnings and evidence that 4Q revenue growth was ahead of expectations. He cited strong advanced bookings and pricing power during the holiday periods. Derchin also pointed to the significant deleveraging of balance sheets and lower unit-cost escalation.

He told the Dallas Morning News, "Despite higher oil prices and slowing PRASM [passenger unit revenue] growth, we are forecasting net income to rise 60% to USD6.5 billion in 2011 from USD4 billion in 2010," Derchin concluded, adding if profit projections were right, it would be the first 4Q profit in a decade.

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