Several airline stocks are rated as "Strong Buys" based on improving fundamentals and extremely low stock prices, suggests analyst Colin Scarola in CFRA Research's flagship newsletter, The Outlook.
Major airlines posted Q3 EPS well above consensus on average, despite this year's surge in fuel prices and high inflation biting consumer budgets.
2022 has brought a host of challenges to U.S. airlines, including average Q3 jet fuel prices up 80% vs. 2019 (U.S. Energy Information Administration), major shortages of flight and ground crew workers, and red-hot inflation hurting consumers.
Nonetheless, U.S. airlines generated material profits in Q3, and materially exceeded expectations in aggregate. Q3 adjusted EPS for the big four beat sell-side consensus by 16% on average, with no material misses. Robust air travel demand shows no signs of cooling in Q4, and CFRA sees further demand growth in 2023.
The conventional wisdom regarding airlines this year has been that demand would boom on pent-up demand for leisure trips during the first spring and summer without Covid-19 restrictions. But then drop sharply during the historically more business dependent fall and winter seasons, and with high inflation hurting consumers.
Instead, as it routinely has since the pandemic, airline demand is surprising pessimists to the upside, with the recovery in passenger volumes markedly improving in September and October, rather than worsening.
Further, the cash big four airlines were holding as of Q3-end for tickets sold but not yet serviced was up an impressive 47% vs. Q3 2019, supporting CFRA's view that demand will continue to grow and surpass 2019 levels during 2023.
We see strong average revenue growth of 13% for the big four airlines in 2023, with the key element of continued demand growth being the increasing prevalence of work-leisure trips for millions of workers that were formerly tethered to offices five days a week. These white-collar employees are increasingly traveling to destinations and working out of hotels or rental properties on weekdays.
This relatively newfound ability to spend workdays at a vacation destination without using vacation days is a major demand catalyst for travel. We expect this new type of demand will replace any permanent loss of traditional business travel in the post-pandemic era, which we expect to be minor.
In addition to the strong top-line trend in 2023, airline unit costs should materially improve as well, especially as headcount to fully restore 2019 capacity should be back in place by year end.
The big four airlines should also see material improvements in 2023 operating margin from large upticks in asset utilization. Given the robust and growing demand for air travel we see in 2023, we expect the big four to increase their 2023 seat-miles flown (capacity) by 13% in aggregate vs. 2022.
Importantly, given the still depressed level of 2022 capacity (estimated -7% Y/3Y in Q4), the large growth we forecast for next year will only bring 2023 capacity roughly in line with 2019 levels, meaning the asset base of planes and gates doesn't need to expand much. This full restoration to 2019 capacity hasn't been possible in 2022 due to labor shortfalls, but it will be in 2023.
In 2023, the airlines will be able to add back significant capacity without commensurate cost growth, as most of the capacity gain will come through improved asset utilization — more flights for each plane and gate they already own — and transitioning already employed trainees into active roles. This type of capacity expansion will materially lower unit costs next year, in our view, as many more seat-miles will be flown without much increase in headcount.
The airlines should also see much better absorption of fixed costs for airport gates, planes, and the large employee base for non-flight operations, like marketing and scheduling. Accordingly, we expect another material step-up in profitability for airlines next year as revenue growth should greatly outpace cost growth.
Now is an opportunistic time to invest in U.S. airline stocks. The big four airlines were all solidly profitable in Q3 and have major revenue and profitability improvements on the horizon in 2023-2024. Meanwhile, their market caps are down 55% in aggregate vs. pre-pandemic high water marks.
Current valuations, therefore, look extremely attractive to us, and we suspect these prices will look like no-brainers a year from now with the gift of hindsight. Hence, we have Strong Buy ratings on Delta Air Lines (DAL), Southwest Airlines (LUV), and United Airlines (UAL). We exclude American Airlines (AAL) from a Buy rating due to it being an outlier in terms of its over-indebtedness and low operating efficiency relative to peers, in our view.
