Are Airlines Securities Set To Soar?

In the first seven months of 2015, the S&P 1500 Airline index declined 11%, as we think investors
focus on capacity additions with a worrying eye. However, S&P Capital IQ thinks that airline execs have learned from past costly mistakes on adding too much capacity and forecasts 2015 as a record profitability year, driven by revenue growth and the benefits of lower oil prices.

According to Jim Corridore, an S&P Capital IQ equity analyst, years of consolidation, bankruptcies, and capacity adjustments have given the airlines increased pricing power, which has led to rising industry revenues and passenger yields over the past five years. Fare increases, fewer fare sales and an increased mix of business travelers (who tend to pay more for tickets) contributed to industry revenue growth. Average fares have risen sharply over the past five years and passenger load factors (a measure of how full, on average, flights are) are at record levels for the industry. In 2014, the load factor was 83.4%, up from 83.1% and 82.8% in 2013 and 2014, respectively.

Meanwhile, much to the displeasure of passengers, airlines have been adding and increasing these fees in an effort to shift their customers toward an "unbundled" strategy of paying a base fare for air travel plus additional fees for whatever "extras" the customer may require, like a checked bag or a hot meal. Bag fees and reservation change fees alone accounted for $4.6 billion in revenues in 2014, up from $3.5 billion in 2012, according to statistics from the Bureau of Transportation Statistics. 

From a cost perspective, the U.S. airlines industry consumes about 19-20 billion gallons of jet fuel a year, according to Corridore, so lower oil prices can drive significantly lower costs. For many years, jet fuel has been the largest cost category for most U.S. airlines, eating up about a third of the industry's revenues. Oil prices were recently around $50 a barrel, down nearly 50% from a year earlier. 

Over the past five years enterprise value (EV) to EBITDA has ranged from 4X to 10.5X EBITDA, on average, with the low in 2012 and the high in 2009. Airline stocks are currently trading at an EV/EBITDA of about 8X. Corridore believes a number of airline stocks are undervalued and has improving profitability. S&P Capital IQ has Strong Buys recommendations on Delta Airlines (DAL), JetBlue (JBLU) and American Airlines (AAL 42).

In April 2015, US JETS (JETS) launched providing investors with diversified way to gain exposure to the improving fundamentals of the airline industry. AAL, DAL and JBLU are all top-10 holdings, though the ETF also has some aerospace & defense exposure.

Airline stocks such as DAL and AAL are represented in more diversified industrial sector ETFs such as Industrials Select Sector SPDR (XLI). At a 4.7% weighting, airlines are surrounded by aerospace & defense (27%), industrial conglomerates (19%) and machinery (16%) companies. JETS has a 0.60% expense ratio above the 0.15% of XLI.

S&P Capital IQ operates independently from S&P Dow Jones Indices.

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