Is It Time To Short This Industry Favorite?

A combination of capacity growth, higher fuel prices and worries about the health of the global economy have sent airline stocks skidding this year. The US Global Jets ETF (NYSE: JETS) is down 10% and many of the major carriers are down upwards of 20% since the beginning of the year.

Investors are now skittish about shares that have popped triple-digits over the last five years in an industry notorious for cyclicality and heavy competition. 

#-ad_banner-#Taking a closer look at the data reveals some broad differences in outlook among the individual names and an opportunity to profit from the current selloff. Capacity growth could moderate in some routes and oil may have topped out for the year. 

One heavy-weight is trading for nearly half the valuation of its peers and is taking advantage of the situation to buy up its shares. 

Diverging Outlooks For Regional Versus International Carriers
The Air Transport Bureau reported in May that available seats per kilometer, the industry metric for capacity, grew by an annualized 9.6% in February on a year-over-year basis. The increase was significant because it was the first time in more than a year that capacity growth had outstripped passenger traffic. Airlines were taking advantage of strong passenger demand and low fuel prices by significantly increase their number of flights. 

Combined with fears of higher fuel prices on the rebound in oil since mid-February, capacity growth has helped send the airlines into a tailspin. If capacity growth continues to outpace traffic, the carriers could get sucked into a price war from which nobody benefits.

But within the larger airline industry, the outlook may be diverging between regional carriers and their larger international rivals. Regional carriers like Southwest Airlines and JetBlue are continuing to expand capacity through 2016, while larger international carriers are planning on slowing capacity growth.

The four largest regional carriers by market cap have provided 2016 guidance to increase capacity by up to 11% on average. Capacity growth this year at the three largest international carriers is expected to be between 1.5% and 2.5% on average. This could support pricing for the international and transcontinental markets while regional pricing will remain more competitive.

Despite sluggish global economic growth, the airlines are recording very strong passenger traffic growth. Global passenger traffic increased 8.6% on a year-over-year basis in February, its second consecutive month of higher YoY gains. The North American market booked 9% growth in February and all six global regions reported growth of  7% or more. 

Oil prices seem to have stalled out around $50 a barrel on the second straight week of rising numbers of oil rigs, which threatens renewed production. The price of crude has nearly doubled since its February low, and $50 per barrel could be an important psychological barrier to stabilize production levels, holding prices for crude and jet fuel in stasis. 

Large international carriers will be biggest beneficiaries of dollar weakness when second quarter results are announced. The greenback fell throughout April and has recently given back gains made in May. Any further weakness in the dollar throughout the year could provide upside surprise as the larger airlines translate international profits.

Hedging Industry Risks With A Long-Short Strategy
A resurgent dollar, lackluster economic growth and competition all threaten a rebound for the industry. The effect of a stronger dollar could be offset by lower oil prices, but for airlines risks remain. A long-short strategy, which involved shorting shares of a relatively over-priced competitor while going long on a stock with strong fundamentals can help to lessen the risk to further industry weakness while still allowing for upside.

American Airlines (Nasdaq: AAL) has the youngest fleet of U.S. network airlines with an average age of 10 years, and should thus be able to benefit from lower capital spending over the next couple of years. Management cut its guidance for capacity growth during the Q1 release to just 3% this year. The company has continued to use fuel hedges to control costs while competitors may remain more exposed to rising fuel prices. 

American guided to a cost of $1.30 per gallon for 2016 fuel costs, below most other international carriers.  Earnings are expected at $5.65 per share this year, 38% lower compared to 2015 on an income tax adjustment, but the stock trades for just 5.9 times expected earnings. First quarter earnings beat expectations by 5% to $1.25 per share, and the board authorized a new $2 billion repurchase program through 2017, potentially reducing the share count by up to 10% over the next 18 months. 

Southwest Airlines (NYSE: LUV) expects to increase capacity by up to 6% this year, compared with capacity growth of between 8% to 15% of other regional carriers. This could mean a more competitive pricing environment for regional routes, especially if capacity growth continues to outpace passenger traffic. The company has not been as conservative with its fuel hedging strategy as have other carriers, choosing to leave prices unhedged. The increase in the price of oil has hit costs with management guiding to $1.75 per gallon in 2016 fuel costs. 

Analysts have reached a strong positive consensus of Southwest and valuations show it. Earnings are expected to jump 20% this year to $4.23 per share on just 6% in revenue growth. The company will need to see some significant cost cuts to meet expectations, something that may be difficult given marketing expenses needed in the competitive regional environment. Even on expectations, shares trade for 10-times full-year earnings, a hefty 70% premium to shares of American Airlines.

Risks To Consider: Airline stocks are relatively cyclical which leaves them at risk to further weakness in the economy.

Action To Take: Take a long position in larger carriers like American Airlines while hedging industry weakness with a short in relatively expensive Southwest.

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