Why Did US Airlines Deliver Record Profits in the Seasonally Weak First Quarter?

The year 2015 began on an optimistic note for the US airline industry as the major airlines – American Airlines (NASDAQ: AAL), United Continental Holdings (NYSE: UAL), Delta Air Lines (NYSE: DAL), Alaska Air Group (NYSE: ALK), Southwest Airlines (NYSE: LUV), and JetBlue Airways (NASDAQ: JBLU) – posted consolidated net income of over $3 billion during the first quarter. The performance was particularly striking as the first quarter has traditionally been the weakest quarter for the industry due to seasonal fluctuations. The major reason behind the sudden surge in the industry’s profitability was the plummeting crude oil prices over the last nine months. Other factors that influenced the industry’s performance included capacity restraint and the strengthening of the US dollar against other currencies.

Most of the airlines either matched or exceeded the consensus earnings estimate for the March quarter. Delta initiated the earning season with its remarkable profits of $746 million in the quarter – almost thrice the profit earned a year ago – making it the best first quarter for the airline. American, the world’s largest airline in terms of traffic, posted whopping profits of $932 million on the back of fuel cost savings of $1.2 billion during the quarter.  United earned a profit of $508 million in the latest quarter – beating the consensus estimate by more than $0.08 per share – an improvement of $1 billion over the loss of $609 million incurred in the same quarter last year.

In this article, we will discuss the reasons that led to a record first quarter for most of the US airlines.

See our complete analysis for American Airlines here

Depressed Crude Oil Prices Lead To Lower Fuel Costs

Global crude oil prices have plummeted by over 50% over the last nine months on the back of weak global demand, lead by the slow growth in the Chinese economy, and surplus oil production due to the rising tight oil production in the US.  This has accelerated the bottom line of all major US airlines, as jet fuel costs constitute nearly a third of an airline’s total operating expense. On average, the fuel costs dropped by over 30% during the quarter for most of the US airlines, except Delta, which suffered hedging losses of about $1.1 billion due to mark-to-marketing of its hedging positions. American Airlines reported a decline of 43% in its fuel costs as the airline’s decision to adopt US Airways’ policy of no-hedging enabled it to convert the fall in oil prices into fuel cost savings of $1.2 billion during the latest quarter. United’s fuel expenses dropped by 36% leading to cost savings of over $1 billion in the three-month period. Southwest’s average fuel price stood at $2 per gallon, compared to $3.08 per gallon a year ago. If oil prices continue to remain at the current levels, 2015 could turn out to be one of the most rewarding years for the US airline industry.

See our complete analysis for United Continental Holdings here

Rapid Capacity Additions Benefit Low-Cost Carriers, Legacy Carriers Continue To Adopt Capacity Restraint

The consolidation of the US airline industry through the recent mergers, along with the capacity restraint followed by legacy carriers, has lifted the industry out of its heavy losses over the last couple of years. Consequently, the large carriers have continued to add flying capacity with caution. During the quarter, American reduced its capacity by almost 1%, while United’s capacity remained flat during the quarter. Despite being a large network carrier, Delta, however, expanded its capacity by 5% in the first quarter in its quest to establish an international hub at Seattle.

Contrary to large carriers, smaller airlines and low-cost carriers aggressively added capacity during the quarter. The Seattle-based airline, Alaska Air, grew its capacity by 11% on a year-on-year basis, the highest rate of capacity expansion in the industry for the quarter. This was followed by low-cost carriers, JetBlue and Southwest that recorded a capacity growth of 9.6% and 6%, respectively. The rapid capacity increase by these airlines led to a surplus of seats in the market, creating a pricing pressure for the large network carriers. As a result, the passenger unit revenue (amount collected from each passenger per seat for a mile) of most airlines experienced a gradual decline. The only exception to this downward trend was New York-based JetBlue, as it witnessed a 4.5% increase in its unit revenue and 1.2% improvement in its load factor on the back of rapid capacity expansion during the quarter.

Despite a fall in the unit revenue, most of the airlines managed to post an improvement in their passenger traffic during the first quarter. This implies that the demand for air travel remained strong throughout the quarter, translating into better-than-expected top-line growth for the industry. JetBlue outpaced the industry by reporting the highest revenue growth of 13% on a year-on-year basis. Delta delivered revenue of $9.39 billion, representing a top-line growth of 5.3% on the back of passenger growth of 3.6% during the quarter. The Texas-based American Airlines recorded first quarter revenue of $9.83 billion, a decline of 1.7% versus the analyst estimate of a 4% drop.

While the air travel demand is expected to remain strong for the full year, American, United, and Delta, that together control more than half of the total domestic capacity, have decided to add capacity with restraint to bypass the pricing pressure created by rapid expansion by the smaller airlines.

See our complete analysis for JetBlue Airways here

Currency Fluctuations Pulled Down Profits Of Large Carriers

The strengthening of the US dollar proved to be a big drag on the profitability of the large network carriers, particularly Delta and United. While the stronger US dollar encouraged US passengers to travel abroad, it pulled down the international sales of airlines as tickets in weaker foreign currencies converted into fewer dollars. This impacted large airlines that have high exposure to markets affected by currency fluctuations.

The Atlanta-based airline, Delta, was among the worst hit airlines, given that its international operations account for approximately 30% of its total sales. Consequently, Delta announced a reduction of 3% in its international capacity in the coming quarters to reduce its exposure in Japan, Brazil, Africa, India, and the Middle East, markets that are severely affected by the strengthening of the US dollar. The airline will trim up to 15-20% of its services in these markets to improve its pricing power and long-term margins. In addition, it will suspend all flights to Moscow during the winter.

Following Delta’s footsteps, American and United have also decided to restrict their capacity additions to ease out pressure in the international markets. While American has delayed the delivery of the latest Boeing 787s, scheduled for 2016, until 2017 because of weak international demand, United has lowered its capacity expansion target from 1.5-2.5% to 1-2% for the full year.

See our complete analysis for Delta Air Lines here

Cost Control Measures

Since the currently low crude oil prices may not be sustainable over the long-term, airlines implemented cost reduction measures to enhance their profitability. Most of the airlines switched their existing aircraft with bigger and more efficient airplanes, in order to reduce their non-fuel costs. United announced its plans to replace its 50-seat airplanes with bigger ones, and to shift 10 Boeing 777s from international operations to domestic services. Southwest has also moved to larger Boeing 737-800 jets which helped the Dallas-based airline to reduce its total operating costs by 8% to $3.6 billion, which enabled the airline to scale up its operating income to $770 million from the $242 million posted a year ago.

See our complete analysis for Southwest Airlines here

Returning Value To Shareholders

Driven by lower crude oil prices and capacity additions, the US airlines posted extraordinary returns, far exceeding their cost of capital. Southwest’s return on invested capital (ROIC), before taxes and excluding special items, for the trailing twelve months stood at 25.6%, compared to 14.2% for the same period last year. United and Alaska Air reported ROIC of 17.1% and 20.1%, respectively, for the last twelve month period.

Also, most of the airlines, except JetBlue, used their free cash flows to enhance shareholder returns in the form of dividends and the buyback of shares. Southwest generated free cash flows worth $859 million, of which $381 million were returned to the shareholders through dividends and share repurchases. Delta also returned $500 million to its shareholders via dividends and share buybacks. While United does not pay dividends to its shareholders, the Chicago-based airline returned $200 million to shareholders as part of its previously announced $1 billion share buyback program.

See our complete analysis for Alaska Air Group here

Conclusion

Once considered to be a laggard, the US airline industry has regained investor confidence with their exceptional earnings in the historically seasonally weak quarter. We believe that the changing dynamics of the airline industry, along with the weak crude oil prices and focused capacity additions, will enable these airlines to deliver an even bigger surprise for investors with their superior full year results.

View Interactive Institutional Research (Powered by Trefis):

Global Large Cap | U.S. Mid & Small Cap | European Large & Mid Cap
More Trefis Research