Chinese Whispers – Are The Legacy Carriers In Trouble Again?

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Despite delivering extraordinary second quarter results, most of the US airline stocks have witnessed a sharp decline over the last one week. The situation worsened on Monday, August 24, when the majority of airline stocks lost close to 8% on average within a single trading day. This sudden plunge in airline stocks was caused by the volatility in the global markets as the recent devaluation of the Chinese Yuan caused investors to worry about the economic health of the one of the world’s largest economies. The Dow Jones Industrial Average (DJI) Index was down more than 1,000 points during the day before closing almost 4% lower, while the Standard & Poor’s 500 Index went into correction territory for the first time since 2011. While legacy carriers such as American Airlines, United Continental, and Delta Air Lines may see prolonged weakness due to a potential reduction in Chinese air travel demand, we continue to maintain an overall positive stance for the US airline industry on the back of sluggish crude oil prices. In this article, we will briefly discuss the impact of a potential slowdown in the Chinese economy on the US airline companies.

Price_china

Source: Google Finance

Legacy Carriers Likely To Take A Blow If The Chinese Economy Plunges

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If the market fears materialize, that is to say the Chinese economy will experience a further slowdown, it could be bad news for the large air carriers. As witnessed during the economic slowdown in 2009-2010, a slower-than-expected economic growth generally translates into a steep decline in demand for air travel. Thus, if the Chinese economy falters, air travel from and to China will likely drop. The airline that will be most susceptible to this trend is United Continental. Without having any major joint ventures with the Chinese carriers, United has managed to significantly expand its operations in China. At present, the airline offers 11% more seats to China than to Japan. Also, the Chicago-based airline’s Chinese capacity is more than twice that of American’s. Thus, a decline in Chinese travel demand will have a direct impact on the airline’s international business.

UAL_China

Following United’s footsteps, American has also added services to Beijing, Hong Kong, and Shanghai in the last one year to create a footing in the Chinese market. In fact, the airline has reduced its presence in the Japanese market and now offers 22% more seats to China than to Japan. Just like United, weakness in the Chinese economy is likely to take a toll on American Airlines’ revenue.

AAL_China

Apart from these two legacy carriers, Delta Air Lines also has a notable presence in the Chinese market. In addition, earlier this year, the Atlanta-based airline showed inclination towards establishing an international hub in Shanghai, China’s largest and most populous city, to cater to the Chinese as well as other Asian markets as part of its long-term strategy. Following up on this, the airline entered into a partnership with China Eastern Airlines (NYSE:CEA) and a code-share agreement with Shanghai Airlines (a wholly-owned subsidiary of China Eastern). While weak Chinese demand could force the airline’s expansion plans to falter, it will have a less severe impact on the airline’s international operations relative to its competitors, United and American.

Delta’s non-stop US-Asia seat capacity by markets – 2015

DAL_China

Source: CAPA – Centre for Aviation and OAG

Though the magnitude cannot be predicted with certainty, there is a potential downside to the large network carriers if the Chinese economy does poorly.

Domestic Airlines Will Remain Immune To The Slowdown

The market has penalized domestic and low-cost carriers in the same measure as legacy carriers. For instance, JetBlue’s stock fell more than 18% in the last five trading days and closed at a price of less than $20 per share on Monday. However, we believe that unlike the legacy carriers, domestic and low-cost carriers such as Southwest Airlines, Alaska Air Group, and JetBlue are less likely to be influenced by the downturn in the Chinese economy. This is because the majority of their operations are concentrated in the US domestic markets. Consequently, we see the current sell-off to be a temporary phenomenon and maintain a positive outlook for these stocks. In case the Chinese economy weakens in the future, we expect these airlines to remain resilient due to their limited exposure to the Chinese market.

Price_China1

Source: Google Finance

To sum it up, we forecast that the markets will normalize soon, enabling the majority of the airline stocks to bounce back to recent levels driven by a low oil price environment. However, if the Chinese economy suffers a more significant slowdown, then the legacy carriers – United, American, and Delta – will see a potential downside to their current valuations, while the domestic carriers will likely remain resilient.

See Our Complete Analysis For United Continental Holdings Here

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