Airline Stocks Soar on Capacity Cuts and Solid Demand Outlook

by Trefis Team
US Airways
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Stocks for several major US airlines took flight this Tuesday as they cited expectations for a robust demand outlook and announced plans to maintain capacity discipline at the Deutsche Bank Aviation and Transportation Conference. US Airways (NYSE:LCC) was up by 16%, United Continental (NYSE:UAL) and Delta Air Lines (NYSE:DAL) were both 7% higher, with American Airlines (NYSE:AMR) and Southwest Airlines (NYSE:LUV) up around 5%. Most airlines have plans to either trim capacity or keep it flat for 2012 while maintaining that no evidence indicating a slowdown in demand could be sought. Below we specify few instances of the capacity guidance provided by some of the major airlines at the conference and try to understand how capacity reduction can act as a source to enhance valuation for US airlines.

Capacity reduction efforts undertaken by major US airlines

Delta aims to extend its planned 4% to 5% fourth-quarter cut in capacity into the first quarter of 2012. The airline plans to cut capacity by 2% to 3% for all of 2012. United Continental expects to keep consolidated capacity, which includes its mainline flights and those outsourced to regional partners in line with 2011 levels. Southwest plans to keep capacity flat “or slightly down” next year. American Airlines announced reduction of its fourth-quarter capacity this year by an additional 0.5%.

Impact on Load Factors

Capacity cuts could result in reduced frequency of flights or removal of certain relatively less profitable routes. With robust demand expectations as cited by most airline companies at the conference, the reduction in capacity should boost load factors for the remaining fleet by shifting demand to available flight schedules. In the event of drying up demand, this helps boost profits by exploiting operating leverage (A business that has a higher proportion of fixed costs and a lower proportion of variable costs is said to have used more operating leverage).

Capacity reduction programs can reducing operating expenses

Fuel Costs – A major component of the airline income statement are fuel costs that account for almost 30% of the revenues. By reducing the number of aircraft available for passenger travel, the airlines not only save fuel bill on the aircraft removed from the fleet but are also able to spread fuel costs per aircraft over a larger number of passengers. This is achievable through the higher load factors on reduced fleet size, which result in lower fuel cost per seat.

Crew and Maintenance Expenditure – A reduction in the number of aircraft flown also results in reduced staff requirements for pilots and cabin crew, thereby reducing the spend on employee expenses. Additionally, the costs incurred on aircraft maintenance like repairs, overhauls etc are also reduced.

Operating Lease Rental – Many airlines use operating lease arrangements for their fleet. These provide flexibility to the airlines so that they can manage fleet size and composition as closely as possible, expanding and contracting to match demand. While reducing capacity, airlines may undertake to terminate or forgo renewal for fleet taken on operating lease, thereby saving the rental payments required to be paid to the aircraft lessors.

Overall, the airline industry has an opportunity to boost its valuation by reducing capacity in the current scenario when the growing economic uncertainty can put pressure on margins.

See our analysis for US Airways | Southwest | United Continental | Delta | American

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