Airline Demand Takes Off

Most major U.S. airlines reported second-quarter earnings last week, and profitability generally met or exceeded expectations. From a unit revenue perspective, most airlines had a rough spring, but this was offset by a significant year-over-year decline in fuel prices.

However, oil prices have begun to rise once again, and Gulf Coast jet fuel prices have climbed by $0.20 per gallon since the end of June. As a result, airlines will need revenue growth to accelerate this summer and beyond in order to deliver further earnings improvement. Fortunately, all of the major airlines have seen relatively strong demand for the summer season, and most expect to see unit revenues continue to increase this fall. This should allow the airlines to maintain their recent earnings momentum.

Summer demand looks strong
Delta Air Lines
(NYSE: DAL  ) has been at or near the top of the industry in terms of unit revenue growth for the past two years. The carrier saw very strong demand around the July 4 holiday, which is helping to drive an expected 3% improvement in unit revenue for July. Management expects unit revenue for the rest of the quarter to improve in a similar fashion, as Delta continues to gain share in the corporate market.

By contrast, United Continental (NYSE: UAL  ) reported very disappointing unit revenue numbers for most of 2012, due to integration problems. However, the company has made up a little bit of ground in 2013, leading the industry in unit revenue gains in several different months, including June.

United's outlook for July is similar to Delta's, with unit revenue projected to improve 2.5%-3.5%. However, the company expects some strengthening in August and September, with unit revenue expected to increase by 3%-5% for the full quarter. Some of the upside may be due to United's poor performance last summer (when a variety of reliability problems led many customers to take their business elsewhere), making for easier comparisons.

US Airways (NYSE: LCC  ) has lagged the industry a bit in unit revenue performance during 2013, because its capacity has been growing due to the addition of larger Airbus A321 aircraft to its fleet. However, management expects June unit revenue to increase by around 4%, followed by 2%-4% gains in August and September. This implies that US Airways will keep pace with the rest of the industry on the unit revenue front, which should lead to strong profitability due to good cost control.

The outlook is murkiest at Southwest Airlines (NYSE: LUV  ) , which has gone from industry darling to problem child recently. Like US Airways, Southwest is adding larger aircraft to its fleet, which depresses unit revenue. However, the integration of AirTran is causing additional headwinds, which led to unit revenue declines in each month last quarter. Fortunately, the tide seems to be turning. Unit revenue is expected to show a 3% improvement in July, and management seems relatively happy about advance bookings for the rest of the quarter.

A stabilizing industry
The overall picture in the airline industry this summer is one of stability. While jet fuel prices have risen somewhat in the past month, they are still comparable to last summer's levels. Meanwhile, all of the major airlines expect to post modest but respectable unit revenue increases.

Investors should be cautious in this sector because valuations have risen substantially since late 2012. While the outlook for the industry seems positive, disappointment could lead to a sharp correction for any of these stocks. With that in mind, Delta still seems like the best investment candidate among major airlines, even after reaching a new 52-week high last Friday. Delta continues to post consistent, strong performance, and its cost-reduction initiatives provide further upside in 2014.

Southwest may also be worth a look for long-term investors. It is a contrarian play today, as the investment community seems more pessimistic about Southwest's prospects relative to peers. Southwest is making slow but steady progress on the AirTran integration, and initiatives such as the move to a point-to-point schedule in Atlanta should boost results next year.

On the other hand, I would not recommend investing in United or US Airways at this time. While United has gained a little ground on the industry in terms of unit revenue, its costs have been increasing much faster than rivals' recently. As a result, it was one of the few carriers to post a year-over-year adjusted profit decline last quarter. Meanwhile, US Airways is about to merge with American Airlines, which raises a variety of integration risks, offsetting the company's strong performance.

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