What Does Last Week's U.S. Airline Sell-Off Mean?

After a stellar 2013, most major airline stocks have posted strong gains again in 2014. Shares of Delta Air Lines (NYSE: DAL  ) and American Airlines (NASDAQ: AAL  ) have rallied about 40% and 65%, respectively. Even industry laggard United Continental (NYSE: UAL  ) has put together a small gain.

DAL Chart

Delta Air Lines, American Airlines, and United Continental year-to-date stock chart. Source: YCharts.

However, shares of all three global airlines hit severe turbulence last Wednesday, dropping 5% or more in a single day. The proximate cause was that Delta reported weaker than expected unit revenue for June.

In reality, Delta's June report was only weak in the context of investors' lofty expectations. Furthermore, the airlines still seem on track for a good summer season. That said, the summer will be over in just two months. The recent jitters around airline stocks reflect the challenges that airlines will have sustaining their recent gains in the long run.

A changed industry
Most airlines have posted significant earnings growth in the last two years, as consolidation has helped boost their profit margins. However, multiple expansion has been an equally important driver of the airline stock rally over the last 18 months or so.

DAL PE Ratio (Forward) Chart

Delta and United P/E ratio (forward). Source: YCharts.

Indeed, as recently as 2012, many major airline stocks traded for less than five times expected current year earnings. This included Delta, United Continental, and US Airways (which later merged with American Airlines).

By contrast, Delta Air Lines now trades for more than 12 times expected 2014 earnings. By that same measure, United Continental trades for more than 10 times earnings, and American Airlines trades for nearly eight times earnings.

Airline earnings multiples have soared since 2012. Photo: The Motley Fool

This multiple expansion signifies that investors are much more confident today in airlines' ability to meet analyst forecasts. It also suggests that investors think that airlines can sustain and even grow earnings from today's levels.

Uncertainty grows
The flip side of having higher earnings multiples is that airline stocks are now prone to bigger corrections if investors begin to doubt their long-term earnings potential. Thus, when top European carrier Lufthansa reduced its guidance last month, shares of Delta, American, and United all pulled back in unison.

Last Wednesday, Delta Air Lines added to investors' uncertainty when it estimated June unit revenue growth at 4.5%. That was lower than the company had initially expected, and also fell short of what most Wall Street analysts predicted.

Delta's June unit revenue missed expectations, but the carrier is still performing very well. Photo: The Motley Fool

Nevertheless, unit revenue for the full Q2 period still increased 6%, in line with Delta's initial guidance. By contrast, Delta expects its Q2 unit costs to rise just 1%-2%. With unit revenue expanding much faster than unit costs, Delta's operating margin will widen to 14%-16%, up from 11% in Q2 2013. In other words, despite the slight miss last week, Delta is doing very well.

American Airlines also expects Q2 unit revenue to be up 5%-7%, which should help it post an operating margin nearly as good as Delta's. Of the big three global carriers, only United Continental is struggling -- it has projected that unit revenue will grow no more than 3% in Q2.

Keep everything in perspective
Airline stocks have suffered two significant setbacks in the past month, corresponding to the Lufthansa profit warning and Delta unit revenue report. On the one hand, it's important to keep these "bumps" in perspective: Delta and American are still posting very strong results, and even United Continental is likely to grow earnings year over year in Q2.

On the other hand, investors need to be prepared for further turbulence in airline stocks -- their meteoric rise over the past 18-24 months is not sustainable. Slow industry capacity growth is allowing airlines to boost fares today, but as profit margins rise, it will become more and more tempting for airlines to ramp up growth.

This is almost certain to happen within the next few years -- and could occur as early as next year. Faster growth could cause airline margins to correct as airlines try to balance growth against profit margins. Given the extraordinary return on invested capital being earned by many airlines today, it's quite possible that 2014-level profit margins are not sustainable in the long run.

In light of the risks and opportunities present in the airline industry today, Delta's strong free cash flow makes it an intriguing buy candidate following the recent pullback. American Airlines and United Continental look less appealing as they are reinvesting nearly all of their cash flow, making their stock prices much more dependent on their uncertain long-term earnings power.

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