Shares of airline giants American Airlines (NASDAQ:AAL) and United Continental (NASDAQ:UAL) were in free fall from mid-July until late September. A series of major hurricanes that disrupted air travel across large swaths of the U.S., rising fuel prices, and a brewing fare war all contributed to the poor stock performances.
Stocks of American Airlines and United Continental have bounced back in the past few weeks, though, propped up by bullish long-term outlooks from their management teams.
Both companies kept their share price rallies alive last week by posting favorable third-quarter guidance updates. Nevertheless, neither one is producing an acceptable level of profitability right now.
Guidance comes down
Entering the third quarter, American Airlines' initial forecast called for an adjusted pretax margin of 10%-12%. United's original adjusted pretax margin guidance range was somewhat better at 12.5%-14.5%.
However, United Continental had to slash its margin outlook by 4.5 percentage points in early September, reflecting some strategic missteps, higher fuel prices, and the severe impact of Hurricane Harvey. This left its Q3 adjusted pretax margin forecast range at a measly 8%-10%.
A week later, American Airlines cut its adjusted pretax margin guidance range to 8.5%-10.5%. It blamed the 1.5-percentage-point reduction to its forecast on revenue losses related to Hurricane Irma and an uptick in jet fuel prices.
Management becomes more optimistic
Fortunately, the increase in fuel prices during September was not as bad as initially feared. Moreover, the airline industry pricing environment is starting to rebound.
As a result, in the past week, American Airlines and United Continental have both raised their forecasts again. American now expects to produce a Q3 adjusted pretax margin of 9%-11%, while United has a similar 10%-10.5% adjusted pretax margin forecast.
American Airlines indicated in last week's investor update that Hurricane Irma reduced pretax profit by about $75 million. The financial impact of Hurricane Harvey on United was probably significantly higher, but the company has not provided a final tally of the cost yet.
These results still aren't acceptable
Although the third quarter didn't turn out to be quite as bad for American Airlines and United Continental as investors had feared a month ago, their results aren't especially good, either. Both companies are set to report adjusted pretax margins of around 10% for Q3, compared to 14% for American and 15.7% for United in the year-earlier period.
While a 10% pretax margin is better than what most airlines were achieving a few years ago, it's important to remember that the third quarter includes the summer peak season. Profit margins tend to be a lot lower during the first and fourth quarters.
It's also discouraging that airline profit margins are receding so quickly when fuel prices are still quite low by historical standards and the economy is growing steadily. True, American Airlines and United Continental faced some unusual hurricane-related headwinds last quarter, but the underlying macroeconomic trends are still about as favorable as possible for airlines.
Can investors expect a rebound in the fourth quarter?
One reason why investors have reacted positively to airlines' recent guidance updates is that many airlines expect unit revenue trends to improve in the fourth quarter. American Airlines' management has been particularly outspoken in this regard, repeatedly predicting that unit revenue will grow at a faster pace in Q4 than the roughly 1% increase American will report for Q3.
That said, based on its current outlook for fuel prices and nonfuel unit costs, American Airlines would need a roughly 5%-6% unit revenue increase just to keep its pretax margin steady this quarter. Thus, even if it posts a solid 3%-4% unit revenue gain, American's adjusted pretax margin will recede again relative to the uninspiring 7.9% adjusted pretax margin it reported for the fourth quarter of 2016.
American and United have both outlined a variety of initiatives to improve profit going forward. However, this isn't the first time that they have made big promises. Considering the extent of both companies' earnings declines over the past year, investors should be cautious about blindly trusting management's prognostications. American Airlines and United Continental still need to prove that they are worthy long-term investments.