Oil prices are plummeting. By the end of last week, the price of Brent crude oil for delivery in November had fallen below $90. World oil prices haven't been as low as they are today since 2010. This is great news for airlines, as jet fuel tends to be their biggest expense.
However, falling oil prices will have a bigger positive impact on some airlines than others. Airlines with lower profit margins and more routes under development -- including Hawaiian Holdings (NASDAQ:HA), JetBlue Airways (NASDAQ:JBLU), and Volaris (NYSE:VLRS) -- are likely to be the biggest beneficiaries.
The benefit of falling oil prices
For many airlines, jet fuel costs burn through 30%-40% of revenue. As of last Monday, the Gulf Coast jet fuel spot price had declined to $2.58 from $2.87 in late August, and was still falling. This 10% decline in the price of jet fuel thus represents a 3-4 percentage point margin tailwind.
This has a disproportionate benefit to airlines with lower profit margins. For an airline with a 4% pre-tax margin, 4 percentage points of margin growth would double earnings (holding revenue constant). By contrast, for an airline with a 12% pre-tax margin, 4 percentage points of margin growth would only improve earnings by 33%.
Lower fuel prices also are especially good for airlines with lots of developing routes. On mature routes with significant competition, the cost savings can quickly be eroded by fare wars. (If there is less competition, lower fuel prices raise the likelihood that new entrants will disrupt the market.)
By contrast, developing routes are often unprofitable, as an airline needs to offer low prices to stimulate new demand and gradually build the market to profitability. Lower fuel prices speed up that process by allowing airlines to earn a good return at somewhat lower fares.
Hawaiian Airlines: lots of maturing routes
Hawaiian Airlines has been on a growth tear recently. It has added numerous new routes in the last four years, mostly to Asia. Some haven't worked out, such as recently canceled routes to Taipei and Fukuoka. A few new routes have matured to profitability, such as the busy Tokyo-Honolulu run.
However, many of the carrier's new flights are still spooling up. Some of these routes are taking longer to mature than expected because of unfavorable currency swings. Lower fuel prices will help immensely in terms of getting more international routes to profitability. Economic fuel expense represented 33% of revenue at Hawaiian last year.
Hawaiian Airlines has posted a 3.58% profit margin over the last four reported quarters, which works out to a pre-tax margin of less than 6%. The margin tailwind from lower fuel prices could drive strong earnings growth in the next few quarters.
JetBlue: realigning the network
JetBlue is also in the midst of significant changes in its route network. First, JetBlue has been growing rapidly in Fort Lauderdale, where it plans to offer 100 daily flights by 2017.
Just in the last year or so, JetBlue has added nonstop flights from Fort Lauderdale to Costa Rica, Haiti, the Dominican Republic, Jamaica, Trinidad and Tobago, and Peru. Later this month, it will start new flights to Cartagena, Colombia, Jacksonville, Las Vegas, and Pittsburgh. The domestic flights will offer new connection opportunities to Latin America and the Caribbean.
JetBlue is also adding a number of new routes in Washington, D.C. this year after it won 12 Reagan Airport slot pairs in a recent auction. With so many new routes in its portfolio, JetBlue's profitability has been depressed lately. Last year, its pre-tax margin was 5.1%, and its margin has not improved much year-to-date.
Once again, lower fuel prices could be an important tailwind. JetBlue spent 35% of its revenue on fuel last year. A lower fuel bill will help cushion the impact to JetBlue's profitability of new routes that are still maturing.
Volaris: stimulating demand in Mexico
Volaris is an extreme case of the benefits of lower fuel prices. The company has lost money in each of the last two quarters, and is expected to post roughly breakeven results for the full year. Lower fuel prices may help Volaris rebound to profitability in 2015 -- the carrier spent 39% of its revenue on fuel last year.
Volaris' long-term strategy is to stimulate demand in Mexico by getting travelers to switch from buses to air travel. A significant number of Volaris' customers have never been on an aiprlane before! However, weak economic conditions in Mexico have forced Volaris to offer lower fares to stimulate the market.
If fuel prices stay down, Volaris will be able to make money at these lower fare levels. This will allow it to stimulate even greater long-term air travel demand growth, thereby building its market.
Be careful out there!
Hawaiian Airlines, JetBlue, and Volaris all look like attractive investment candidates today due to their competitive cost structures and sizable growth prospects. Lower fuel prices simply make it easier for them to earn good profits.
That said, oil prices are very volatile. Investors should be aware of the risk that oil prices will quickly snap back above $100. Volaris is a particularly risky investment at this point because it has not been consistently profitable. Nevertheless, in the current environment, the risk-reward tradeoff looks very good for investors in Hawaiian Airlines, JetBlue, and Volaris.
Adam Levine-Weinberg owns shares of Volaris, Hawaiian Holdings, and JetBlue Airways. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.