Fuel Worries Drag on Airlines

On a day when $88 crude oil spooked airline investors, Delta posted impressive Q3 results. Can other large carriers do the same?

Delta Air Lines (DAL) started the airline industry's earnings season on a positive note Oct. 16. But even the best news from the U.S.'s third-largest airline couldn't hide the industry's 800-pound gorilla: Crude oil that hit $88 per barrel for the first time.

Oil rose almost 2%, reaching $88.20, before pulling back below $88 in later trading. "That's a monkey on the back of the industry," says Ray Neidl, an analyst at Calyon Securities. Airline shares would be much higher if not for oil's high price, Neidl says. A chart of jet fuel over the last year shows a close relationship: As fuel prices rose, airline stocks fell.

Still, Delta's earnings report offered investors some good news. Atlanta-based Delta reported earnings of $220 million, or 56 cents a share in the third quarter. According to Reuters Estimates, Wall Street analysts were expecting earnings of 41 cents per share. (Delta shares were not listed in the same period of 2006, when it was operating under bankruptcy protection.) Revenue rose 10% to a quarterly record of $5.2 billion. Delta found ways to cut its non-fuel costs, and it's expanding into more-profitable international routes. Five months after emerging from bankruptcy, Delta paid off $1 billion in debt.

"Delta has emerged as a leader in the airline industry, and we intend to maintain that position," Delta CEO Richard Anderson said in a statement. "Our financial improvements, combined with the power of our people, route network and balance sheet, give us tremendous flexibility and strength as the industry continues to evolve."

Select U.S. Airline Stocks -- 10/16/07
Company Ticker Closing Price % Chg.
AirTran Holdings AAI 9.66 -1.63%
AMR Corp. AMR 24.10 -0.65%
Continetal Airlines CAL 35.81 +0.14%
Delta Air Lines DAL 20.10 0.5%
Northwest Airlines NWA 19.73 -1.1%
Southwest Airlines LUV 14.52 -0.34%
UAL Corp. UAUA 47.79 +2.6%
US Airways LCC 28.78 +2.06%

J.P. Morgan (JPM) analyst Jamie Baker says oil prices aren't as important as some believe. "The fact of the matter is that profits are achievable at any oil price." He said he's far more concerned about passenger demand for air travel, "which at the moment remains robust" but hinges on the general state of the economy.

Industrywide, a deep concern is that travel demand dips this winter or next year, perhaps due to a slowing economy, but high oil prices persist. Standard & Poor's equity analyst James Corridore wrote that Delta showed "strong progress and good cost controls." However, he added, "With oil prices near record levels, we remain cautious on [Delta] and the industry as a whole." (S&P, like BusinessWeek.com, is a unit of The McGraw-Hill Companies (MHP).) Neidl says he's "cautiously optimistic" about the industry. Next year could be a profitable time for airlines if the U.S. economy holds up, he says.

Many large airlines, facing financial trouble in recent years, won big concessions from their labor unions to cut costs. As airline profits return, expect more pressure for workers for higher wages, perhaps in 2009, Neidl says. In fact, American Airlines' parent AMR (AMR) -- which reports its third-quarter income on Oct. 17 -- is facing a pilot group that wants wage and benefit gains after years of cutbacks. According to Reuters Estimates, analysts are expecting AMR to earn 73 cents per share, up from 45 cents a year ago.

The large airlines still face many challenges, analysts note. Those include fuel costs and labor costs, but also "too many U.S. competitors," notes Vaughn Cordle of AirlineForecasts, an airline industry research firm based in Washington, DC. That's one reason large players such as American and United (UAUA) are being pressured to sell or spin-off lucrative assets such as their frequent flier programs and heavy-maintenance operations.

Another fix? Consolidation, which Anderson told analysts Tuesday could benefit his company, which would seek to be an acquirer and not a target in any future deals. During its bankruptcy, Delta fended off a hostile takeover bid by US Airways Group (LCC) and has since emerged from Chapter 11 reorganization with finances that are sufficiently robust to pursue another airline,

The company is "evaluating the best path forward," Anderson said. However, he added, a spin-off of Delta's frequent flyer program would probably have to wait until after industry consolidation takes place. Delta's stock was trading higher on Tuesday afternoon, up 1.1% to $20.21 per share on the New York Stock Exchange.

One solution to tough domestic competition has been to add more flights on less-competitive international routes, with Delta a leader in this area. The airline plans new flights in 2008 from New York to destinations such as Kenya, Egypt, Senegal, and Jordan, while rival American plans new routes from Chicago to Moscow and from New York to London's Stansted, a smaller airport many business travelers prefer. Delta's new international focus was readily apparent in its domestic figures: traffic rose only 3.1% on a 1.8% drop in domestic capacity.