Airlines Anonymous

Welcome to a new on-going series, Airlines Anonymous where we will look at the ins and outs of the global airline industry. Why? Because as an avid traveler the more you know about carriers, their business, their challenges and opportunities, the more armed you’ll be to book better flights, get better fares and enjoy your airline experience much more.

The International Air Transport Association expects global airline profits to rise 10% from 2015 estimates to $36.3 billion in 2016, with North American carriers comprising more than half that. That’s right, North American carriers are back and back in a big way.

Delta Air Lines (NYSE: DAL) and United Continental (NYSE: UAL) have been reducing fuel hedges, the contracts which airlines sign to commit certain fuel prices, allowing them to capture more savings from oil’s ongoing slump. American Airlines (NASDAQ: AAL) closed its hedges in 2014.

However, the IATA said airlines “will soon have realized the maximum positive impact of lower fuel prices,” as most fuel hedges that locked in higher prices expire next year.

And the group sees profits in North America falling to $19.2 billion next year from $19.4 billion this year, making it the only region that will see a decline.

‘Race To The Bottom’

The industry’s profitability could be better described as “fragile” rather than “sustainable” due to higher interest rates and the potential slowing of the industry’s current profitability cycle, which tends to last eight to nine years, the trade group added.

The question for 2016 might be: How fragile?

“In the U.S., what you have right now is a race to the bottom between falling fuel prices and falling airfares,” said Seth Kaplan, managing partner at Airline Weekly.

“So far, falling fuel has been winning…. What investors are looking for is: When the fuel prices stop dropping, will unit revenue stop dropping?”

Declines in unit revenue — a key measure that tracks how much airlines make per passenger for each mile traveled — should ease during 2016, UBS analyst Darryl Genovesi said, citing published flight schedules and the strong dollar, which inhibits foreign travel.

Unit revenue fell through 2015 as cheap oil inspired airlines to expand capacity. In particular, low-cost and regional carriers like Spirit Airlines (NASDAQ: SAVE) and Alaska Air Group (NYSE: ALK) have been adding flights and going to new destinations, partly filling gaps that opened when the airline giants merged and reduced service in some markets.

And last year’s rollback of federal restrictions on flights out of Dallas Love Field allowed Southwest (NYSE: LUV) to expand its flight coverage from its home hub.

Kaplan says falling unit revenue is OK as long as unit costs also stay low, as they have been. But many carriers have since tempered plans following concerns that they had overestimated travel demand.

“We saw a little bit of a domino effect throughout 2015 as that Love Field growth spilled over into the rest of the domestic network, and for the most part we’re kind of done with that now,” Genovesi said.

That could mean a less-intense battle for the lowest-priced ticket in 2016.

Airline busines soutlookDelta, American Best Bets?

Capacity growth has moderated, falling more into line with GDP growth, though it could be pared down more.

“We’ll probably end up with 3.5% to 4% domestic capacity growth over the next couple of years, and that’s a little more than we’d like,” Genovesi said. “You’d like to see something in the 2% to 3% growth range, and I’d like to see no growth at all.”

Delta has more power to control capacity growth, he said, noting that only about 18% of the carrier’s staff is unionized. Across the industry, about half of airline employees are in unions.

And Kaplan noted that recent labor deals, struck amid rising profits, could weigh on financial results.

So Delta’s low unionization rate, plus its reduction in costly fuel hedges, should make it the best-positioned airline for 2016, said Genovesi, who sees 40% EPS growth next year. Analysts polled by Thomson Reuters see 37% growth in 2016 and 40% growth for 2015.

The airlines whose mergers are already well underway should have the biggest advantage in 2016, said Bob Mann, a consultant at R.W. Mann & Co. and a former airline executive.

“So that goes with Delta, who started their merger process in 2008,” he said. “United is still digesting theirs, but I think it is next to realize a greater potential of what they did in 2010.”

Still, American stands to benefit longer-term due to its larger network’s potential to attract corporate customers, he added.

While competition on airfares looks to ease next year, there’s potential for stiffer competition in service quality.

“We have kind of the basis here of the first sorts of real tangible service-level competition that I’ve seen in 40 years,” Mann said.

United, which has lagged American and Delta this year in on-time arrivals, plans to compete with Delta in on-time guarantees for big corporate clients.

And American this month said that late next year it will launch a “premium economy” seating category on international flights, an overlooked class in the U.S. whose comfort level and amenities lie somewhere between business class and economy.

“In an industry where everyone was scraping by, you didn’t really care if you were on time,” Mann said. “But I think now that everybody’s making bank, there’s the money to do it right for a change.”