Airline stocks lose altitude, but for how long?

While some carriers dismiss any long-term effect from rising oil prices, clearly the timing isn’t good. Hungarian budget airline Wizz Air has just scrapped plans for an IPO in London worth €200m (£160m), citing poor industry sentiment and volatility in airline shares. Of course, appetite for stock market listings here has deteriorated rapidly across most sectors, but investors are obviously worried about growth within the airline industry.

Wizz Air's nerves might also indicate something more sinister; that the days of budget airlines Ryanair (RYA) and easyJet's (EZJ) domination of the skies could be numbered. Budapest-based Wizz Air only began flying paying passengers in 2004, and is one of several new low-cost carriers - among them Norwegian Air Shuttle and Vueling - that provides increased competition for longer established European rivals. The timing for these new entrants couldn’t be better. Shares in Lufthansa (GER: LHA) fell 14 per cent earlier this month when the company cut operating profit forecasts for both 2014 and 2015 by 25 per cent to €1bn and €2bn, respectively. Excess capacity in European and US routes were blamed. But industrial action and weak pricing are bugging Lufthansa, too - both problems it cannot solve quickly simply by slashing more costs.

Cost-cutting has been a dominant theme for the airlines in recent years, although the pay-off has been better for some than others. Recovery play Flybe (FLYB) announced its first annual profit since listing three years ago. New chief executive Saad Hammad claimed his recovery plan, largely based around trimming away excess costs, delivered the right results and only a focus on "the four Ds: discipline, discipline, discipline, discipline" would keep Flybe in the black. While the company’s enterprise value stands at eight times cash profits, making recovery prospects appear priced in, investors should not ignore the fact the shares soared 174 per cent over the past year, delivering significant growth in Flybe's market value.

But Flybe’s story has been the exception rather than the rule. Recent research estimates that between 1993 and 2012, return on invested capital (ROIC) in the airline industry never exceeded the cost of capital, leaving them with little to no economic profit. And share prices certainly appear shaky. Lufthansa rallied above €20 earlier this year from a rock-bottom €7.50 in mid-2012. Now they're back below €16. And bad news here is infectious. Both International Consolidated Airlines (IAG) - owner of flag carrier British Airways - and easyJet enthusiastically followed the German's lead lower.

And Lufthansa is not alone. Irish carrier Aer Lingus (AERL), which last September warned that aggressive rival Ryanair was pinching business, now admits that cabin crew strikes have hit customer bookings further. Operating profits for the 2014 financial year could be as much as 20 per cent lower than the €61m achieved last year, following staff strikes in May and the threat of further action this month. Any recovery, Aer Lingus says, will be down to how quickly it manages to regain customer confidence, and, like Lufthansa, it is also in the midst of heavy cost-cutting and big job losses.

Reining in profit expectations is not the only sign of trouble afoot. Multiple cancellations of orders are also an indication of squeezed finances. Airbus suffered a major setback earlier in June after Emirates Airline, the fast-growing Gulf carrier, cancelled a $16bn order for 70 new A350 passenger jets. Dubai-based Emirates was to be a high-profile launch customer for the long-range A350, which is due to enter service at the end of 2014 to compete with Boeing’s 787 Dreamliner and 777 aircraft. While Airbus’s chief executive Fabrice Brégier claimed there’d be no negative impact from the cancellation, news that it would cut the A350 order book by 9 per cent has hurt the jet manufacturer's share price. Rolls-Royce (RR.), the sole engine supplier for the A350, fell, too.

The final cause for concern for airline investors is the stall in easyJet shares. The share price has enjoyed a meteoric rise over the last three years but has started to dip as industry sentiment suffers. Analysts at Davy are not concerned: they believe summer trading will be strong despite foreign currency headwinds and a capital markets day in September will help reignite the performance of the share price. We'll see.

IC VIEW:

There can be little doubt the airlines sector is in a state of flux. New entrants are skittish to make their presence felt in a volatile market while analysts are promoting mixed views on the impact of rising oil prices. As a result, some airline shares are trading at tempting discounts to their long-term averages, and so offer investors a cheaper entry point into the market. Others, however, are still trading at a premium and offer unclear growth prospects despite evident momentum in the share price. Overall, the weakness in the industry is ripe for stock picking but investors should still tread carefully.

FAVOURITES:

While we stop short of upgrading our neutral stance on the airline sector’s dominant players, opportunities for investors keen to diversify their portfolios with an airline holding appear to be emerging. Recovery play Flybe (FLYB) offers the most attractive growth profile having declared maiden profits this year, although the shares have weakened recently and may have further to fall before support kicks in. EasyJet (EZJ) is tipped to grow at a decent pace, too. Trading these days at a more palatable 12 times EPS forecasts for 2015, a 10 per cent discount to its historic average, the shares look interesting again. Lastly, the likelihood of a special dividend from Ryanair (RYA) is far from certain, but the prospect of a generous yield should help reignite investor interest in the shares.

OUTSIDERS:

It’s easy to be negative on the sector, and, clearly, some of the sharp falls in the share price of several airlines could be taken as a buying opportunity. Unfortunately, Aer Lingus (AERL) is not one of them. Trading at a five-year high prior to the latest profits warning, it must rank as the carrier with least potential. Strike action is notoriously difficult to price in as has been the case with companies such as Royal Mail (RMG), and recapturing customer confidence will be no mean feat. Good cost cutting efforts and a long-haul flight proposition will be fairly meaningless if tense industrial relations continue to blight progress.

THE BROKER'S VIEW:

"Ryanair is trading well and the outlook for the current financial year is positive," says Rob Byde, analyst at Cantor Fitzgerald. Summer bookings "are approximately 5 per cent ahead of last year" and €500m of excess cash will "very likely" be returned through a special dividend in early 2015. "The special dividend would have a yield of 5.1 per cent," he adds. Mr Byde also believes as Ryanair continues to improve its customer experience and introduces more services at airports, it will gain market share and margins will expand. He points out that the stock "is not expensive," pointing out that a forward PE ratio of 15 is a 6 per cent discount to its long-run average.

In fact, Mr Byde prefers Ryanair to easyJet as "near-term catalysts for the latter company are lacking." But he admits easyJet’s fundamentals "remain strong and management is busy fine-tuning the network, trimming costs and making the service more attractive to business travellers." He estimates easyJet has “sufficient headroom to pay another special dividend in early 2015." But Mr Byde warns more short-haul capacity in Europe could "dampen fares."

Despite a profit warning, Mr Byde believes Lufthansa's fundamentals "are also sound." He cut forecasts in line with Lufthansa's new guidance, but claims excess capacity "is a problem for all carriers who will now have to trim their plans." He thinks renewed guidance from Lufthansa could prove to be overly conservative, too, particularly as demand continues to recover. "Cost-cutting should now accelerate," he says - management estimates a 4 per cent cut in unit costs this year. In the meantime, Lufthansa trades on a forward PE ratio of 7.7, representing a 15 per cent discount to its long-run average.

Airlines' performance