Which Airline Is Making the Largest Strides?

Zain is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Airlines have hit their stride, with Delta Air Lines as the leader--the stock is up almost 90% since the start of the year. This has come as a surprise given that oil prices have spiked up almost 30% in the last 12 months. The main reason for strong stock performance has been the capacity discipline maintained by industry players. This has kept the margins higher and helped returns to move in the right direction for the airlines.

Many players have been trying to follow Delta’s footsteps in order to enhance their top and bottom line. However, only some of them have been successful in achieving so. Let’s have a look at what these airlines have been up to and if they have been successful in achieving their respective targets.

Slow and steady wins the race

While Southwest Airlines (NYSE: LUV) didn’t hand us the upside surprise that Delta did in July RASM (revenue per available seat mile), there are definitely signs of earnings progress in the first half of 2013. Those not familiar with airline jargon should know that RASM is a measure of an airline's profitability based on its earnings per seat when considering all revenue sources.

Southwest recorded net profit that was above expectations. Despite the choppiness in RASM, pretax margins were ~200bps better than estimates, and the market expects relative performance to improve in the second half of the year and into 2014.

The company gave guidance for flat capacity in 2014, which gives the market incremental conviction that Southwest is on the right path. Beyond the industry benefits, it is important to understand that network ‘optimization’ and ‘re-allocation’ are the major drivers of improving the returns of airlines, and Southwest is working on both.

Unimpressive results and guidance

United Continental's (NYSE: UAL) results, for the second quarter, were as advertised in its recent investor update. However, its 3Q guidance was pretty uninspiring. The RASM of 3% to 5% for 3Q appeared inline with the Street’s estimates. However, it is interesting to note that the company gave guidance of slightly lower capacity, which suggests a softer-than-anticipated revenue outlook (unlike Delta, which surprised to the upside with RASM on higher capacity).

The Street now expects pretax margins, which in 2Q were 250 bps lower than the industry average (seventh quarter of under-performance in a row), to continue into the second half of 2013 and potentially into 2014.

Apart from that, the stock is currently viewed as cheap. Airline stocks have been tanking since the Department of Justice recently challenged the merger between US Airways and American Airlines. United Continental’s stock itself is down 12%. This dip has made the stock look even cheaper, with a forward multiple of only 6 times the 2014 earnings (as compared 12 times for the industry average).

Impressive results but unimpressive guidance

While posting one of the best 2Q margins and ROIC results in the airline industry, Alaska Air's (NYSE: ALK) guidance for the 3Q (particularly on costs) is likely to result in downward pressure on Street estimates. Also, despite a tradition of being silent on revenue guidance, the company provided some color on 3Q RASM expectations.

The carrier, which saw RASM decline of almost 4% in the 2Q, expects another decline in RASM in the 3Q, although "at a rate less than the 3.8% decline in 2Q," according to the company. For now, the Street is penciling in a decline of 2.5% with the hope that the mid-cap carrier returns to improvements in RASM in the 4Q (as seasonal capacity management kicks in) and in 2014 (as the focus shifts from new markets to up-gauging).

On an overall note, Alaska Air is a relatively "safer” legacy airline with solid margins, good hedges, and strong relative liquidity. The company also has less exposure than its peers to international revenue trends and a history of good execution. While positive in a downturn scenario, these characteristics are likely to limit out-performance in the mid-cycle, making the risk/reward less compelling at Alaska Airlines than at legacy peers.

Final word

Out of the three companies discussed above, Southwest seems to be the best investment option. The company deserves credit for making big strides recently, and the Street expects the second half of 2013 and 2014 to show more progress. For United Continental, unfortunately, disappointing RASM guidance points to some further lost ground.

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Zain Abbas has no position in any stocks mentioned. The Motley Fool recommends Southwest Airlines. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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