Airline stocks rose as much as 14% last week, but turbulance could lie ahead (Nasdaq:UAL)

As much of the market marked deep declines this past week, the airline sector was conversely ascendant.

Shares of the US Global Jets ETF (NYSEARCA:JETS) jumped 3% in the week’s trading, inverse to the trend in the S&P for the week. Among individual stocks, this was even more pronounced as United Airlines (UAL) was the top gainer, surging 14% to close the week after CEO Scott Kirby not only called for a recovery in travel demand, but a return to profitability.

However, there are still prominent risks that could delay the lift-off forecast by industry executives. At the very least, the existing problems should give eager investors pause.

Commentary Catalyst

During the spate of earnings flowing through in the past week, it was not actually the earnings prints that pushed shares higher. Instead, it was a steady stream of bullish forecasts from airline CEOs.

Following positive commentary from CEO Ed Bastian of Delta Air Lines (DAL) on April 13, the sector began to garner some positive views from analysts and investors. Once this was bolstered by even more ambitious forecasts from American Airlines (AAL) CEO Robert Isom and United’s Kirby, the entire sector saw significant outperformance amid market choppiness.

“The demand environment is the strongest it’s been in my 30 years in the industry,” Kirby declared on Wednesday. “We’re now seeing clear evidence that the second quarter will be an historic inflection point for our business.”

The executive commentary on booming demand is backed by emerging statistics from the U.S. Travel Association as well. The association notes that about nine in 10 Americans are expecting to travel this summer as stay-at-home trends come to an abrupt end. Among these travelers, about half expect to fly. Additionally, 77% of business travelers surveyed by the group indicated that business travel is “more important than ever” to bring back.

The latter is particularly crucial to forecasts of profit recovery, as the relatively small number of business travelers make up a disproportionate share of airline profits.

Problems in Price, Pilots, and the Pandemic

Yet the problems that seem to have been downplayed in optimistic outlooks on the industry have not actually disappeared. Most prominent among the current problems are staffing shortages, lingering health restrictions and inflationary pressures headlined by rising fuel costs.

“Taken with fuel price volatility, high labor costs and large capital expenditures, [a] company’s earnings and cash flow can swing wildly,” UBS analyst Myles Walton wrote in a recent note outlining industry risks. “Although airlines are generally better positioned today vs. history, outperforming their cost of capital on more durable/diversified revenue streams, given the overall revenue and cost streams, these dynamics can reverse rather quickly.”

The potential for reversal in dynamics is crucial to observe as a recovery in corporate and international travel was cited throughout earnings reports as critical to overcoming fuel cost headwinds. If that demand is to soften, the outlook for rapid recovery could quickly turn.

Potentially provoking this turn would be pricing increases that might significantly dampen demand. At present, about 60% of American travelers believe airline fares are too high, with 33% already advising pollsters that high prices are preventing them from finalizing travel plans. If fuel prices continue to rise, questions about the ability of airlines to pass on costs to consumers will only increase.

Similarly, businesses could be keen to cut back on travel plans should prices continue to rise and broader economic issues cause some belt-tightening. Many major U.S. banks now see recession risks rising into 2023, potentially putting many business spending plans on hold in short order. After a few years of video conferences, the use of online meetings as a cost-saving measure in anticipation of hard times ahead is certainly foreseeable.

Even if such risks are overstated, some industry-research groups are noting that business travel might not return to pre-pandemic levels until 2024. These expectations would therefore render airline-executive estimates significantly over optimistic.

Optimism might also be misplaced in terms of mandate restrictions rolling off. While mask mandates being struck down by a judge in Florida on Monday aided a small rally in airline stocks, the court’s decision might not be the final word on the matter. According to White House Press Secretary Jen Psaki, the administration will seek to fight the ruling and potentially reinstate this restriction.

Yet masks are not a significant determinant of demand. Rather, testing protocols appear much more prominent in international travelers’ minds.

Currently, a U.S. traveler passing through a foreign country will need to produce a negative COVID-19 test no more than one day prior to returning to the United States. Both industry executives and industry lobbyists have objected that these onerous requirements have significantly diminished international travel demand.

While an end to these regulations could be a positive catalyst for airlines, the Biden administration’s willingness to battle the courts on masks doesn’t bode well for prospects of this restriction to be lifted.

Finally, airlines must contend with lingering issues over pilot and cabin-crew shortages. While major airlines like United (UAL), Delta (DAL), and American (AAL) have indicated that they will be able to successfully navigate these staffing issues, schedule cuts across the industry − especially on lower cost carriers − suggest a potentially lingering headache for many carriers.

According to UAL chief Scott Kirby, U.S. air carriers are aiming to hire 13,000 pilots by year’s end − about double the individuals expected to enter the field. But per federal labor statistics, this level of hiring would need to continue for almost the next decade if airlines are to meet projected staffing needs.

“The pilot shortage for the industry is real, and most airlines are simply not going to be able to realize their capacity plan because there simply aren’t enough pilots, at least not for the next five plus years,” Kirby recently told analysts. “The other really large airlines will also probably be able to attract enough pilots − but for anyone else, I just don’t think it’s mathematically possible to meet the pilot demand for the capacity plans that are out there.”

Recent schedule cuts buttress Kirby’s argument, but also potentially underplay the competition that each air carrier will be drawn into for talent.

These hiring issues only add to existing issues in pilot-union negotiations that remain heated. For example, Alaska Air Group (ALK) is currently facing the significant possibility that thousands of its pilots may soon strike. And Delta Air Lines (DAL) could find itself dealing with a similar situation in short order.

That’s not to mention the impact on low cost carriers like Frontier Group (ULCC) and Spirit Airlines (SAVE) that rely upon pilots willing to work for lighter wages.

Raymond James analyst Savanthi Syth recently indicated that UAL’s negotiations with pilots will be pivotal for the broader industry.

“United’s pilot negotiations will be closely watched as to the potential trade-off required, with the risk being a higher than expected pay cost inflation, which would have repercussions for the industry due to pattern bargaining,” Syth told clients in a research note.

Obviously, strikes would be catastrophic for the industry. On the other hand, higher pilot wages would also almost certainly increase fares for consumers, adding to concerns that sticker shock could soften the generational demand Kirby has forecast. Schedule cuts could also hurt airlines’ ability to capitalize on consumer demand.

Bottom Line

In the end, airlines are not soaring for no reason.

Many of the sector’s names appear to be incredibly attractive investments at present. This is only further highlighted as industry executives expect explosive growth and opportunities erode rapidly in other sectors.

However, these forecasts should not be taken as a foregone conclusion, as many issues continue to hang over the industry. And perhaps most importantly, investors must vet each carrier on its ability to navigate the headwinds that still confront the sector as not all will be able to withstand the turbulence.

Read more on what to expect from JetBlue (JBLU) ahead of its earnings release on Tuesday.