- Oil prices have risen 15% since the beginning of 2018.
- Last time oil spiked dramatically, airline stocks got crushed.
- Morgan Stanley points out three reasons why rising oil prices could actually be good for the airlines this time around.
Back when oil prices skyrocketed past $US140 in 2008, airline stocks got decimated as the unplanned costs ate into their bottom lines.
The fuel cost burden eventually got so bad that it even forced American Airlines’ former parent company, AMR, into bankruptcy. United, which was able to stay alive, saw its stock price cut by over a third. But as oil prices fell back to healthy levels – bottoming out at just over $US20 per barrel – airlines saw a period of healthy growth across the board.
And with oil now creeping towards $US70 per barrel, its rising price may actually be good news for the airlines this time around, Morgan Stanley says.
“There has been a level of debate amongst investors around the implications of higher oil on Airline shares, and in our opinion, higher is a good thing,” analyst Rajeev Lalwani told clients last week. “There has been a level of debate amongst investors around the implications of higher oil on Airline shares, and in our opinion, higher is a good thing. This is because it instills: 1) Pricing and capacity discipline; 2) Financial constraints on costs and capex; and 3) Margin and multiple expansion.”
For every $US10 per barrel increase, airline margins can contract 1-2 percentage points, the bank estimates. Because fares tend to move in step with fuel prices, airlines will have reason to raise fares again and “recapture the 5-10 points of lost pricing from recent years.”
Slimmer margins can also give a launchpad for higher valuations, the bank says.
“This is because they create opportunities for margin expansion and healthy EPS growth off a lower base,” it said. “And typically, higher oil is indicative of a healthier economy, which further supports the better multiple argument.”
Airlines currently trade at a healthy average price-to-earnings multiple of 9.5, according to data compiled by Bloomberg. That’s less than half the 24.26 average of the S&P 500 benchmark index.
“There is a good amount of cushion for Airline multiples to expand, even if earnings are reset to lower levels,” Morgan Stanley said. “We estimate that a move to $US80/bbl from today’s $US60-65/bbl would take P/Es to ~12x from the current ~8x on a 2019 basis.”
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