Shares of Spirit Airlines (SAVEQ -0.23%) and American Airlines (AAL 3.47%) moved lower on Monday after getting negative reviews from Wall Street analysts. Andrew Didora of Bank of America downgraded shares of both airlines due to his projection that industry unit revenue trends are poised to deteriorate. To add insult to injury, Spirit Airlines stock was also downgraded by analyst Jack Atkins of Stephens.
Spirit Airlines and American Airlines have certainly faced plenty of setbacks this year. And while American Airlines isn't doomed, it's reasonable for analysts to take a cautious attitude toward the company. By contrast, Spirit Airlines' troubles are not as bad as they seem.
Spirit Airlines is not in as much trouble as it may appear. Image source: Spirit Airlines.
Analysts turn negative on two airlines
In his recent report, Bank of America's Didora noted that the return of the Boeing 737 MAX -- which will likely occur in late 2019 or early 2020 -- will drive a sharp uptick in U.S. airline industry capacity growth in 2020. He projects that domestic capacity will increase nearly 6% next year. Meanwhile, demand growth appears to be slowing. As a result, airlines could face significant unit revenue pressure as industry capacity growth accelerates.
In this context, Didora is advising investors to avoid shares of airlines that face cost pressures. He observed that American Airlines has numerous labor contracts up for renewal soon, which could lead to big wage increases or increased labor strife. He also pointed to Spirit Airlines CFO Scott Haralson's comment in late July that nonfuel unit costs would likely be flat or up slightly in 2020, despite very easy year-over-year comparisons.
Both American and Spirit have significant route network overlap with top 737 MAX customer Southwest Airlines. As a result, Didora believes they will face a double whammy of higher unit costs and weak unit revenue next year. That's why he downgraded American Airlines stock to neutral, with a $31 price target, although that's still above the stock's Friday closing price of $27.99. Didora cut his rating on Spirit Airlines to underperform (the equivalent of sell) and reduced his price target to $39. The stock closed at $38.03 on Friday.
Analysts at Stephens were slightly more generous but agree that Spirit Airlines' business is facing significant near-term headwinds. They cut the stock's rating to equal-weight (the equivalent of hold) and slashed their price target to $45 from $55.
A mixed outlook at American Airlines
American Airlines has faced more than its share of difficulties this year. The grounding of the 737 MAX has hurt its bottom line by hundreds of millions of dollars. An alleged slowdown by mechanics frustrated by slow contract negotiations caused a spike in delays and flight cancellations, alienating customers.
2019 has been another disappointing year for American Airlines. Image source: American Airlines.
If the 737 MAX returns to service before year-end, as American's management expects, it would create a substantial unit cost tailwind in 2020. That said, depending on when the airline agrees on new contracts with its pilots, flight attendants, and mechanics, higher labor costs could more than offset the savings from a return to normal operations.
On the flip side, all of American Airlines' growth next year will come in Dallas and Charlotte, North Carolina. Those are its two largest hubs and two of its most profitable bases. Expanding these fortress hubs may enable American to capture more high-margin connecting traffic from small cities. That in turn could help the airline buck analysts' expectations and deliver solid unit revenue growth despite a tough competitive environment.
In short, American Airlines may be able to overcome the challenges it faces, but a neutral rating is reasonable in light of the risks -- particularly because the company has a heavy debt load.
Analysts are overreacting to Spirit Airlines' recent challenges
As for Spirit Airlines, it's harder to justify the analysts' concerns. Spirit stumbled badly this summer, scheduling too many flights, such that bad weather caused huge operational disruptions that were aggravating for customers and costly for the airline. As a result, whereas the company posted massive earnings growth in late 2018 and the first half of 2019, analysts expect sharp earnings declines in the back half of the year.
It's also true that Spirit Airlines expects nonfuel unit costs to be flat at best next year, while it could face meaningful capacity increases by Southwest in some of its markets. On the other hand, this cost forecast could be conservative -- Spirit has often been able to reduce its costs more than expected.
In any case, the carrier has plenty of tools at its disposal to boost unit revenue. Spirit's delayed project to install in-flight Wi-Fi should be finished (or very close) by the end of 2020. An updated loyalty program could also start to positively impact unit revenue as early as next year. More tangibly, after entering nine new cities last year, Spirit Airlines has started culling routes that didn't work. It ended its flights to Cap-Haitien, Haiti, in June. In November, the airline will exit three routes from Fort Lauderdale, Florida, that it launched last year. It will stop flying between Tampa, Florida, and Greensboro, North Carolina, at the same time.
These route network refinements should offset the potential competitive capacity increases in Spirit's markets. As a result, Spirit Airlines should be able to return to unit revenue growth and margin expansion next year. That makes shares of the fast-growing airline a screaming buy at just eight times earnings.
