Airlines have benefited from buoyant demand since early 2022. Despite high inflation and recession fears, consumers (and business travelers, to a lesser extent) have been eager to return to the skies, making up for missed time.
Sky-high fuel prices have kept a lid on airlines' profits for most of this period, though. Fortunately, jet fuel prices have fallen dramatically in recent months. That's setting up airlines for an extremely profitable 2023.
So far, however, the stock market isn't giving them any credit. Alaska Air (ALK -1.83%) and Delta Air Lines (DAL -1.86%) shares look especially attractive.
Jet fuel comes back to earth
After averaging $1.86 per gallon in 2021 -- down slightly, compared to 2019 -- the price of Gulf Coast jet fuel rocketed to an average of $3.37 per gallon last year. The biggest pain for airlines came during the second quarter, when Gulf Coast jet fuel averaged nearly $4 per gallon.
Gulf Coast jet fuel remained above $3.50 per gallon as recently as January, mainly due to high refining margins. However, the price plummeted beginning in February. Gulf Coast jet fuel averaged approximately $2.37 per gallon in April and $2.17 per gallon in May.
U.S. Gulf Coast Kerosene-Type Jet Fuel Spot Price, data by YCharts.
Jet fuel remains a bit more expensive than it was four or five years ago. But thanks to the strong demand environment, well-run airlines can deliver margins in line with pre-pandemic levels with fuel at current prices.
America's most profitable airline will get more profitable
Last year, Alaska Air led the U.S. airline industry with an adjusted pre-tax margin of 7.6%. Still, this was a far cry from the 12% adjusted pre-tax margin it logged in 2019 -- and even that was below the company's long-term target. High jet fuel prices were the main reason the airline's profitability remained below historical levels.
As expected, Alaska Air lost money in Q1 2023. However, management projected that the company would log an adjusted pre-tax margin between 14% and 17% in the second quarter -- equal to or better than the already-impressive 14% adjusted pre-tax margin it posted in Q2 2022.
This guidance assumed an average jet fuel price (including taxes, hedging costs, and other fees) between $2.95 and $3.15 per gallon. Management noted that this was a conservative estimate, as its all-in jet fuel costs were close to the low end of that range as of April 20.
In fact, jet fuel prices have fallen further since then. That likely puts Alaska on pace for an average jet fuel price between $2.75 and $2.80 per gallon this quarter. Meanwhile, demand hasn't wavered. For example, American Airlines recently increased its Q2 unit revenue forecast by 1 percentage point.
This suggests that the Alaska Airlines parent could post an adjusted pre-tax margin between 18% and 20% this quarter, handily beating its guidance. Looking ahead, Q3 tends to be even stronger seasonally. As a result, Alaska Air has a good chance of reaching the high end of its full-year earnings per share (EPS) guidance ($7.50). That would mean the stock is currently trading for just six times earnings.
Delta looks good, too
Delta Air Lines was also predicting strong Q2 profits even before the most recent drop in fuel prices. As of April 13, it projected an operating margin between 14% and 16% for the current quarter. That would translate to an adjusted pre-tax margin of roughly 11% to 14%.
As with Alaska, the combination of strong demand and lower fuel costs should allow Delta to easily beat its guidance. Indeed, because Delta reported its Q1 earnings a week before most of its peers, it was likely projecting a higher average fuel price than the rest of the industry.
The company may be on pace to achieve an adjusted pre-tax margin between 16% and 18% this quarter. That would allow it to post adjusted EPS well above its guidance range of $2 to $2.25.
Assuming demand stays reasonably strong and fuel prices don't spike higher, Delta's full-year adjusted EPS target range of $5-$6 looks very conservative. With shares currently trading around $36, Delta Air Lines stock is also valued at around six times earnings.
Picking the strongest horse
While I own shares of both companies, Alaska Air offers the most attractive balance of risk and reward today. Delta still has work left to pay down debt incurred during the pandemic, whereas Alaska has already fixed its balance sheet.
Carrying less debt makes Alaska Air a less risky stock. It also unlocks additional long-term upside potential, as the company may use excess cash generated this year to buy back stock at bargain prices. That would turbocharge EPS growth, supporting even greater share-price appreciation over the next few years.
