Among the four largest U.S. airlines, Delta Air Lines (NYSE: DAL) and Southwest Airlines (NYSE: LUV) have stood out in the past few years for producing consistently strong profits. Investors have acknowledged their strong performance recently, sending both stocks to record highs this week.
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However, it's reasonable to wonder whether Delta and Southwest shares have room to keep climbing. After all, both stocks have surged more than 60% from their Brexit-related lows a year ago.
Despite these big gains, Delta Air Lines and Southwest Airlines both trade at very low earnings multiples, especially the former. Furthermore, despite posting steep earnings declines earlier this year, they are likely to return to strong EPS growth in the second half of 2017, continuing into 2018. As a result, both stocks could continue to climb higher.
Unit revenue is improving
One good sign for investors is that Delta Air Lines and Southwest Airlines will both return to unit revenue growth this quarter. That's critical for ensuring their long-term ability to offset unit cost increases.
Southwest expects revenue per available seat mile (RASM) to increase 1% to 2% year over year in the second quarter. Meanwhile, Delta has projected that RASM will rise 1% to 3%. Thanks to a strong showing in May -- when RASM rose by 3.5% -- Delta is tracking toward the high end of this guidance range. Its second-quarter unit revenue would have been even higher but for a slew of flight cancellations in early April related to severe storms in the Atlanta area.
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Delta's current unit revenue momentum bodes well for its RASM performance in the second half of the year. It will also benefit from the Trump Administration's recent decision not to widen the "laptop ban" to major European airports, as had previously been expected. Southwest Airlines should also be able to post strong RASM growth in the second half of 2017, as it will face significantly easier unit revenue comparisons.
Fuel prices have moderated
Another important factor is that fuel prices have declined significantly since April. During the first four months of 2017, market prices for jet fuel averaged about $1.50/gallon. However, jet fuel prices have since fallen to less than $1.30/gallon.
Obviously, oil prices are quite volatile, so it's possible that jet fuel prices could surge higher again in the next few months. But if this $0.20/gallon fuel price decline sticks, Southwest Airlines would save about $400 million a year, while Delta would save roughly $800 million annually.
Southwest Airlines will benefit from additional fuel cost savings in 2018 as it finally gets relief from poor hedging decisions it has made in the past few years. Southwest is on pace to incur more than $400 million in hedging losses in 2017, whereas hedging losses should be negligible thereafter.
Strong earnings growth ahead
The combination of strengthening unit revenue and lower fuel prices sets up Delta Air Lines and Southwest Airlines for a return to strong earnings growth. (They will also benefit from lower non-fuel cost inflation in the second half of 2017 and beyond.)
Both companies are likely to post double-digit earnings growth as soon as next quarter. The outlook for 2018 is bright as well. Analysts expect Southwest Airlines' EPS to surge 24%, to $4.79, as it will finally reap the full benefit of lower fuel prices. Analysts also expect strong 13% EPS growth at Delta next year.
Despite its big gains over the past year, Southwest Airlines stock trades for a very reasonable 13 times forward earnings. Delta Air Lines stock is even cheaper, trading for 9 times forward earnings. Furthermore, analysts' current earnings estimates for the second half of 2017 and 2018 probably assume that fuel prices will be significantly above today's level. As a result, earnings growth could be faster than expected.
Given this favorable outlook, shares of Delta and Southwest both have more upside. But Delta seems like the better bet right now. Between its rising unit revenue momentum and its rock-bottom valuation, Delta Air Lines stock has plenty of room to run.
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