It is a well known fact that the airline sector is going through tough times, thanks to the plethora of headwinds faced by carriers. The issues hurting these companies include declining unit revenues, plunging ticket prices, technological glitches, feuds with worker unions, reduced air travel demand due to the surge in terror attacks and Brexit-induced uncertainty. The struggles are reflected by the bearish Zacks Industry Rank of 201 (among more than 260 groups) carried by the Transportation-Airline segment.

The latest challenge for carriers is Hurricane Matthew. The storm is likely to hit Florida soon and has caused severe devastation across Haiti apart from affecting the entire Caribbean region with heavy rainfall and strong winds. The severity of the storm has apparently resulted in some causalities in the areas. Hurricane Matthew has prompted many carriers including American Airlines Group Inc. (AAL), JetBlue Airways Corporation (JBLU - Analyst Report) and Alaska Air Group (ALK - Analyst Report) to cancel flights/offer refunds owing to safety-related concerns.

Will Unit Revenue Issues Ease?

Although, unit revenues issues have been plaguing airline stocks for quite some time there have been a few favorable developments which suggest that problems on that front might be easing. In its September traffic report, Delta Air Lines (DAL) stated that its passenger revenue per available seat mile (PRASM: a measure of unit revenue) declined only 3% in the month. The reading compared favorably to those in July and August where PRASM had declined 7% and 9.5%, respectively. In fact, Delta expects to be the first network carrier to return to “positive unit revenue growth.”

Moreover, last month JetBlue predicted a decline of only 3–4% for its revenue per available seat mile (RASM) the third quarter of 2016. This indicates an improvement from the 8.2% decline in the second quarter.

Oil Prices Remain Low

Cheap oil has been the biggest tailwind for carriers in recent times. Low oil prices resulted in huge profits for carriers with their bottom line improving significantly through huge savings. This has strengthened the balance sheet of these carriers, which in turn, enabled them to increase investments to enhance flying experience of passengers. A stronger balance sheet also facilitated dividend hikes and share buybacks along with profit sharing payments.

Although oil prices have been weak for quite some time (since mid-2014) and consequently have been priced in, this major tailwind continues to be the main factor behind the considerable year-over-year earnings growth of carriers. Currently, oil prices are hovering around the $50 a barrel mark, a long way off the above $100 a barrel mark witnessed two years ago. Despite the recent OPEC action, oil prices are unlikely to touch the highs of mid-2014 anytime soon. This factor will continue to aid these carriers’ bottom line, going forward.

The bullish forecast by the International Air Transport Association for the airlines industry for 2016 is also based on the assumption of oil prices remaining weak.

Havana Approval: A Positive

We are optimistic about the decision by the U.S. Transportation Department (DOT), announced in August this year, to grant final approval to eight U.S.-based carriers to initiate commercial flights to the Cuban capital of Havana. Once operational, the top line of the carriers should be benefitted immensely as Havana is a favorite tourist spot.

We note that U.S. carriers have already started operating commercial flights to other Cuban cities. The first commercial flight to Cuba from the U.S. touched ground on Aug 31, 2016, after more than 50 years. The flight was operated by JetBlue.

Q3 Round the corner

The Q3 earnings season will commence in the next few days for the airline industry. Given the turbulent times the sector is passing through, the third-quarter performance of carriers is expected to be lackluster in spite of the positives highlighted above.

The bearish projection for the transportation sector according to our latest Earnings Trends report, of which airlines are a part, also highlights the fact that airlines stocks are not likely to fly very high in Q3. The report suggests that the bottom line in the transportation space is likely to contract 21.8% in Q3.

How to Pick Likely Q3 Winners?

Despite the overall gloomy scenario, the aforesaid factors clearly suggest that all is not lost for airline stocks. There exist few hidden gems in the space that investors can unearth. The stocks have the potential to generate handsome returns.

However, given the vastness of the airline space and the issues that it is currently, it is by no means an easy task to identify the attractive picks. This is where our proprietary model comes to the rescue. According to our model, stocks that have a favorable Zacks Rank #1 (Strong Buy), 2 (Buy) or 3 (Hold) and a positive Earnings ESP are likely to outperform. More often than not, a positive earnings surprise delivered by a company leads to stock price appreciation.

Earnings ESP is our proprietary methodology for identifying stocks that have high chances of surprising with their upcoming earnings announcement. It shows the percentage difference between the Most Accurate estimate and the Zacks Consensus Estimate. Our research shows that for stocks with this combination, the chance of a positive earnings surprise is as high as 70%.  

Our choices

With the aid of the above methodology, we have zeroed in on four airline stocks that are likely to beat the Zacks Consensus Estimate in Q3.

Based in Long Island City, NY, JetBlue Airways Corporation (JBLU - Analyst Report) is a low cost passenger airline that operates primarily on point-to-point routes. It operates an average of 825 daily flights and carries more than 30 million customers a year to 86 cities in the U.S., the Caribbean, and Latin America. The carrier has a Zacks Rank #2 and an Earnings ESP of +1.70%. The Zacks Consensus Estimate for Q3 has increased by 7 cents over the last three months to 59 cents per share. The carrier is expected to unveil its Q3 results on Oct 25. You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.
 
Hawaiian Holdings Inc. (HA - Snapshot Report) , a holding company of Hawaiian Airlines, is involved in transporting passengers as well as cargo. The carrier makes it to our list of likely outperformers in Q3 by virtue of its Zacks Rank #3 and Earnings ESP of +2.79%. The Zacks Consensus Estimate for Q3 has risen by 20 cents over the last three months to $1.79 per share. The carrier is scheduled to unveil its Q3 results on Oct 18.

Our next choice is Alaska Air Group (ALK - Analyst Report) , the parent company of Alaska Airlines. The Seattle, WA-based company carries a Zacks Rank #3 and has an Earnings ESP of +0.98%. The Zacks Consensus Estimate for Q3 has increased by 3 cents over the last month to $2.04 per share. The carrier is expected to unveil its Q3 results on Oct 27.

Las Vegas, NV-based Allegiant Travel Company (ALGT - Snapshot Report) also features in our current list of favorites owing its Zacks Rank #3 and an Earnings ESP of +3.03%. The Zacks Consensus Estimate for Q3 rose by 14 cents over the last month to $2.31 per share.

The parent company of Allegiant Airlines, which focuses on linking travelers in small cities to world-class leisure destinations, is expected to reveal its Q3 results on Oct 19.