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Morningstar | We’re Grounding Our FVEs for Southwest, Westjet, and Air Canada; Delta Remains Our Top Choice

We plan to lower our fair value estimates for Southwest, Air Canada, and Westjet by 5%-6% after U.S. and Canadian authorities grounded Boeing 737 MAX aircraft following the second fatal crash in five months. Among the names we cover, the indefinite grounding affects Southwest, American Airlines, United Continental, Air Canada, and Westjet. We find Southwest, Air Canada, and Westjet the most affected because MAX aircraft make up 8% of Air Canada’s current fleet and most of its 2019 aircraft deliveries, all of Southwest’s upcoming deliveries, and 6% of Westjet’s mainline fleet.

In each model, we've revised our 2019 unit revenue, fuel cost per seat mile, capacity (available seat miles), and revenue passenger mile forecasts to reflect ensuing flight cancellations and passenger reimbursements, but also network reorganization and weaker fleet economics stemming from 737 MAX absences. Carriers expected new MAX aircraft would bring lower fuel burn per seat, higher density, and longer range versus outgoing aircraft. Assuming the groundings last for several months, we think Air Canada and Southwest will slow their planned aircraft retirements in 2019 (24 for Air Canada and 20 for Southwest). For Southwest, we expect newer 800s will relieve grounded MAX aircraft. A mix of retiring A320s and 767s will fill the void left by Air Canada’s MAX aircraft. Westjet didn’t plan to retire aircraft in 2019, so it will need to redeploy next-generation 737s and wide-body aircraft to offset MAX groundings.

Historically lean fleets will face near-term supply pressure with few aircraft available in storage and already tight 737 lease markets likely to command a premium now. Our updated valuations feature narrower margins from lower unit revenue and higher costs. We do expect Boeing to compensate carriers for flight cancellations, but neither Boeing nor airlines traditionally reveal the value or nature of payments, so we’ve excluded remuneration for the time being.

Southwest’s 2019 expansion target (4%-5%) is based on penetrating Hawaiian markets (more dependent on 737-800s) and enhancing mainland U.S. routes with added capacity and longer stage lengths (highly dependent on new 737 MAX additions). The first batch of MAX aircraft allowed Southwest to beef up travel between its strongholds and improve offerings to sun markets (Caribbean, Latin America, and Southern United States), but now these routes will fall short of planned capacity targets with older, costlier aircraft occupying those routes. Assuming we see an extended suspension of service, we have lowered our 2019 available seat mile and revenue passenger mile growth forecasts by about 65 basis points. Southwest runs its fleet lean and doesn’t store aircraft, so we expect it to pull planes from high-frequency routes in order to support thinner markets. We expect unit revenue growth will decelerate due to this reorganization.

The 737 MAX aircraft is an integral part of Air Canada’s Atlantic, transborder, and transcontinental expansion strategy. With Canadian authorities grounding the MAX, we expect Air Canada will consolidate routes and fail to reap the benefits of planned upgauging. Since we believe MAX aircraft will remain grounded for several months, we assume Air Canada will cull 767 and A320 retirements, absent any costly maintenance work. Through route consolidation, wide-body aircraft will replace MAX aircraft in long-haul markets like Hawaii, the Caribbean, and Europe. Meanwhile, A320s, which the MAX 8 was intended to replace, will help alleviate stress in North American markets that reach into the U.S. or cover Canada. We raised our cost per available seat mile expectations for 2019 after considering the higher costs associated with keeping older aircraft in service. We also lowered unit revenue forecasts on fewer premium and high revenue seats per aircraft, given the downgauge.

Our available seat mile and revenue passenger mile revisions for Westjet were slightly more severe since the carrier doesn’t have retirements to ease the burden of grounded MAX 8s. Also, the four MAX deliveries planned for 2019 constitute over half of Westjet’s additions, making the new narrow bodies highly important to growth through the remainder of 2019. We lowered available seat mile and passenger mile growth by 50 basis points for domestic markets but slashed U.S. transborder and international growth by 500 basis points, since MAX 8s were expected to underscore new routes into the Atlantic and sunshine markets.

United and American also have exposure to MAX aircraft, but we believe both carriers can use supplementary narrow-body and wide-body aircraft to make up for downed MAX capacity. Our forecast revisions for these two carriers are immaterial because MAX aircraft constitute an insignificant percentage of flights.

Delta is the only carrier we cover with no exposure to the recent groundings, thanks to its use of A320 neos instead of 737 MAXs. Delta remains our top choice, and we think the shares offer decent upside compared with our $61 fair value estimate.