Strong pent-up demand is driving a recovery in the travel and tourism sectors, although rising cost-of-living pressures are expected to eventually bite.

Morningstar director of equity research Brian Han says consumer spending on leisure and travel has so far held up well despite rising interest rates and inflation.

"I think that pent-up demand is palpable and still being released," he says.

Han points to a battle between the release of pent-up demand to travel and have a good time, versus the rising cost of living, which revenge travel—or people making up for lost time during the COVID-19 pandemic—is currently winning.

Airport

Pent-up demand has driven a recovery for airlines, travel agents and leisure businesses.

But Han believes it is inevitable that the pent-up demand will eventually die off.

"Sooner or later cost of living pressures and interest rate rises, and mortgage stress, will eventually have an impact."

Revenge travel boom driving recovery


Han says the travel and leisure sector has proven to be very resilient to this point, thanks to the significant demand from consumers to resume travel and the savings accumulated during pandemic restrictions.

"It has been resilient because there's just been this release of pent-up demand after two-odd years of COVID imprisonment," he explains.

The release of pent-up demand has helped drive a recovery for airlines, travel agents and leisure businesses hit by domestic and international travel restrictions.

Despite the recovery in revenue and earnings, Han notes travel and leisure-related companies still have a long way to go to return to pre-pandemic profitability levels.

"There will be a natural reversion back to that level. If economic conditions stay weak or precarious it might take longer to get back to pre-pandemic levels, but eventually I think they will."

Flight Centre (FLT), one of the world's biggest travel agents, and Helloworld Travel (HLO) say travel demand is holding up strongly despite challenging economic conditions.

Overseas arrivals into Australia in March reached 80% of March 2019 levels, and the number of short-term international trips by Aussies is up significantly compared to a year ago, Tuesday's Australian Bureau of Statistics data shows.

Morningstar equity analyst Angus Hewitt, who covers Qantas (QAN) and Air New Zealand (AIZ) which have both returned to profitability, says there is plenty of pent-up demand for domestic and international travel.

Consumers' COVID savings are helping dampen the impact of rising cost-of-living pressures on air travel, he adds.

"There's enough pent-up demand and supply is still tight enough that that's not yet having an impact."

Air New Zealand has upgraded its earnings guidance for the 2023 financial year, as it continues to experience strong levels of demand on both the domestic and international networks while jet fuel prices have moderated.

Possible sign of slowing leisure demand


Han says a relatively subdued trading update from theme park owner Ardent Leisure (ALG) may be an early sign that post-pandemic leisure demand is slowing after 11 rate hikes over the past year and escalating cost-of-living pressures.

"That is the first perhaps tentative sign that maybe, just maybe, 11 interest rate increases are now finally having some impact on even this pent-up travel and leisure demand," he says.

"In the near term I think that pent-up demand has held up relatively well, better than expected. But over the long term, it was bound to slow down and there is no surprise in that.

"You would have to say that over the next 12 months things will just normalise."

In Friday's update, Ardent Leisure notes its theme parks and attractions business had a meaningful increase in attendances and per capita revenues in the third quarter.

But the Dreamworld owner says year-on-year growth has moderated in the second half compared to the previous corresponding period, when it had its busiest Easter for several years.

It also points to a reduction in consumer spending in the current macroeconomic environment of high inflation, rising interest rates and recession fears.

"The group is of the view that the current economic headwinds are episodic and not emblematic of the leisure industry," Ardent says, adding that international visitation is gradually recovering and presents upside potential for its attractions.

Strong demand driving airline profits


Hewitt says airlines are enjoying strong conditions after having their wings clipped during the pandemic.

"Demand is roaring back. There is still a bit of a bottleneck of capacity, so what we're seeing is demand outstripping supply and it's leading to high ticket prices and really full planes."

Hewitt says the strong demand is driving exceptional profitability for Qantas, which rececently announced a new CEO, and Air New Zealand.

"We're definitely seeing them really bounce back. They've gone from record losses to record profits in a very quick time."

Hewitt says investors should note the current conditions will not persist in the long term.

"These conditions are abnormal and profitability on the back of it is abnormal," he says.

"These conditions are about as good as it gets for airlines."

Hewitt expects the airlines will face increasing competition, along with price competition.

In the lucrative Australian domestic market, Virgin Australia has rebounded from its 2020 administration and its private equity owner is looking to relist the airline, ASX-listed Rex (REX) has expanded its routes and private equity-backed budget airline Bonza is flying.

"The competition in the domestic market is certainly ramping up quickly," Hewitt says.

"As capacity comes back, competition will come back between airlines and internationally it's more competitive."

Qantas' domestic capacity is expected to exceed pre-COVID levels this financial year, while Morningstar expects the international business will return to 2019 fiscal year levels in fiscal 2024.

Hewitt expects Air New Zealand's domestic capacity will have recovered to June 2019 levels by June this year, although its international capacity will not return to pre-COVID levels as the airline now has a smaller long-haul fleet.

Picking stocks amid the revenge travel battle


Han believes investors' differing views about the battle between pent-up demand and rising living costs is a reason half the leisure stocks he covers are trading below what Morningstar thinks they are worth, and half are trading above their fair value estimates.

He notes companies like Ardent Leisure, Corporate Travel Management (CTD), and hotels, cinemas and Thredbo ski resort operator EVT are still trading around 15% below what Morningstar thinks they are worth.

But companies like Flight Centre and Webjet (WEB) are trading about 15% above Morningstar's fair value estimate.

"It does show that we're at that precarious balancing stage whereby some people now believe that all that pent-up demand has been fully released and now we have to keep an eye on the economic factors, whereas the other half is a glass half full crowd and they say there is still a little bit more to go."

Noting the leisure and travel sector is highly cyclical, Han says it is important investors have a firm view about a company's longer-term sustainable earnings and derive an intrinsic value based on that.

Morningstar views Qantas shares as fairly valued, while Air New Zealand is trading at a 20% discount to its fair value estimate.

Kelsian (KLS), a defensive tourism stock newly covered by Morningstar is trading in a range considered to be fairly valued.