Global travel demand is rebounding as two years of Covid-19-induced mobility restrictions and health concerns ease up globally. This presents a sunny outlook for airlines, an industry battered by the fallout of the pandemic.

Leading North American airlines are seeing a spike in booking activity based on factors including pent-up demand, “revenge travel” and consumers’ willingness to shrug off soaring jet fuel prices in the wake of sanctions on Russia, a major oil producer.

These trends point to a multi-year growth for the travel and tourism sector. Investors may want to take a close look at the following undervalued airline stocks in the Morningstar coverage universe.

Air Canada (AC) 

Canada’s largest airline, Air Canada (AC) serves nearly 50 million passengers each year together with its regional partners. The carrier is a sixth freedom airline, similar to Gulf carriers, which flies many U.S. nationals on long-haul trips with a layover in Canada. It racked up $19 billion in revenue in 2019 before the pandemic hit operations and dragged revenue down to $6 billion in 2020.

The Canadian flag carrier is internationally focused with only about 22% of 2019 capacity was utilised for domestic Canadian flights.

“We’re anticipating a short-haul leisure-led recovery, and think that Air Canada’s low-cost carrier, Rouge, will continue providing a low-cost product that effectively competes against [rivals],” says a Morningstar equity report.

The company’s long-haul leisure traffic is contingent on the global distribution of the COVID-19 vaccine and “will keep capacity lower for longer until international travel demand returns,” says Morningstar equity analyst Burkett Huey, pointing out that Air Canada came into the COVID-19 crisis in better financial shape than many U.S.-based peers.

The pandemic has been airlines’ sharpest demand shock in history. However, border reopenings offer Air Canada a pathway for recovery.

Management intends to fly about 66% of 2019 first-quarter available seat miles during the first quarter 2022. “The firm will finally be able to redeploy long-haul capacity at some scale in 2022,” asserts Huey who puts the stock’s fair value at $28.

The carrier’s frequent flier program, Aeroplan, which it reacquired in 2019, has been popular with frequent fliers and “provides a high-margin income stream to the airline,” Huey says.

Delta Air Lines Inc (DAL)

Delta Air Lines (DAL) is one of the world's largest airlines. Its network spans to more than 300 destinations across more than 50 countries. Delta operates a hub-and-spoke system network, where it gathers and distributes passengers across the globe through key locations such as Atlanta, New York, Salt Lake City, Detroit, Seattle, and Minneapolis-St. Paul.

“Delta is the highest-quality legacy carrier because it has been able to attract high-yielding business travellers through its product segmentation and credit card partnerships, primarily with American Express,” says a Morningstar equity report.

Delta-cobranded cards alone account for about a fifth of American Express’ loan book.

The legacy airline’s five-cabin segmentation strategy allows high-spending travellers to purchase premium options. “Frequently, business travellers use miles from a cobranded credit card to upgrade flights when their company is unwilling to pay a premium price,” says Huey, noting “Delta can continue expanding this higher-margin business after the pandemic.”

Delta will continue to target high-yielding business travellers, even though the market may remain difficult for the time being, he adds.

Huey forecasts a full recovery in capacity and an 80%-90% recovery in business travel that subsequently grows at GDP levels over the medium term. “We think that Delta is well positioned to withstand the pandemic, but its strategy of extracting value from business travellers will be challenging in a lower-fare environment,” says Huey recently lifted the stock’s fair value from US$54.50 to US$57, prompted by the pace of the recovery in air traffic and midcycle operating margin.

Southwest Airlines Co (LUV)

The largest domestic carrier in the US, Southwest Airlines (LUV) operates over 700 aircraft in an all-Boeing 737 fleet. Despite expanding into longer routes and business travel, the airline still specializes in short-haul leisure flights, using a point-to-point network. 

“Southwest’s customer-friendly tactics benefit the firm by providing the closest thing to a brand asset in the airline industry,” says a Morningstar equity report.

More than 85% of Southwest's sales are through its own distribution channel, while other carriers have a higher reliance on third-party distributors to earn customers.

In the leisure market, Southwest will have to contend with competition from ultra-low-cost carriers, “but we think that Southwest's customer-friendly tactics allow it to target higher-income demographics,” says Huey, who expects commercial aviation to recover on the back of leisure travel, “reflecting customers' greater willingness to visit friends and family and go on vacation in a pandemic than to travel for business.”

That said, Southwest is also courting higher-yielding business travellers to support growth. A structural lack of transoceanic routes and premium options may limit Southwest's ability to attract the highest-yielding business travellers, but the airline’s “focus on providing low fares and its relatively new global distribution system, which enables bulk purchases of reservations, ought to allow it to take business travel share while business travellers are looking to cut costs,” argues Huey, who recently raised the stock’s fair value from US$63 to US$65, prompted by a rebound in air traffic.

Air New Zealand (AIR, AIZ)

Air New Zealand (ASX: AIZ) provides air passenger and cargo transport services within New Zealand, as well as to and from Australia, the South-West Pacific, Asia, North America, the United Kingdom, and South America. Air New Zealand dominates the local market, with around 80% market share, although the majority of revenue is derived from international and trans-Tasman activity.

Morningstar equity analyst Angus Hewitt has recently downgraded his fair value estimate for Air New Zealand by 5% to AU$1.68 following the release of its interim fiscal 2022 earnings. However, his long-term thesis remains intact, namely that despite near-term headwinds, the worst is now behind Air New Zealand, and it is well-positioned to thrive as borders reopen and air travel returns.

"The underlying pretax loss of NZ$376 million was nearly double the NZ$186 million pretax loss in the previous corresponding period as international border closures and domestic movement restrictions weighed on air travel," he says. 

On the elevated price of oil, Hewitt expects this to weigh of AIR's fuel bill in fiscal 2022 and fiscal 2023. But he forecasts fuel prices have peaked and will not impact long-term profitability. 

"While movements in oil prices can lead to short-term swings in profitability, carriers' long-term profitability has little to do with fuel given the cost affects all players almost equally," he says. 

"Reductions in fuel costs are typically competed away, and savings are passed through to customers, reflecting the extremely high level of competitiveness in the airline sector."

Additional reporting from Emma Rapaport, editorial manager, Morningstar Australia.