Stock Watch
Flying High with Airline Stocks
The notoriously cyclical sector is booming, but the record shows it can’t stand prosperity.
By Lawrence Carrel, Contributing Editor, Kiplinger's Personal Finance
October 29, 2010
The skies have been unusually friendly of late for investors in the fickle airline industry. Over the past year through October 28, the NYSE Arca Global Airline Index surged 83.9%, walloping Standard & Poor’s 500-stock index by 68 percentage points. Can the sector keep it up? Don’t bet on it.
One big reason for the airlines’ big move is that they are classic cyclical stocks. When the economy takes a dive, travel is one of the first expenses cut by both businesses and vacationers. As the economy picks up, airline profits rebound robustly as businesses reinstate travel budgets and start filling planes with passengers paying full freight, as opposed to leisure travelers who buy the cheapest tickets they can find. The International Air Transport Association, a trade group, recently boosted its estimate for the industry’s 2010 profit, from $2.5 billion to $8.9 billion. The industry lost $9.9 billion last year, according to IATA.
Profit centers
One factor fueling the profit surge is, well, cheaper fuel. Until a recent jump to $83 a barrel, oil prices had been fairly stable at about $75. Meanwhile, ill-timed hedges that locked the airlines into paying almost $140 a barrel as oil prices fell have expired. On top of that, the fees instituted to cover the high cost of oil, such as charging for luggage, food and pillows, have brought in billions for airlines. Those fees fall right to the bottom line. By instituting all of those nuisance charges and reducing the number of routes they fly, the “airlines have changed their business model,” says Craig Hodges, co-manager of the Hodges Small Cap Fund.
The reduction in capacity has given the airlines a newfound ability to boost -- or at least maintain -- fare prices. The airlines have cut routes by retiring planes and engaging in a frenzy of mergers. Delta Air Lines (symbol DAL) merged with Northwest in 2008. On October 1, United Airlines closed its merger with Continental Airlines to create the new United Continental Holdings (UAL). This came just days just after Southwest Airlines (LUV), the largest U.S. discount carrier, agreed to buy AirTran Holdings (AAI), a low-cost rival, for $1.4 billion.
Still, not everyone is convinced that the airlines have transformed from a money pit -- in which most of the big players have gone through bankruptcy at least once -- to a solid, long-term investment. “I’m reluctant to say it’s different this time,” says Helane Becker, an analyst at Dahlman Rose & Co., a New York City–based investment bank. “Stuff always goes wrong.”
The headwinds facing the industry include sluggish economic growth and a high unemployment rate that will keep consumer confidence low. And if taxes increase in 2011, disposable income will drop. As always, the industry is unable to control its largest cost, the price of jet fuel. “People bought airline stocks because they thought the airlines would recover, and they have,” says Bob McAdoo, an analyst at Avondale Partners, in Nashville. “If we have a double-dip recession, these stocks will pull back more than the rest of the market.”
Given the industry’s record and the recent run-up in share prices, it’s hard to be enthusiastic about the stocks. Southwest is the best bet. The Dallas company should be able to dominate the U.S. market after its merger with AirTran. By launching price wars and refusing to charge for bags, it will be a big hit in the high-fare markets it moves into, such as New York, Washington, D.C., and Atlanta. Not only will this increase Southwest’s market share, but it will take a toll on the revenues of competing airlines in these cities. Southwest’s takeover of AirTran’s Atlanta hub will hit Delta especially hard.
Southwest reflects the industry’s improving profit picture. The company earned $140 million, or 19 cents a share, in 2009. Analysts were expecting 71 cents a share in 2010 and see 94 cents a share in 2011. The stock has recovered from about $5 in March 2009 to $13.76 as of the October 28 market close. “We think Southwest is fairly priced, but it has a 15% upside if the merger is approved,” says Vaughn Cordle, chief analyst at AirlineForecasts, a research group based in Washington, D.C. “However, I would sell as soon as it approached $15.”
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