Airline Stocks Not Ready for Take-off

The major U.S. air carriers are selling 80% of their seats, losing luggage at a record pace and departing and landing late like never before. Yet, the financially unstable industry is actually making money in 2007. So why not pick up some shares as you shell out $798 for that dreaded middle seat?

That wouldn't be smart. Airline stocks are not a good buy even though they appear to be cheap compared with other kinds of stocks in a market that is flirting with record highs. It's not an accident that virtually every major airline's stock is down this year, some of them by more than 30%. Here's why:

Trouble with the government. Even President Bush, who rarely baits big business, has ordered the airlines to fix their most horrific public-relations problem: taking care of delayed and stranded passengers so they don't sit in grounded planes for hours on end.

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The only solution the airlines seem to offer, besides apologizing that this only happens a few times a year, would be to cancel more flights, which means the payment of cash penalties and refunds or free tickets.

Plus, the various passengers' bills of rights, which deal with such things as clean restrooms and food and water, get more and more strident and add more costs for the airlines to shoulder.

Profit growth is slowing. A year ago the domestic airlines' operating revenues per seat-mile flown (if you ride 500 miles from Washington to Atlanta, you represent 500 seat-miles) were growing at 9%, while expenses were growing at a rate of 3%. Expenses have stopped rising this year (perhaps because fuel has temporarily leveled off). But so have revenues from passengers, even though fares are up, on average, and planes are fuller. This suggests that more people are flying at discounts.

In fact, more and more of the new seats coming into the sky for international and foreign flights are at deep discounts or low fares. Ryanair, an Irish company that flies cheap routes to out-of-the-way airports all over Europe, is now the biggest publicly traded carrier by market value and says its net profit margin of 20% is the highest in the industry. (Its American depositary receipts trade on Nasdaq under the symbol RYAAY; they closed October 12 at $47.02, up nearly 2%.)

But even though Ryannair says it will double in size by 2012, it is already warning of soft traffic for the months ahead. The stock trades trading at 25 times earnings -- and that's after a steep drop in the price of the ADRs last winter.

Fuel. Analysts at Lehman Brothers, like some others, make a case for a traders' rally in airline shares for 2008 -- if there are big drops in what the companies pay for fuel. (Ryanair's fuel costs are hedged for another 18 months, another reason why it's highly profitable). If the price of refined fuels falls, the airlines could see wider profit margins -- but that is a very big if.

Competition. The heavy demand for flying means that more airlines are starting up or expanding in the U.S. One example: Virgin America, which flies cross-country flights for $139 each way. More startups will put more pressure on the older, high-cost carriers and their share prices.

Bad history. Finally, there's the nasty history of investing in airlines. In a bad year, such as 2005, the industry lost $27 billion, including write-offs for bankruptcy charges at United, Delta and Northwest.

In a good year, such as 2007, the industry might make $4 billion. In recent memory, only one airline stock has ever taken on the characteristics of a long-term growth company, and that was Southwest Airlines (LUV), which expanded rapidly from a regional to a national airline in the 1980s and 1990s.

But over the past eight years, despite the strongest balance sheet in the business, no strikes and regular profits, the stock has gone nowhere. Southwest's successful fuel-hedging protected it for a while from inflation in oil prices, but that is no longer the case. Southwest is not so much a speculative stock but a grounded one. It closed at $14.67 October 12, essentially unchanged.

As for the rest of them, you're as likely to take off on schedule as see your shares get airborne.

Kosnett is the editor of Kiplinger Investing for Income and writes the "Cash in Hand" column for Kiplinger Personal Finance. He is an income-investing expert who covers bonds, real estate investment trusts, oil and gas income deals, dividend stocks and anything else that pays interest and dividends. He joined Kiplinger in 1981 after six years in newspapers, including the Baltimore Sun. He is a 1976 journalism graduate from the Medill School at Northwestern University and completed an executive program at the Carnegie-Mellon University business school in 1978.