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American and Southwest: Still Flying

Airline stocks are already recovering from the knee-jerk selling that followed news of the British terror bust.

The sell-off among airline stocks on the news of the foiled terrorist plot was hardly surprising. After all, passengers could choose to stop flying, as many did after 9/11, because of fear or inconvenience. And airline stocks had been doing well, as the industry was once again making some money after many dismal years.

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But Citigroup analyst Andrew Light doesn't think the British affair will empty out the planes. "People travel for a reason, and these reasons are unlikely to go away," he explains in a research note. Although he acknowledges it's too early to assess the short-term financial effects of last week's disruptions, he thinks lasting damage will be minimal and that investors' knee-jerk reaction has created buying opportunities in a couple of carriers: Southwest Airlines (symbol LUV) and American Airlines (AMR).

Light says both stocks' stumbles have made them more attractive, so he upgraded both of them to buy on Tuesday, leaving his target price for each stock unchanged. He says that although his 2006 earnings estimates could go lower, his 2007 estimates look more resilient, given the airlines' ongoing cost-cutting efforts and favorable industry revenue conditions. Passengers as well as airport and security authorities will adapt to new restrictions. And though airlines will spend more for security, Light says carriers should be able to pass on the costs to customers with little problem. In any case, he notes that fuel costs are a much greater concern than extra security expenses.

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Protecting itself from higher fuel costs is what Southwest Airlines is famous for. Its fuel hedges have been a big financial advantage in the face of soaring oil prices. The hedges are scheduled to fall away over the next few years, which could be a challenge for Southwest if oil prices remain high. But oil is expected to come down. And Southwest still has its efficient operations and strong balance sheet -- a set of virtues rare among airlines. After a 3% lift on Tuesday, Southwest is at $17, about 7% below its 52-week high of $18.20, reached in July. Light figures the shares should pass $19 over the next 12 months.

American is a different story from Southwest. It has the usual culprits of an old airline: an underfunded pension plan, limited fuel hedges, a balance sheet in need of repair and an aging fleet, to name a few challenges. But Light says the earnings and balance sheet are improving, and he and other analysts do expect the company to turn a profit this year: The average earnings estimate is $1.92 per share, according to Thomson First Call. Still, this is a riskier stock than Southwest.

American shares enjoyed a 4% gain on Tuesday. At $20, they're about 32% off their 52-week high of $29, reached in May. Light hopes the stock can fly to $27 over the next year.

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