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A Turnaround for Airline Stocks

After years of bankruptcies and mergers, the airline business is profitable (for a change) and likely to remain so for years.

Yes, you can make money in airline stocks, one of the market's sorriest sectors over time. There's a simple explanation for the long-suffering group's turnaround: Airlines are making money (for a change), and prospects for future profits are as bright as they've been in years. The Standard & Poor's Dow Jones U.S. Airlines index gained 31.1% in 2012, beating Standard & Poor's 500-stock index by nearly 15 percentage points.

The past year aside, you can hardly find an industry with a more troubled history than airlines. From 1979, following the industry's deregulation the year before, through September 2012, U.S. passenger airlines suffered a total cumulative loss of $51 billion. S&P's airline index lost 1.2% annualized over the past 20 years through December 31, compared with an 8.2% annualized return for the S&P 500-stock index.

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But because bankruptcies have been so commonplace, airline indexes don't adequately show how miserably the stocks have performed over the long term. Delta Air Lines (symbol DAL), for example, has performance history tracing only to 2007, when it emerged from bankruptcy. US Airways (symbol LCC) was relisted, following bankruptcy reorganization, in 2005. AMR, the parent of American Airlines, filed for Chapter 11 in 2011, and it was delisted from the New York Stock Exchange in early 2012.

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But brighter times are finally on the horizon. "In each of the past three years, the industry has been profitable," says Michael Derchin, an analyst with CRT Capital Group. "This is a turning point."

After the mergers

In part, that's because of massive consolidation among U.S. carriers -- for example, Southwest Airlines (symbol LUV) acquired AirTran in 2011, and Delta purchased Northwest Airlines in 2008. Consolidation has helped to reduce the total number of seats available. That allows airlines to fill their planes more easily, and it means customers are more willing to pay up for existing seats. In 2011, the most recent year for which data is available, the average U.S. flight was 83% full. Ten years earlier the average U.S. flight was just 69% full, according to Airlines for America, the lobbying arm for U.S. carriers (both figures include passenger and cargo airlines).

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Smarter approaches by post-bankruptcy management teams also deserve credit. In the past, airlines have sabotaged themselves by unprofitably expanding capacity, adding routes and engaging in price wars in bids to gain market share. That's not happening anymore. Instead, companies have been cutting flights to many small and unprofitable airports. "They've become more focused on the markets where they have the most strength instead of adding unproductive capacity," says Jim Corridore, an analyst with S&P Capital IQ.

That focus stems from a broader shift in management's priorities. "When you hear these management teams speak in investor presentations, they're saying, ‘What can we do to expand profit margins? What can we do to improve return on invested capital?'" says Fred Lowrance, an analyst with Avondale Partners. "I'm not sure the companies' CEOs would have known how to calculate that ten years ago."

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The imposition of new kinds of fees has also been a boon. Though travelers find them annoying, charges for such things as snacks, roomier seats and checking a single bag are helping to expand airlines' bottom lines. So-called ancillary charges now total about $6 billion per year, says Derchin.

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North American airlines as a group are forecasted to earn profits of $3.4 billion in 2013, following anticipated earnings of $2.4 billion in 2012, according to the International Air Transport Association, the industry's international trade group. And air carriers' net profit margin (net profit divided by revenues) is forecasted to widen to 1.3% in 2013, from 1.0% in 2012. (Because running an airline is such a capital-intensive business, profit margins tend to be thin.)

That forecast, however, depends on fuel prices staying flat or falling over the next year. Jet fuel is currently at $128 per barrel, up from about $70 per barrel five years ago. At that price level, "it's a whole different kind of operating environment for airlines," says Lowrance. "Normally you see these peaks in prices, but they correct themselves when the economy slows. This time they haven't corrected themselves." The trade association projects that fuel will account for about one-third of airlines' costs in 2013. Carriers have limited ability to pass on rising fuel costs because price competition is so intense. "Because of the Internet you have pretty much total transparency on pricing," Derchin says.

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Continued strength in the airline business also depends on the health of the economy. Air travel is closely tied to the performance of the overall economy, because consumers can postpone vacations and companies can hold more meetings virtually when times are tight.

The best of the lot

Delta is the industry leader. It recently gained greater control of the busy New York-London route by agreeing to acquire 49% of Virgin Atlantic, a privately held British carrier. In April, Atlanta-based Delta announced that it would buy an oil refinery in a bid for a long-term solution to skyrocketing fuel costs. Delta executives have said they expect the move to result in about $300 million in savings annually. "They've been very innovative in trying to come up with solutions to their problems," says Derchin.

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On average, Delta earns more per seat on its planes than its competitors do because it serves more business travelers and has a more attractive destination mix, says Corridore. (Business-travel customers tend not bargain hunt as avidly as leisure travelers, so business travel tends to be more profitable for airlines.) Delta shares have climbed 51% over the past year, but they're still statistically cheap, as are most stocks in the cyclical airline industry. At $12.23, Delta trades for less than 5 times the $2.52 per share that analysts expect the company to earn in 2013 (all share prices are as of January 2).

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The granddaddy of discount travel, Southwest has long kept its focus on keeping down costs, and it has the record to show it. The Dallas-based company has earned an operating profit (meaning profits before subtracting for taxes and interest payments on debt) in each of the past 39 years.

Southwest has done so in part by keeping things simple. For example, it flies only one type of aircraft, the Boeing 737, in order to save on repairs and the cost of training crew and mechanics. And Southwest can turn its airplanes around faster than competitors because it does not operate on a hub system -- instead it flies point to point -- and because it often favors less-trafficked airports.

Southwest's recent acquisition of AirTran has shifted its focus, however. It will now run more flights to large, heavily trafficked airports, and it has an unfamiliar fleet of airplanes on its hands. Still, Corridore says that overall the marriage is a plus because it potentially means more business travelers for Southwest and gives it better access to hubs such as Boston and Atlanta. And rather than operate AirTran's fleet of Boeing 717s itself, Southwest will be leasing them to Delta. Southwest's shares have surged 23% over the past year. At $10.47, they trade for 11 times estimated 2013 earnings of $0.98 per share.

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Although Alaska Air Group (symbol ALK) may not be a household name for East Coasters, it one of the better-positioned U.S. airlines. The carrier primarily serves the Pacific Coast, with flights from Alaska, Canada, the mainland U.S. and Mexico. "The company has earned its cost of capital for the past three years in a row," says Derchin, who rates the stock a "strong buy." Alaska Air also has one of the best balance sheets in the industry, with more cash than debt on its books. At $43.94, the stock trades for 8 times forecasted 2013 earnings of $5.46 per share.

We’re not as high on the other three major U.S. carriers -- United Continental Holdings (symbol UAL), US Airways (symbol LCC) and JetBlue (symbol JBLU). That said, the stocks are likely to move in sync for the foreseeable future, so we wouldn’t dissuade you from buying a basket of all six companies.

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