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4 ways to play the airlines' comeback
Simple supply and demand means airlines -- at least the ones not in bankruptcy -- are now thriving on higher fares and fuller planes.
By Michael Brush
Airline investors don't have to keep their airsick bags quite so close at hand these days.
With airlines such as Delta Air Lines (DALRQ, news, msgs) and Northwest Airlines (NWACQ, news, msgs) nose-diving into bankruptcy, you may have missed the good news from the airline sector: Stocks of the old-line airlines that dodged bankruptcy (or that have emerged from it) are climbing fast.
Continental Airlines (CAL, news, msgs) and AMR (AMR, news, msgs), the parent of American Airlines, have advanced more than 250%. US Airways Group (LCC, news, msgs) stock is up about 65% since the company came out of bankruptcy in late September.
These legacy airlines were once written off because of high costs and competition from more nimble regional carriers. So whats providing the lift, now? Its a simple matter of supply and demand, says Roger King, an airline analyst at the independent research shop CreditSights.
After the terror strikes in 2001, air travel plummeted and the airlines put expansion plans on hold. Over the past two years, demand has been rebounding. But airlines were slow to start booking orders for new aircraft, which take years to deliver.
The result is an imbalance between demand and available seats, which gives the legacy carriers the power to raise prices. Barring a sharp spike in oil prices or an economic slowdown, results at the legacy airlines will continue to improve because of the supply-demand imbalance. Because orders for new planes take so long to fill, this imbalance could continue for another two years, predicts CreditSights King.
Goldman Sachs Group analyst Glenn Engel believes U.S. passenger airlines might even break even this year, after losing $28 billion over the past five years. He expects the airlines to post $2 billion in pretax profits in 2007.
Putting passengers in seats
The bull case was confirmed in early March, when Continental Airlines released February traffic numbers. Traffic was up 13%, and the airlines "load factor" -- the percentage of seats with passengers in them -- was 76%, 2.1 percentage points above last February. That was a record for February.
Related news and commentary on MSN Money
This meant Continental could hike prices, an unusual twist for whats normally considered a slow travel month, points out Ray Neidl, an analyst with Caylon Securities. The airline increased revenue per available seat mile (RASM) by over 8%.
Continentals results are a sign of things to come at other airlines, because Continental releases traffic numbers early and is one of the few to report RASM monthly.
The biggest problem is that it takes so long for orders for new planes to get filled. Orders placed last year wont be filled until after 2008 at the earliest, predicts King. "Worldwide demand is growing faster than Airbus and Boeing (BA, news, msgs) are building planes," says King. "Production will catch up and surpass demand in a few years, but for now the tailwinds are behind the airlines."
Part of the reason is that aircraft manufacturers committed lots of production to airlines in India, China, Brazil and Western Europe, says JP Morgan Chase (JPM, news, msgs) airline-sector analyst Jamie Baker.
To compound the problem, many U.S. airlines are redeploying aircraft to foreign markets where profit margins are higher, says Thrivent Investment Management bond analyst William Hochmuth. Another factor reducing supply: Airfreight companies are buying a lot of wide-body planes, taking them out of use for air travel.
"I fly a lot, and flights are all full these days, first class or coach," says investor James Rogers, author of "Adventure Capitalist," who owns many airline stocks as a play on the trend. "Fares are going up, and I dont mean just a little, even if you book in advance."
King calculates that RASM at U.S. airlines went up anywhere 10% to 14% a month from September through January. Given that so much of the cost of running an airline is fixed, increases in ticket prices drop right to the bottom line. King estimates that if RASM goes up another 10% and oil prices go back to $50 a barrel, the cash flow at U.S. airlines will double.
Here are four ways to play the airline resurgence.
The momentum plays
AMR and Continental Airlines look risky because their stocks have climbed the most since September. And investors are making big bets against these airlines with huge short positions (investors go short by borrowing stock and then selling it, betting the stock will go down so they can replace it at a lower price).
About 25% of the available shares in both of these airlines are short. But this huge short position could actually be bullish for shareholders, points out Todd Salamone, vice president of research at Schaeffers Investment Research.
After all, what happens if things go right for these airlines, as King expects? The stocks will advance. Then shorts may feel pressure to buy the stock to cover their positions, driving the shares up higher.
Back from bankruptcy
US Airways shed a lot of costs in bankruptcy, and it should be more profitable than AMR or Continental. Yet its stock is cheaper. Thats why J.P. Morgans Baker rates the stock "overweight" with a price target of $47 by year-end. The stock may be weak near-term because millions of shares subject to lock-up arrangements after the bankruptcy will be free to trade this spring.
Likewise, UAL (UAUA, news, msgs), parent company of United Airlines, should do well because it strengthened its balance sheet and cut costs while it was in bankruptcy.
The airlines in bankruptcy
It may be tempting to buy shares of airlines in bankruptcy such as Delta and Northwest because they trade for pennies. But dont be fooled. More often than not, the shares of companies in bankruptcy get wiped out, making them a bad bet.
Instead, investors can play the turnaround in these companies by purchasing bonds. Just be aware that bankruptcy can drag out for many months. During that time, it wont always be clear how well your bonds will do in the process of determining the size of various creditors stakes in the reorganized company. "So you have to have a fairly strong stomach," says George Putnam of The Turnaround Letter, who owns Northwest Airlines debt in managed accounts at his investment management firm, New Generation Advisers.
China
Thanks to a booming economy, there are capacity shortages in China, too. Rogers is playing the trend by owning shares in several Chinese airlines, including two that are listed in the U.S.: China Southern Airlines (ZNH, news, msgs) and China Eastern Airlines (CEA, news, msgs). He also holds Northwest Airlines bonds because the airline, which is in bankruptcy, owns lots of valuable routes in Asia.
Risks
The biggest threat is a sharp spike in oil prices that would saddle airlines with higher fuel costs. But airlines are aware of this risk -- one reason they have been careful about adding too much capacity, says Rogers. "The airlines have stopped pricing tickets on the expectation that oil is going back to $25 a barrel," Rogers says. "They have stopped living in never-never land."
Another big risk, of course, is that the economy slows down -- killing demand and reminding investors that airlines go through regular cycles of boom and bust that create sharp volatility in their stocks.
Thats one reason Morningstar advises buy-and-hold investors to steer clear of these stocks. "We do not recommend legacy airlines to long-term investors who seek stable price appreciation throughout economic cycles," Morningstar said in a recent note.
At the time of publication, Michael Brush did not own or control shares of companies mentioned in this column.
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