Airline Stocks Take Off in 2010
Andrew Leckey

HOME > WEALTH

The skies are always turbulent for investors in airline stocks, whether due to oil prices, economic trends, fare wars or labor union issues.

Yet 2010 has been the start of something big in terms of financial success, with many airline stocks strong performers. The question is how long surprisingly good times will last.

"The airline industry is in a sweet spot right now," observed Hunter Keay, airline analyst with Stifel Nicolaus in Baltimore. "Business travel has recovered after one of the worst crisis periods the industry has ever suffered, there's been discipline in handling capacity and oil prices have stayed in a tight lower-price band."

Throughout its history, the industry has been cyclical, with a tendency to fall into pricing battles and financing of too many aircraft. For now, it's exhibiting restraint as it copes with a difficult economy.

"Airlines are acting in a much more disciplined manner than they have historically," acknowledged Michael Derchin, airline analyst with CRT Capital Management Group, Stamford, Conn. "They're no longer ordering too many new aircraft, they're not flying routes that lose money and they're using their extra cash to pay down debt."

It is a time of consolidation, with the Southwest Airlines purchase of AirTran and the merger of United and Continental recent examples. Keeping up with all the trends is not easy.

"There are fewer flights and ticket prices are higher, a pure case of supply and demand," said Basili Alukos, airline analyst with Morningstar Inc. in Chicago. "Tight credit meant most carriers couldn't buy more planes unless they had a lot of cash on hand and high oil prices deterred new carriers from entering the industry."

There are opportunities to invest in airline carriers of varying sizes if you focus on fundamentals and ability to navigate the future.

For example, the stock of the largest U.S. airline is recommended by Derchin and Keay. In fact, United Continental Holdings Inc. (UAL), holding company for the merged United and Continental, may have the greatest upside potential of the large carriers. It has strong cash flow and more seats to China than any other U.S. carrier.

United Continental operates about 5,800 flights daily on six continents and is also a member of Star Alliance, with 21,000 daily flights to 181 countries. It has placed special focus on first-class and economy-plus passengers to woo business travelers. Besides potential cost-savings from the merger, it has the muscle to steal market share from competitors.

"Only one airline merger in the past 30 years has been a success since there are usually differing priorities between management and labor unions, and it is difficult to integrate the unions at two different airlines," said Keay, noting that United Continental stock is inexpensively priced. "The merger of Delta and Northwest was executed flawlessly in 2008 and 2009, resulting in a new playbook which United Continental would be wise to learn from."

Another investment choice is a smaller carrier that receives a lot of respect on Wall Street. Alaska Air Group Inc. (ALK), which has about 25 percent of its capacity in the state of Alaska, is recommended by Alukos in part because its local market is so small that no other carrier can compete effectively with it there.

It also provides service to about 90 destinations on the west coast, Mexico and Canada. This outstanding operator with strong customer satisfaction ratings has upgraded its entire fleet to more fuel-efficient Boeing 737 aircraft. About half of flights emanate from Seattle. Alaska Air could potentially also be an acquisition target of a larger carrier such as Delta Airlines Inc.

Besides United Continental, Derchin recommends Delta (DAL) and JetBlue Airways Corp. (JBLU) because their discipline is better than their peers and they are certain to make gains from recovering economies around the world.

"The airline industry unfortunately is structurally flawed over the long run," cautioned Keay, who deems the current discipline is likely to continue through 2011 and into 2012. "It will at some point in the future self-destruct because aircraft is an attractive asset to finance that can lead to insufficient capital."

Because of individual carrier risks and volatility, a basket of hub-and-spoke airlines with strong ties to business travelers is the strategy suggested for investors by Keay. His basket of stocks would include AMR Corp. (AMR); US Airways Group Inc. (LCC); Delta Air Lines Inc. (DAL); United Continental; and Alaska Air.

"Not only do we see major mergers going on in the U.S., but we have global alliances that are almost like mergers," said Derchin, who believes many changes such as downsizing of operations will be long-term. "Governments are allowing airlines to basically collude on setting prices and schedules with antitrust immunity."

In addition to Alaska Air, Alukos also likes stock of regional carriers Republic Airways Holdings Inc. (RJET), SkyWest Inc. (SKYW) and Pinnacle Airlines Corp. (PNCL) because the large legacy carriers need them.

"I would still agree that airline stocks should be considered trading stocks rather than long-term investments," concluded Alukos. "The difference today is that they do appear to be a little wiser than in the past, even though there will always be wildcards in the airline industry."

Available at Amazon.com:

The Seven Deadly Sins of Investing: How to Conquer Your Worst Impulses and Save Your Financial Future

Generation Earn: The Young Professional's Guide to Spending, Investing, and Giving Back

What Investors Really Want: Know What Drives Investor Behavior and Make Smarter Financial Decisions