The managers of U.S. airlines finally have become "more concerned about profits than market share," says Ray Neidl, a senior aerospace analyst at Maxim Group in New York. And that's great news for investors.
The industry broke even in the seasonally weak first quarter, was profitable in the second and probably will earn more than $1 billion in the third quarter. The respectable results have come despite a 40% jump in jet-fuel prices in the second quarter from the year-earlier level, to more than $3 a gallon.
The improved outlook isn't evident in airline stocks, most of which have been pummeled this year on concerns about those fuel costs and the economy, plus memories of the bankruptcies of carriers including United Airlines, Delta Air Lines (DAL, news), US Airways Group (LCC, news) and Northwest Airlines over the past decade.
An emphasis on profitability, rather than market share, is lifting the prospects of U.S. airlines. This, in turn, should lift the stocks of the best-run carriers.
Indeed, despite their healthier prospects, airline stocks remain best suited for risk-tolerant investors. "They're the ultimate high-beta, economically sensitive stocks," says Michael Linenberg, the airline analyst at Deutsche Bank. "They're the first stocks that people get out of." High-beta stocks are more volatile than the overall market.
Adding to the potential volatility: Airline earnings estimates for 2011 have fallen since the start of the year, in part on worries that business travel, which accounts for an estimated 65% of carriers' revenue, may be weak. But airline-stock valuations look compelling. And they'll look even more so if fuel costs stabilize -- a distinct possibility, given the likely resumption of Libyan oil exports by year's end -- and the U.S. economy doesn't slide back into recession.
AMR (AMR, news), parent of American Airlines, is down more than 50% this year to about $3.50, not much above its 2009 low. Delta is off by a third; United Continental (UAL, news) has fallen about 25%; Southwest Airlines (LUV, news) has dropped about 35%; and JetBlue (JBLU, news) is off about 35%.
Some of the better plays are United Continental, Delta, Alaska Air (ALK, news), Southwest Airlines and JetBlue. All are expected to operate in the black this year. United Continental has an excellent network, including hubs in Newark, N.J., San Francisco and Chicago, plus lucrative Pacific routes. Delta is benefiting from the integration of its merger with Northwest. And United and Delta trade at just four times projected 2012 profits.
Alaska Air has industry-high profit margins of 13% and a solid niche on the West Coast. Southwest has the best balance sheet and a history of making money in good times and bad, while JetBlue has one of the newest fleets, loyal fliers and a growth strategy keyed to Boston and the Caribbean.
Dismal history
Since the Sept. 11, 2001, terrorist attacks, which disrupted airline travel around the world, the industry has chalked up big cumulative losses.
AMR, parent of American Airlines, is the group's riskiest stock, because it's losing money, owing to a high cost structure. US Airways Group has good management but a relatively weak route network, limited international exposure and near break-even results.
Overall, says Gary Chase, the airline analyst at Barclays Capital: "I don't think the fundamentals are as bad as what the stocks are suggesting. The market is discounting some probability of a global financial crisis."
It's understandable that investors are down on airlines, because most have significant debt, and their profits are acutely sensitive to changes in revenue. While most industry executives sounded upbeat on second-quarter conference calls, Southwest CEO Gary Kelly was cautious: "I am concerned about the U.S. economy. I have concerns about fuel prices."
Given their volatile history, airline stocks scare many long-term holders. But they're frequently trading vehicles for hedge funds and others seeking high-octane plays on energy prices and the economy.
Institutions often avoid stocks with negative profit revisions. United Continental now is expected to earn $3.30 a share in 2011, down from a forecast around $5 per share at the end of 2010. AMR is expected to lose almost $4 a share this year, versus a profit projection of 23 cents per share at year-end 2010.
Barclays analyst Chase is encouraged that airlines are doing a better job of aligning supply and demand, with the major carriers reducing domestic capacity as they retire older, less-fuel-efficient planes.
Comments Deutsche Bank's Linenberg: "The industry is reaping the benefits of a significant restructuring and greater concentration. For the first time in history, it is deleveraging its balance sheet." It's also consolidating. Pairings in recent years include Delta and Northwest, Continental and United Airlines, and USAir and America West.
United, Delta, Northwest and USAir used bankruptcy to restructure labor agreements, aircraft-leasing obligations and pension plans, to become competitive with low-cost carriers like Southwest and JetBlue.
