Are airline stocks a bargain now?

By Michael Brush

With the clouds of recession so dark, what's keeping airlines aloft?

The economy's nose dive has already pushed scores of once-healthy companies into bankruptcy, even threatening to send icons such as General Motors (GM, news, msgs) into Chapter 11.

And while airline stocks are down (along with fares -- good news for consumers), the B-word so far hasn't really entered the conversation.

Why are airlines getting off so easy? The short answer: energy prices. What looked like the bane of the sector last summer -- skyrocketing fuel costs -- has actually turned out to be a saving grace. Despite a continuing decline in the number of flights taken by vacationers and business travelers, most airline companies are still expected to be profitable this year.

Some investors even consider the recent slide in the stock prices of Delta Air Lines (DAL, news, msgs), Continental Airlines (CAL, news, msgs), Southwest Airlines (LUV, news, msgs) and other carriers to be a buying opportunity for the long term.

Early to cut, early to rise

Those high energy prices forced airlines to cut capacity sharply throughout 2008. That gave them a jump on cost-cutting ahead of the severe pullback in consumer spending that followed later in the year. And as the economic pullback got worse, energy prices came down sharply, helping airlines further.

"The industry is actually in pretty good shape," says Mo Garfinkle, an airline-sector strategist with GCW Consulting. "What they did differently this time is take out capacity quicker and deeper and more permanently than they ever have before. They can actually weather the recession storm reasonably well, as long as it isn't a prolonged recession."

To be sure, airline investors have been through some terrible turbulence, and it is not over yet. Airline stocks have dropped as much as 75% in the past two years. Earnings are down sharply because cost-cutting hasn't kept up with fare reductions. Many analysts expect sales trends to remain anemic. And some say AMR (AMR, news, msgs), which runs American Airlines, and UAL (UAUA, news, msgs), which operates United Airlines, could go into bankruptcy if the recession drags out.

But there's good news in all this for consumers and investors.

Those pesky baggage fees aren't going away anytime soon, but intrepid vacationers and business travelers are enjoying ticket prices that are downright cheap. In February, domestic airfares were 8.7% lower than a year earlier, according to the Air Transport Association. Plus it's a lot easier now to upgrade to all those empty seats in business and first class.

Although airfares should firm up some during the summer travel season, competitive price cuts likely will begin anew in the fall. "The only way the airlines are going to attract people is to lower prices. It will be next year before we see an uptick," Garfinkle predicts.

As for investors, those who are patient and don't mind a little risk will probably do well to pick up airline stocks if the broader market pulls back in coming weeks. A market retrace would be typical after such an enormous run from the early March lows. Plus the coming release of March and April traffic data and lousy first-quarter earnings could hit airline stocks, Stifel Nicolaus analyst Hunter Keay cautions.

Investors bailing out too soon?

Here's why the airlines are likely to come back: Air travelers typically overreact in the first three to six months of a recession. Then air travel rebounds in a way that can lift the airline stocks nicely, Barclays (BCS, news, msgs) analyst Gary Chase says.

For example, U.S. domestic airline revenue fell 30% in the first two months after 9/11. But a year later, it was off only 22%. This time around, domestic revenue was off 16% as of January, followed by 19% declines in February and probably 15% to 20% declines in March, by early indications.

These grim trends have had investors heading for the exits. "We sense a good deal of capitulation, ironically, at a stage when the revenue environment has historically turned for the better," Chase says.

Because this recession could drag out and eliminate the potential for the short-term turnaround in airline stocks that Chase is looking for, it's probably better to go into the sector with a three- to five-year time horizon, says Craig Hodges of Hodges Capital Management, a mutual fund group that owns shares of Continental Airlines and AMR.

There are two ways to do this: One is to simply buy all the airline stocks and hope for the best. The other is to focus on those that will be sure survivors. Your overall returns might be lower than if you'd bought the whole group, because the stocks of the stronger players generally haven't dropped as much. But your risk would be lower, too.

Continued: On investors' radar

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