Airline stocks are ready to soar

By Robert Walberg

It's often said that the best way to make a small fortune in the airline business is to start with a large fortune.

Yet it may be time for investors to venture back into airlines.

Even as the broader market has flown to new highs recently, the airline sector remains grounded with concerns about high fuel costs and a modest upturn in capacity. The legacy carriers have seen their shares decline by an average of 39% from highs set in January. Regional carriers have declined an average of 20%.

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In addition to stubbornly high jet fuel costs, the sector must deal with aging fleets, contentious management-labor relations and heavy debt burdens. Competition among low-cost carriers such as JetBlue Airways (JBLU, news, msgs), Southwest Airlines (LUV, news, msgs) and AirTran Holdings (AAI, news, msgs) is also keeping a lid on fare increases while reversing the favorable capacity trend of the past couple of years.

Despite all that, most airline companies are expected to see increased profitability in fiscal 2007 and 2008. United Airlines parent UAL (UAUA, news, msgs), Delta Air Lines (DAL, news, msgs) and JetBlue should be among the biggest winners, with gains averaging in the triple digits in each of the next two years.

Not only are airline stocks relatively cheap when viewed against future earnings estimates, but bad news is being overstated, and the potential for new sources of revenue are being ignored. Toss in the likelihood of major mergers, and airline stocks could easily take flight within the next three to six months.

Fuel prices could lose altitude

Let's start with the bad news. Nothing gets more media attention than the high cost of fuel, though the average price of jet fuel is down from a year ago. Even crude at more than $70 a barrel would be roughly flat with year-ago levels. Considering that the peak travel season is already one-third over, it should be easy to see that fuel prices could start trending lower within the next 60 days.

From August 2006 to January 2007 the price of crude tumbled nearly 35%. Not surprisingly, airline stocks enjoyed a huge rally. Could a similar move be in store this year? You bet.

Meanwhile, airlines, especially the legacy carriers, have done an excellent job of reducing capacity. Industrywide load factors average about 77%, an improvement of roughly 12 percentage points over the past decade. Much of that gain has come amid the downsizing since Sept. 11, 2001.

Airlines have also been busy slashing nonfuel costs, starting with labor. According to a study by the International Air Transport Association (IATA), unit labor costs declined by more than 30% from 2001 to 2005, as did maintenance and distribution costs. Reduced nonfuel costs and increased capacity have helped offset the impact of higher fuel prices.

Though nonfuel costs are edging up again, the increases aren't big enough to threaten renewed profitability. Mergers could also improve operating efficiencies. Just last week, UAL Chief Financial Officer Jake Brace noted that the company is still interested in a merger. Potential targets include Delta, Continental Airlines (CAL, news, msgs) and US Airways Group (LCC, news, msgs).

Seeking new revenue sources

Airlines are also prepping to update their aging fleets with fuel-efficient planes. The cost could strain already leveraged balance sheets, but if the sector starts delivering the kind of profits expected over the next couple of years, those balance sheets will start to improve.

Most importantly, airlines are beginning to seek new sources of revenue. Taking a cue from the banking industry, they are starting to warm to the idea of user fees. For instance, a couple of regional carriers have begun to charge a fee for checked bags. Others are considering fees for everything from blankets and pillows, to window and aisle seating. Don't be surprised if in the near future you also see a nominal $5 to $10 jet fuel surcharge.

Expect the move to fee income to come gradually because price competition remains intense. But successful execution will only add to the earnings growth rates of the airline sector. If you find yourself wondering what to do now that the overall market is near its highs and many stocks seem overpriced, then ignore conventional wisdom and do some bargain hunting in the battered airline sector. Names worthy of consideration are American Airlines parent AMR Corp. (AMR, news, msgs), Continental, UAL and JetBlue. I expect all to keep pace with, if not outperform, the overall market for the rest of the year.

At the time of publication, Robert Walberg did not own or control shares of any company mentioned in this article.