Tailwinds are in Place for This Industry -- Down the Road

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During the past few years, airlines staged a remarkable comeback. The major legacy carriers such as Continental (NYSE: CAL ) , Delta (NYSE: DAL ) , AMR's (NYSE: AMR ) American Airlines and UAL's (Nasdaq: UAUA ) United took a lot of planes out of service, cut major cost-saving labor agreements, and benefited from sharply lower fuel prices. Large losses became large profits, helping the AMEX Airline Index (AMEX: XAL ) to rise from around $12 in March 2009 to $40 in mid-June.

Yet in recent weeks, the index has headed south, falling for eight straight sessions before a modest uptick on Wednesday. The sector saw some life when Delta 's CEO Richard Anderson spoke bullishly earlier in the day at his company's annual meeting. "The recession was a 'terrible cycle' that has wreaked havoc on balance sheets and stocks," he said, "but we are now moving into an up cycle."

That's certainly the case, by any measure. Ticket prices are higher, leading to +20% year-over-year gains in passenger revenue per average seat mile (known by the unwieldy industry moniker PRASM), fuel costs remain manageable, and the European volcano scare has abated, boosting air traffic on the Continent to pre-recession levels.

Firming prices and low costs add up to money in the bank: Continental, Delta , AMR and UAL should see profits rise sharply this year, posting their best gains in years. Continental for example, has a decent shot of earning even more than the $3.74 a share bagged in 2007, a high point for the last decade.

But clouds loom on the horizon. For starters, management talked labor into major concessions a few years ago, and many of those contracts are coming up for re-negotiation. You can bet that labor will be a lot less cooperative this time around.

In addition, even as European air travel has posted a solid rebound, further economic weakness on the Continent could spell trouble. Remember that planes have the same expenses whether they are half-full or completely full. As a rule of thumb, a plane needs to be roughly two-thirds filled to be operating at break-even. Right now, the load factor (the percentage of seats filled) is inching toward 80%. It helps that there are roughly 15% fewer planes flying than in 2008. The major carriers will begin releasing their latest load factors and PRASMs in the coming days (starting with Continental after the bell on Thursday), and share prices may move quickly up or down on that data.

Finally, the industry is always one step away from a profit-sapping spike in oil prices or a terrorism-related slump in air travel. Neither of those factors is of concern at the moment, but they can arrive without warning.

Company Name Ticker Recent Price 52-Week High 52-Week Low Loss from peak 2010 P/E Ratio 2011 P/E Ratio Market Cap. ($m)
Delta DAL $11.73 $14.94 $5.56 21% 7.1 4.9 9,270
Continental CAL $22.03 $25.58 $8.76 14% 6.2 4.8 3,080
AMR/American AMR $6.61 $10.50 $3.93 37% Neg. 7.0 2,210
UAL/United UAUA $20.64 $24.59 $3.07 16% 4.8 3.8 3,460
Southwest LUV $11.02 $13.97 $6.40 21% 15.5 11.5 8,180
JetBlue JBLU $5.44 $6.95 $4.08 22% 15.5 9.2 1,580
US Air LCC $8.75 $10.87 $2.00 20% 4.5 3.3 1,400


As the accompanying table shows, these stocks are dirt cheap, with several of them trading for less than five times projected 2011 earnings. Those price-to-earnings ratio (P/E) multiples are based on consensus estimates. And analysts are assuming very strong profit growth in 2011. But should they? After all, labor costs are set to rise, and it may be awhile before the global economy is truly healthy. So further volume and pricing gains may be hard to achieve.

Action to Take ---> It increasingly looks as if 2011 profit estimates will need to come down. So the industry P/E ratios are probably not as low as they appear in our table. But the kind of earnings power that analysts expect to see in 2011 could still well happen in 2012 or 2013. So shares are indeed quite cheap if you have that kind of time horizon.

It's worth noting that Southwest Air (NYSE: LUV ) is not as exposed to rising labor costs, as it inked more recent labor contracts. So analysts' estimates for LUV are not likely to come under the same pressure. In addition, this is the first time in its history that JetBlue (Nasdaq: JBLU ) has traded for less than ten times projected earnings. JetBlue also has a better labor cost profile than the big carriers. These two low-cost carriers are also less exposed to the possibly turbulent European air market, making them the safer plays, even if they sport higher P/E ratios than the larger legacy carriers.





-- David Sterman
Staff Writer
StreetAuthority


Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.

StreetAuthority


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

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This article appears in: Investing , Investing Ideas

Referenced Stocks: AMR , CAL , DAL , JBLU , LUV , UAUA , XAL

David Sterman

David Sterman

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