Airlines Must Overcome Legion of Doubters

Even as oil prices have been falling steadily, the Amex Airline Index (XAL) has been stuck in a trading band. The sector is pushed (by falling oil prices) and pulled (by fears of an extremely weak economy in 2009).

A bottom-up analysis shows that falling oil prices are the more meaningful variable. The chart below highlights a couple of unusual points. First, the top seven domestic carriers are now set to be solidly profitable in 2009 (compared to losses at six of them in 2008). Second, the four biggest carriers trade for just 3.1 to 5.5 times projected 2009 consensus profits.

I have written about the airline group when oil was at $120 and at $70. With oil now under $50 and perhaps going below $40 per barrel, the case for airline stocks has become increasingly compelling. The plunge in oil represents a savings of more than $20 billion to the entire domestic industry.

But many obviously remain dubious of a profit renaissance. They cite concerns that the economy will contract even more deeply than is currently anticipated. To be sure, many analysts are already building in assumption of a 10% to 15% revenue drop in 2009 as more planes are taken out of service. Analysts are also concerned that the industry will resort to its old nasty habit of fare wars. Yet the entire logic of massive capacity cuts in 2008 and again in 2009 is to keep planes sufficiently full to avoid the temptation to discount.

But let's revisit that chart above to include only the most bearish forecast on First Call. These forecasts presumably include the worst-case scenario in terms of demand and pricing, or they could simply be outdated estimates that have not yet incorporated the sharp plunge in jet fuel costs.

Although stocks don't look stunningly cheap in this worst-case scenario, it is clear they can generally remain profitable, a far cry from the massive losses they are set to post this year.

It's helpful to get a read on revenue trends, capacity plans and load factors (how full the planes are). Let's look at Delta (DAL - commentary - Cramer's Take), which is now the nation's largest carrier after merging with Northwest. Delta reduced its mainline capacity 12% in November when compared to a year ago; regional jet service fell a heady 19%. The combined carrier has hinted at another 8% to 10% cuts in 2009. Delta expects that the drop in fuel prices will save the carrier $5 billion in 2009; add in headcount reductions and other savings, and that figure rises north of $7 billion.

Thanks to declining capacity, Delta's load factor actually rose 0.3% when compared to a year ago. In fact, Delta and all its peers are generating load factors of between 72% and 78%. If they can stay in that area in the months to come, the odds of profit-sapping fare wars will be greatly reduced.

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David Sterman has been an equity analyst and financial journalist for 15 years, most recently serving as Director of Research at Jesup & Lamont Securities.