Low-Cost Carriers Rally on Upgrade

Broker Raymond James says fare cuts by legacy airlines are having a limited impact.
By Eric Gillin ,

Shares of low-cost airlines may be fashionable once again.

After battered and near-bankrupt legacy carriers saw their shares skyrocket in 2003, Wall Street analysts have been bearish on the low-cost carriers, saying rivals have more upside and earnings leverage as they restructure. But Raymond James questioned that thesis on Thursday by upgrading three low-cost carriers and telling investors that legacy carriers' efforts to compete are falling short.

The brokerage upgraded

JetBlue Airways

(JBLU) - Get Report

and

AirTran Holdings

(AAI)

to strong buy from outperform and

Southwest Airlines

(LUV) - Get Report

to outperform from market perform, saying that negative sentiment on those shares has peaked.

Investor reaction to the upgrade was strong. By midday, JetBlue was up $1.45, or 6.1%, to $25.05, with AirTran up 86 cents, or 7.3%, to $12.60. Southwest was the laggard, up 27 cents, or 1.8%, to $14.91.

So far this year, shares of all three are down, but none more than JetBlue, which has been the target of drastic discounting from

AMR

(AMR)

, parent of American Airlines, and

Delta Air Lines

(DAL) - Get Report

.

Just after the start of the New Year, American launched a 2-for-1 sale targeting frequent flyers. The promotion provides a free round-trip ticket anywhere the carrier flies after the purchase of two round-trip tickets from locations in the Northeast to either Florida or California, JetBlue's bread-and-butter markets. Delta matched the sale, which was designed to use large route networks to keep customers loyal and steal market share back from JetBlue.

In the wake of the increased competition and concerns that JetBlue's rapid expansion would leave profit flat in 2004, investors dumped shares, which are down nearly 20% since American announced the sale. But according to Raymond James, the 2-for-1 sales haven't hurt JetBlue's business and investors' fears --at least with regard to the deep discounting -- are overblown.

"The perceived impact of the legacy carriers' competitive tactics appears to be worse than their actual impact," said Jim Parker, airline analyst at Raymond James. He said that "150,000 passengers have participated in American's free round-trip ticket promotion, but only 13,000, or 9%, of these passengers are new."

While the sales may have kept customers, by failing to steal customers away from JetBlue, Parker said American is cannibalizing its own business routes. At the same time, he notes that JetBlue's Florida and California routes are extremely profitable, while Delta has shelved its plans for a nationwide expansion of its low-cost Song unit, which was designed to compete with JetBlue.

"Delta recently stated that it is placing Song's growth plans on hold, which, we believe, is further evidence of Song's poor performance," said Higgins.

Furthermore, the deep discounts are a short-lived phenomenon designed to boost demand during a seasonally slow period.

Both the Delta and American sales end on April 14, so the real test will come during the summer, when demand is higher and low-cost names begin moving into legacy carrier hubs. Sometime in May, Southwest will make a splashy debut in Philadelphia, home of

US Airways

(UAIR)

, while JetBlue is expected to add service from New York's LaGuardia Airport.

Ultimately, with the legacy carriers planning to restore flights that were shelved a year ago during the build-up to the war in Iraq, they run the risk of adding supply faster than the return of demand, which could lead to more fare sales during the summer. While Higgins cedes fare sales represent a risk to the share prices of low-cost carriers, they don't change the long-term growth prospects and advantages certain low-cost names have.

Unlike legacy carriers, Southwest's earnings won't be as impacted by the price of oil, which could remain high after OPEC said it would cut daily oil production in April. Southwest has 83% of its fuel requirements hedged for 2004, unlike

Northwest Airlines

(NWAC)

, which hasn't hedged the price of oil at all and is subject to the vagaries of the open market.

While the negative opinion on low-cost carriers may, in fact, be overdone -- there's no denying that the legacy carriers have some major catalysts for upside momentum. American is expected to post a profit in 2004 and is highly leveraged to not only a business travel recovery, but also international travel, where margins are higher and low-cost competition is nonexistent.

Both Delta and Northwest are looking for wage concessions from unionized employees, and if recent history is any indication, they will be successful at some point. Last year, American received $1.8 billion in concessions from its unions, allowing the carrier to shock Wall Street by returning to profitability a full year ahead of schedule.

With the economy improving, the rising tide should lift all the carriers, but with low-cost names being punished so far this year, at least Raymond James feels they're worth another look.

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