Airline Rally Looks Toppy to Some

A growing chorus of analyst opinion suggests the run-up in airlines stocks has gone too far.

The sector's recent stock performance has been spectacular. Since March 11, the American Stock Exchange Airline Index has jumped nearly 75%, four times better than the S&P 500's gain of about 18% over the same span. The rally followed equally breathtaking declines: the index's 2003 performance prior to March 11 showed a loss of 35%, outpacing the S&P 500's 12% drop.

There have been numerous reasons for the run-up. Big labor concessions at AMR ( AMR) led to cost reductions at other airlines; traffic has returned to prewar levels; and several analysts have declared the bankruptcy risk for several troubled carriers reduced. Moreover, the federal government has acted to help beleaguered carriers with billions of dollars in aid and concessions, while the price of oil fell to more reasonable levels.

It's possible the party could be ending. Over the past seven days, as the Amex airlines index continued to rally, Morgan Stanley and Lehman Brothers both issued cautionary notes. Lehman's note, released a week ago, asked if the industry was "Flying Too High?" while Morgan's note, from Thursday, delineated a bumpy road ahead.

"Airline stocks have soared in recent days and have handily outperformed our expectations for a post-war rally. Sentiment appears to have bottomed and the stocks are beginning to discount a near-term recovery. Unfortunately, we believe share prices are ahead of fundamentals," said Lehman's analyst Gary Chase, in the first line on the first page of last week's research report.

Another factor in the sector's success has been the forced buying by short-sellers who had bet on a longer war -- not in and of itself a sign of secular strength.

"We believe that sentiment around airline shares has likely bottomed given the extreme challenges the industry has faced of late. That bottoming in sentiment is perhaps best manifest in the explosion of short interest in the shares, especially the network airlines, moving into April," said Chase, in his report. "We expect short-covering has played a significant role in the sector's outperformance."

Indeed, Lehman Brothers research shows a massive run on short interest in network (older carriers) airline stocks over the last five months. At the beginning of December 2002, less than 10 million shares of AMR stock were shorted. By April 1, 2003, that number had more than quadrupled. Similarly, short positions in Delta Air Lines ( DAL) and Northwest Airlines ( NWAC) had more than doubled.

Ultimately, analysts warn that airline investors will have to grapple with fundamentals as the network airlines struggle to reinvent themselves as cheaper outfits.

Morgan Stanley analyst William Greene emphasized this point after attending the Phoenix International Aviation Symposium, where many of the network carriers were commenting on business trends. One nagging issue Greene felt has been underaddressed is capacity, because overall revenue is down 30% since Sept. 11, but capacity is only down 15%.

"Most executives seemed unwilling to volunteer to sacrifice the size of their networks for the good of the industry," Greene said, in his report. "Absent significant capacity reductions, we find it hard to believe a sustainable pricing recovery is possible in the next 12 months."

Such comments fly in the face of burgeoning optimism that carriers can raise ticket prices. Furthermore, Greene expressed doubts that the enormous wage concessions from labor, which have helped reduced costs industrywide, would be deep enough to provide for lasting change.

"Even after the massive concessions from labor at some airlines," he wrote, "we do not believe the cost structures of those restructured airlines can be supported by the current revenue environment."

And while summer traffic levels are improving, few analysts believe that airlines can resist the urge to lower ticket prices to fill planes, which does nothing to improve the overcapacity problem and lack of pricing power.

For investors holding shares in stocks that have tripled, now could be the time to take profits.

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