The airline industry entered 2003 practically dead on arrival, after losing $16 billion over the last two years. But six months into 2003, much has changed for the better.

Airline stocks now have doubled from March lows, oil prices have fallen, the government has kicked in some aid and analysts have become increasingly bullish about recovery hopes. It's a big change from the beginning of the year, when the world's largest airline teetered on the verge of bankruptcy and the No. 2 carrier flirted with total liquidation. At that time, oil prices were rising, demand was slipping and war in Iraq loomed.

So why have the stocks gone up so much, and can the rally last?

Some say that after two years of getting hammered amid nonstop gloom, stocks had nowhere to go but up. "Let's put it this way: Since the end of the Iraq war, there has been no bad news. It seems since Sept. 11, they've had one pounding after another: the war, terrorism fears and SARS," said Ray Neidl, analyst at Blaylock & Partners. "We haven't had that for a couple of months, and that by itself has helped."

American Airlines, a unit of AMR ( AMR) and the world's largest carrier, best represents the challenges the industry faced and how simple survival can boost shares. Shares dropped from $7 at the beginning of the year to $1.50 in mid-March, as American careened toward bankruptcy after an ugly fight over wage cuts between labor and management. Short interest skyrocketed and the end seemed near.
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At the same time, a report from the Air Transport Association said the war in Iraq could cause more than $13 billion in losses , potentially wiping out the entire industry if another large-scale terrorist attack were to occur. Even in a slightly rosier scenario that the ATA deemed most likely, the industry would lose $10.7 billion and 70,000 jobs.

Yet the tide turned after AMR management brokered a last-minute deal that included the exit of Chief Executive Don Carty. The war in Iraq lasted 30 days instead of three months, dropping fuel costs and putting industry losses more in line with ATA's best-case estimate of a $6.7 billion loss. Short interest dropped dramatically as AMR shares -- and the rest of the industry -- skyrocketed.

Meanwhile, UAL ( UALAQ), the second-largest carrier, wheedled key wage concessions from its unions. Today, the Amex airlines index has nearly doubled from its 2003 low, with AMR close to $9.

"From March 2002 to March 2003, the median airline stock dropped 75%. With the exception of Southwest Airlines, investors were factoring in bankruptcy for nearly all airline stocks," said Glenn Engel, analyst at Goldman Sachs. "In April, a combination of sizable government grants , capacity cuts and a quicker-than-expected rebound in traffic ... caused the stocks to double from mid-April to mid-May."

Cloudy Skies

Whether such gains can continue remains to be seen. The industry has been in a similar situation before, with grim results: In 2002, airline stocks also had rallied, while airline analysts had grown more bullish and the industry had seemed poised for recovery. The problem was that the broader economy didn't recover, business travelers didn't take to the skies and those stock gains vanished.

This time around, the industry's fortunes will depend on corporate spending, said Engel. "Because business travel typically represents 70% of airline revenues, airline revenues more highly correlate with corporate profits than consumer discretionary income and GDP," he said. "We see mixed signals regarding a recovery in business confidence. Without a sustained recovery in business travel, any airline rally would prove short lived."

After the release of May traffic data from some of the largest airlines, it doesn't appear that business travel has rebounded much, or at all. Northwest ( NWAC), American and Continental ( CAL) all reported that revenue passenger miles -- or one paying customer flown one mile -- were down from year-ago levels.

"Other people have said different, but the May numbers were disappointing. Traffic was down over last year," said Blaylock's Neidl.

Brighter 2004

Wall Street consensus and comments from airline executives indicate that profitability won't come until the second half of 2004 at the earliest, which means 2003 could mark the first tentative step -- but certainly not evidence that a recovery is at hand.

"I think people who feel the recovery is at hand are wrong," said Neidl, who thinks, like many in the industry, that regional carriers such as Mesa ( MESA) and AirTran ( AAI) will feel recovery first. "It's not at hand at the big carriers; no one's projecting any profits before the second half of 2004. Any recovery is a sigh of relief that there are not any more bankruptcy filings, and therefore they've rallied off bankruptcy-level trading."

Even Leo Mullin, Delta's ( DAL) CEO, says the recovery will take a while. "We're in for another extremely tough year here in the United States," he said. "It will be mid-2004 to late-2004 before we really begin to see some uptick in traffic. I would not suggest anybody should presume that anything like a true uplift is on the way." The ATA predicts that summer travel will show a slight increase over 2002's depressed levels, as companies struggle to restructure and get the same kind of cost cuts that AMR, US Airways and UAL unit United have been able to get. Cutting these fixed costs will help these companies stave off Chapter 11, but it won't make them profitable again.

The critical issue for carriers in the summer of 2003 will be yield management -- delicately balancing supply and demand levels, which are growing but still anemic.

"The post 9/11 rally proved short lived because airlines restored capacity too fast and revenue momentum quickly faltered," said Goldman's Engel. "Risks remain high that history could repeat, particularly if business confidence fails to improve."

So what does this mean for investors? Analysts are divided on whether investors should take profits now or wait to sell sometime before the end of the year, as traffic tends to slide in winter.

"The near-term optimism notwithstanding, we ... believe that the absolute level of recovery in the industry may ultimately disappoint, especially since capacity reductions appear likely to tail off as the year progresses," said Jim Higgins, airline analyst at Credit Suisse First Boston, in a research note. In other words, airlines won't be cutting traffic as much at the end of the year, which will make it harder to fill planes. "And we therefore fully expect to want to sell airline shares sometime before year end," he said.