Fear of terror attacks and high oil prices have caused investors to shun airline stocks, but analysts say stocks have been overly punished and may be worth a look.

Over the last week, the Amex Airline Index fell 13.3%, as investor optimism for an industry recovery was replaced by pessimism that profits won't ever return. There are reasons to be afraid. Over that same span, Delta Air Lines ( DAL) issued an earnings warning because of oil prices and a highly organized bombing in Spain reignited terror fears around the world.

But even as Wall Street lowers estimates to reflect the fact that crude oil has been at or near $36 a barrel for much of the first quarter, analysts say airline shares represent a good buying opportunity at these levels. On Tuesday morning, Sam Buttrick, airline analyst at UBS Warburg, dropped earnings estimates on Delta and AMR ( AMR), parent of American Airlines, but told investors that the fall in stocks has outpaced the fall in EPS estimates.

"Industry fundamental recovery has slowed on higher jet fuel prices and domestic revenue weakness," said Sam Buttrick, "but not enough in our opinion to justify the 30% to 40% declines in leveraged airline share prices, which increasingly discount a fear factor associated with the recent Madrid bombing."

Other analysts concur. Daniel Hemme at Prudential Equity Group notes that the risk of terrorism, while real, has obscured the generally positive traffic trends reported in January and February. In Hemme's view, investors may not be giving the airline industry enough credit for the security effort made in the wake of the World Trade Center attacks two-and-a-half years ago.

"Risks to U.S. airline firms have diminished over the past several years based on a number of tactical actions that have increased the rigor and quality of security procedures for air travel," said Hemme. "The event in Spain may itself be evidence of the decreased risk to airlines as the terrorist target was staged on a rail transit system."

Bad Moon Rising
So far this year, airline stocks have been hammered by terrorism concerns, high oil prices, low ticket prices and excess capacity. Despite lower EPS expectations, some analysts say fears,
and the sell-off, are overblown.
Company/Index % Change YTD # of Up EPS Revisions* # of Down EPS Revisions* New 2004 EPS Est. Old 2004 EPS Est.
American -1.8 3 4 $0.84 $0.65
Continental -29.6 0 6 -0.18 0.42
Delta -34.3 1 6 -4.93 -3.58
Northwest -30.5 1 2 -2.92 -1.41
JetBlue -16.8 0 2 0.86 0.97
Southwest -18.2 0 3 0.54 0.58
America West -26.0 1 1 1.15 1.02
AirTran -6.2 0 5 0.64 0.81
*Over the last 30 days. Source: Baseline

Furthermore, all airlines aren't necessarily in the same boat because of varying degrees of exposure to rising oil prices and different labor agreements.

While network carriers like Delta and Northwest Airlines ( NWAC) have no fuel hedges and desperately need wage cuts from unions, and Southwest Airlines ( LUV) has 80% of its fuel needs hedged and is known for relatively friendly relations with unions, all three are off more than 15% this year.

In Hemme's view, the risks related to fuel won't cause any of the airlines to go out of business and he says the market hasn't really differentiated between the competitive situations at many carriers.

But one problem facing the entire industry is the fear that airlines are increasing capacity too much, creating a glut of flights that can only be sold with deep discounts. And in the seasonally slow winter period, this appears to be the case, with analysts lowering their estimates for the amount of revenue generated per available seat mile, a key metric known as RASM.

From 1999 to 2003, a period of both boom and bust for the industry, Credit Suisse First Boston research shows that RASM increased by 3.4% sequentially, while capacity, measured in available seat miles, rose 2.8%. In 2004, however, capacity will be up 5.2%. while RASM is expected to rise just 1.7% -- a definite cause for concern, especially given the industry's chronic failure to raise ticket prices to offset high fuel costs.

Consider the case of Continental Airlines ( CAL), whose inability to show RASM growth has certainly cost it some standing in the eyes of investors and Wall Street alike. In 2004, Continental was expected to be one of the few network carriers to post a profit, but with RASM off, analysts no longer see the company becoming profitable in 2005 -- leaving American the only profitable network name in 2004.

And like much of the industry, Continental has been powerless to boost RASM growth. This month, the carrier's bid to tack on a $10 fuel surcharge to roundtrip tickets was matched by some rivals, but not all, forcing the carrier to rescind the increase. That lack of pricing power hasn't just hurt the majors -- JetBlue's ( JBLU) earnings are expected to be flat in 2004 because the company's margins on the fares it sells are falling, due to aggressive two-for-one promotions from American, Continental and others.

Nonetheless, CSFB analyst Jim Higgins believes that the rise in capacity may be able to offset the slide in RASM.

"We increasingly believe, however, that the capacity trends could be setting the stage for upside surprises in revenues, and therefore recommend buying at current oversold levels, and more aggressively into any incremental weakness," said Higgins.

On Tuesday, investors continued to have a downward bias on some names, dropping the Amex Airline Index by 0.9% just after midday, led by a 3.2% fall in JetBlue, which was down 71 cents to $21.35. Notable winners included Continental, up 25 cents, or 2.2%, to $11.70; and Northwest, up 27 cents, or 3.1%, to $9.05.