Updated from 2:41 p.m. ESTAirline stocks took another nose dive Monday after a report showed February unit revenue was weaker than expected because carriers are adding too many flights back to their schedules, but that didn't stop brokerages from telling investors with a stomach for risk to buy shares in what they consider an oversold sector. The Air Transport Association said revenue per available seat mile, a key metric called RASM, grew 2.8% in February, missing some Wall Street expectations, which ran as high as 5% growth. The results, released late Friday, are especially disappointing given easy comparisons with last year, when results were lower because of a pair of East Coast blizzards and the run up to the war in Iraq. "RASM fell 2.9% in February of last year vs. 2002 on the eve of the war in Iraq," said Gary Chase, analyst at Lehman Brothers. "Returning capacity is to blame for the industry's revenue woes, in our view. Our fear that industry unit revenue would suffer given significant capacity growth is becoming a rather problematic reality." In reaction to the news, the Amex Airline Index was off 3.4%, led lower by AMR ( AMR), parent of American Airlines, which was off 61 cents, or 5.4%, to $10.77. Indeed, estimates from Goldman Sachs suggest that capacity, a supply metric measured in available seat miles, is outstripping demand. In the fourth quarter, industry revenue increased 4% to 5% while capacity declined 2%, a strong performance that helped boost airline stocks and fueled hopes of a recovery. With capacity up between 4% and 5% in the first quarter, revenue should grow in lockstep, but with RASM coming in below estimates, revenue growth, in fact, appears to have stalled out. The weakness in revenue generated from domestic flights underscores this point. In the domestic market, legacy and low-cost carriers have been adding or restoring flights, filling out their routes and increasing the frequency of service. Sensing an economic recovery this year, legacy carriers are bringing back flights that were shelved last year heading into the war, while low-cost carriers are adding new markets and connecting flights.
As a result, domestic capacity rose 7.6% in February, which is the major reason why domestic revenue rose just 0.7% during the month. International results, where there is no low-cost competition, were much stronger, with RASM on Pacific routes up 20.3% on 2.2% less capacity. Overcapacity has put a damper on the revenue recovery, especially when it comes to the domestic market. Over the last six weeks, Wall Street has pulled an about-face on the industry's revenue recovery story as a combination of high fuel costs and a lack of pricing power has eroded results. Heading into 2004, many economists and Wall Street analysts felt that oil would drop from $32.50 a barrel below $30, giving airlines a break on fuel, which accounts for 12% to 14% of total expenses, second only to the cost of labor. But with oil consistently near $35 a barrel, legacy carriers like Delta Air Lines ( DAL) and Northwest Airlines ( NWAC) that have
not hedged their fuel needs are completely exposed to the open market. And like last year, airlines have been powerless to offset the rise in fuel with higher ticket prices. Three weeks ago, Continental tried to hike fares, but failed when the rest of the industry didn't match. Continental is a good example of the shifting mood within the investment community. In mid-February, the carrier was expected to post profits. But when Continental announced that its February RASM would decline between 2.5% and 3.5% , the optimism vanished. Over the last four weeks, seven analysts have dropped their 2004 EPS estimates by an average of 65 cents and now the carrier's consensus estimate calls for a loss of 41 cents. But conventional wisdom in the airline sector is to buy when things look bleakest. Recent history bears that out. Investors who bought AMR on March 11 of last year, when American Airlines was on the verge of a bankruptcy filing, have seen shares appreciate more than 700%. With the Amex Airline Index off 26.2% from its Oct. 9 peak, many brokerages feel that stocks could represent a buying opportunity, despite the fact that earnings estimates could be taken down again before airlines release first-quarter results in a month. Because of the strength of its international operations over the pacific, Northwest ( NWAC) will be a big winner -- something analysts have noted more often , despite the fact that the carrier is engaged in difficult negotiations with employee groups. According to Lehman Brothers estimates, without Northwest the industry RASM growth would have been between 1% and 2% lower. "While we expect the sector to respond negatively today, we also believe that many of our accounts have held off exploiting the recent sector selloff until this data point was behind us," said Jamie Baker, analyst at J.P. Morgan. "As such, we're cautiously optimistic that airline stocks have reached close to a near-term bottom." Indeed, other analysts have been toying with the notion that stocks are attractive again. After the Madrid attacks two weeks ago, a number of analysts issued positive comments and in a note from last Thursday, Sam Buttrick, analyst at UBS Warburg, noted "historically, we have liked to buy 30% to 35% corrections," but added that "there is no question that the industry recovery is faltering."
But in the airline industry, where losses have been in the billions for three years, "bad" is an extremely relative concept. And although RASM growth was limited and pricing power is weak, Credit Suisse First Boston analyst Jim Higgins said results could have been worse, especially considering the fare wars in transcontinental markets that used to be the exclusive domain of the legacy carriers. "We believe that for trading-oriented accounts, this is a time to buy, as we think that stocks have factored in a greater degree of pessimism than is warranted," said Higgins. While it's hard to tell if pessimism is overstated, given the airline industry's hypersensitivity to everything from oil prices to geopolitical events to international outbreaks of disease, if shares are bottoming, they could see explosive upside moves if fundamentals pick back up. "In recent months, supply has begun to outstrip demand, but we expect balance to reemerge by midyear," said Glenn Engel, analyst at Goldman Sachs. "The airline index has dropped 25% over the past six weeks and prices are below post-9/11 lows. Any signs that the airline profit recovery is still on track could cause dramatic outperformance of shares."