Airlines' Recovery Up in the Air

Things should improve for the airline industry in 2005, but that's not saying much, given the disaster that was 2004.

Going into the year, observers predicted the industry would return to profitability. Major carriers had instituted cost-cutting measures, and industry capacity had fallen off somewhat. Airlines would ride a wave of increased passenger demand from the economic recovery, the thinking went.

"But capacity crept back up this year 2004, and oil prices shot up over 30%, and for some airlines, over 50%," said Jim Corridore, equity analyst at Standard & Poor's. "The combination of those two made it difficult for carriers as a whole."

Oil's rise meant that jet fuel went from an average of about 15% of airline expenses in 2003 to around 17% or 18% in 2004, according to S&P. Most carriers paid dearly for that. American Airlines' parent AMR ( AMR) has said that each 1-cent rise in the price of a gallon of jet fuel costs it more than $30 million a year.

Individual carriers' attempts to pass on costs to passengers in the form of higher fares, however, failed in the face of tough competition made tougher by the growing market heft of low-cost carriers. Even though passenger demand did increase, the glut of capacity put downward pressure on unit revenue. The top 10 U.S. carriers likely will lose $5 billion for all of 2004, according to S&P.

All of this has been tough on airline investors. As 2004 drew to a close, the Amex Airline Index was down 2.2%, vs. a 9.1% rise in the S&P 500 and a 3.8% gain in the Dow Jones Industrial Average (see charts).

But the Amex Airline Index doesn't reflect the full magnitude of the sector's carnage, because it doesn't include all the publicly traded U.S. airlines, notably the three worst performers (see chart). They are ATA Holdings ( ATAHQ.PK), a low-cost carrier that filed for Chapter 11 bankruptcy protection in October and was down 86% recently; FLYi ( FLYI), whose attempt to morph from regional carrier to low-cost airline in 2004 was ill-timed and whose shares have plummeted 81.7%; and US Airways ( UAIRQ.OB), which in September filed for Chapter 11 for a second time in two years and saw its stock fall 79.4%.

A Very Tough Year
Best-performing airlines in 2004
Company/Index Ticker 12/28/04 Close Change
Alaska Air Group ALK $32.27 18.20%
Skywest Inc. SKYW $20.19 11.70%
Southwest Airlines LUV $15.88 -1.60%
Amex Airline Index XAL 59.99 -2.20%
Source: TSC Research

Among publicly traded U.S. airline stocks, only two had logged gains late into 2004. They were regional carriers Alaska Air Group ( ALK), up a handsome 18.2%, and Skywest ( SKYW), which has risen 11.7%.

Alaska has benefited from having the second-best fuel-hedging position in the industry behind Southwest Airlines ( LUV), while Skywest has managed to profit by efficiently operating regional flights under contracts with larger carriers. Southwest, with its aggressive fuel hedges and strong balance sheet, was the third-best performer; its shares have lost only 1.6% year to date (see chart).

A moderation in the price of crude oil futures from their $55.17 record close in October is likely to give U.S. carriers some cost relief, but not enough to end the pain. Merrill Lynch analyst Michael Linenberg bases his 2005 airline forecasts on crude oil averaging $40 a barrel. That's obviously well off the highs, but it's still well above the $32.50 area it navigated going into 2004. And $40-a-barrel oil likely would mean the nine largest U.S. airlines would still record pretax losses of $1.6 billion. If crude were to average $35 a barrel, Linenberg forecasts, those carriers would merely break even before taxes.

"Every $1 change in our oil price assumption swings pretax profitability for the industry (which we define as the nine largest U.S. airlines) by $320 million," Linenberg wrote in a recent research note. (Merrill Lynch does and seeks to do business with companies covered in its research reports.)

Obviously, predicting where crude oil is headed is tough. Despite the recent correction from October's high, a multitude of factors could continue to buoy crude prices, including the possibility of future disruptions in Middle East supply and moves by OPEC. In early December, the cartel agreed to cut production by 1 million barrels a day, effective Jan. 1, and there's been talk among members of raising its price band.

All Pain and No Gain
Worst-performing airlines in 2004
Company/Index Ticker 12/28/04 Close Change
ATA Holdings ATAHQ.PK $1.35 -86.00%
FLYi Inc. FLYI $1.80 -81.70%
US Airways UAIRQ.OB $1.28 -79.40%
Amex Airline Index XAL 59.99 -2.20%
Source: TSC Research

For investors looking at the near-term potential for airline stocks, moves in the price of oil remain important, analysts note. The Amex Airline Index has risen almost 30% since crude futures began a significant retreat from their October closing high of $55.17 a barrel.

The correlation between gains in airline stock and declines in the price of oil, however, may be out of sync with the effect of current oil prices on airline bottom lines. "These stocks largely trade on what oil prices are doing, regardless of the actual impact to the airlines of the price of oil," S&P's Corridore said. And Gary Chase, an analyst at Lehman Brothers, wrote in a recent research note: "Oil prices have declined markedly from extremely high levels, but remain unsustainably high from an industry perspective." (Lehman Brothers does and seeks to do business with companies covered in its research reports.)

Nevertheless, it's hard to rate any airline stock a sell amid the current improvements in investor sentiment, said Corridore. (Standard & Poor's does not do investment banking business with the companies its analysts cover, but its affiliates may provide other services to them.)

Should oil prices continue to decline, Merrill's Linenberg believes, the stocks likely to move the most are the carriers that have the least amount of fuel needs hedged. " Northwest ( NWAC) and AMR would be our two top picks under this scenario given their unhedged fuel positions for 2005, and the fact that they have ample liquidity to keep them afloat in the event that oil prices bounce back to $50-plus a barrel," he wrote.

On the other hand, given another spike in crude above $50 a barrel, investors would do well to consider Southwest, which has more than 80% of its 2005 fuel needs capped at $25 a barrel, and 60% of its 2006 needs hedged at $31 a barrel, wrote Linenberg, who rates the stock a buy.

Of course, oil is only one key variable airline investors need to consider going into the new year. The other is capacity. The irony is that what's good for airlines overall is irrational for individual airlines. "If Delta ( DAL), or AMR or United parent UAL ( UALAQ.OB) cuts capacity, they can't cut it enough to impact the entire industry," said Corridore. "It takes all of them as a whole to make a difference. But if an airline figures capacity is going to be high anyway, they figure they'll at least maintain their own market share."

Some encouraging signs have emerged on the capacity front. For example, United announced in October that it would cut capacity in the U.S. but boost it on more lucrative international flights early next year.

Still, some analysts worry that capacity will remain high enough to continue to pressure revenue. "Despite headlines of capacity reduction (they should more accurately read moderate reduction in growth ambitions that were too high to begin with), we expect the above-average pace of capacity growth to continue next year," wrote Lehman's Gary Chase. "At present, we estimate that capacity growth by industry will significantly exceed our current GDP forecasts. ... We do not expect, therefore, that the domestic revenue environment will improve meaningfully next year, and we think the network carriers, desperately seeking places to earn premiums, are in the process of ensuring that the international revenue environment will also fade."

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