Analyst Interviews: Airline Industry Stock Review

Airlines are highly susceptible to negative financial impacts caused by major changes in the global economy that drive sudden severe swings in costs or revenues. During 2009, the combined forces of extensive competition and a severe global recession drove numerous U.S. and international carriers to file for bankruptcy and, in some cases, to liquidate.

While fuel costs have significantly fallen since reaching historic highs in the summer of 2008, overall demand for airline services has decreased, and may decrease further. The depth of, and recovery from, the global recession continues to be uncertain. The current economic conditions may continue to have negative impacts on passenger demand, revenues, the level of credit card sales activity and cargo operations.

The Airlines industry will be spending the next five years playing catch-up after suffering through the recession. Industry drivers are expected to result in a slow recovery during 2010 and faster growth in the following four years. Additional fees and charges will continue to be the main method to offset oil price volatility.

Hedging strategies are another profit protection tool and will be more extensively undertaken than in the past, despite the large drop in oil prices. The volatility of oil has brought the benefits of successful risk management strategies such as hedging to the forefront of airline executives’ minds.

Air fares are expected to increase in the second half of 2010 with slightly higher passenger numbers. Both consumer and business confidence are expected to be up during that period, supporting demand for air travel. Fuel prices will remain subdued in 2010, giving the industry some relief after years of losses.

We also expect an increase in merger and acquisition activity in response to the challenges that the industry has been facing. During 2010, operating conditions will remain tough and some companies will need rescuing from bad debts, large losses or similar items. Low-cost airlines are expected to turn around faster than their peers, as consumers will keep turning toward cheaper options. This will put low-cost airlines in a favorable position this year, and they may purchase some smaller regional operators as a result.

OPPORTUNITIES

Though almost all the carriers are expected to recover slowly in 2010, yet we favor Southwest Airlines (LUV) with a Zacks #3 Rank, as we expect it to recover earlier than other carriers. Its low-cost model is an advantage. The airline has reported a 7.1% traffic increase in Jan 2010, with strong bookings in place for February and March.

It has also benefited from the “Bags Fly Free” initiative, causing it to attract a bigger share of business. Southwest has also maintained continued profitability for the last 30 years, even during periods of industry downturns mainly due to its strong fuel-hedging strategies. Low-cost airlines are expected to get a higher share of revenue in the future, and we should see structural changes in the industry and consolidation as a result of competitive pressures.

With demand for air travel slowly returning back, we believe UAL Corp. (UAUA) and US Airways Group (LCC) will benefit in 2010. These companies carry a Zacks #2 Rank. 
 
WEAKNESSES
 
JetBlue Airways Corp. (JBLU) with Zacks #4 Rank and Alaska Air Group Inc. (ALK) with Zacks #3 Rank signaled a cautious approach to the economic rebound as they released their financial results for the fourth quarter 2009. Although corporate bookings are picking up with more people flying, the mixed earnings show that the airlines still have costs — pension, labor and other non-fuel expenses — that can be a drag on profitability.