By James Corridore Investor optimism about improved prospects for the beleaguered U.S. airline industry burst forth on June 26. Shares of AMR (AMR), parent of American Airlines, soared after it reported positive cash flow from operations in May, thanks to reduced costs and improved revenues at its operating units.
AMR -- like its industry brethren -- has faced a host of well-documented troubles. In 2002, it posted a $3.5 billion loss, the largest in aviation history, and earlier this year it scrambled to reach agreements with its unions for cost cuts that would help keep it out of bankruptcy. But we at Standard & Poor's Equity Research believe AMR's liquidity position has stabilized, which should lessen the near-term risk of a Chapter 11 filing.
And things appear to be looking up for other major U.S. carriers as well. With passenger demand increasing modestly, investor sentiment toward airline stocks has shifted. That has led us to upgrade our investment ratings on AMR and two other major carriers, Northwest Airlines (NWAC), and Continental Airlines (CAL), to 3 STARS (hold) from 2 STARS (avoid).
CUTTING CAPACITY. It looks as if bargain hunters are sniffing out the group. Witness the 15.3% advance in the S&P airline industry index thus far in 2003, vs. a 13.1% gain in the S&P 1500. Of course, the sharp gains are coming from greatly depressed levels. In 2002, S&P's airline index fell 39.8%, a far more dramatic drop than the S&P 1500's 22.5% drop that year.
It's our opinion that airline stocks have advanced in recent weeks in expectation of a recovery. Signs point to some revenue pickup, but sales are still well below historical levels, and it's too early to become overly optimistic. The airlines, already suffering from weak passenger traffic as a result of soft economies worldwide and terrorism fears, were dealt a severe blow earlier this year with the emergence of SARS, which led to large declines in Asian travel. Our investment outlook for the airline group remains cautious, and we don't anticipate a return to pre-September 11 revenue levels until 2005.
We expect a 5% rise in revenue-passenger miles (RPMs) in 2003, to about 630 billion, following a 2.6% decline in 2002. Still, 630 billion RPMs would be lower than 2000 levels. Most airlines are again moving to cut capacity restored in early 2002 following sharp post-September 11 cuts. Domestic capacity will likely be down about 6% in 2003, following a 5.2% drop in 2002. Operating losses in 2002 by the top 10 carriers totaled about $11.3 billion, vs. a $7.3 billion loss in 2001. The industry will probably post a significant loss in 2003 as well.
UPHILL BATTLE. While we think AMR, Northwest, and Continental will continue to lose money and underperform such better-positioned, lower-cost competitors as JetBlue (JBLU) (5 STARS, buy), Southwest (LUV) (4 STARS, accumulate), and AirTran (AAI) (4 STARS), the overall improvement in demand could lead to lower-than-expected losses for the second quarter and the full year.
Investors appear to have seized on the glimmer of hope offered by AMR's June 26 announcement, but the industry still faces an uphill battle. The 2002 bankruptcy filings of United Airlines parent UAL and US Air (UAWGQ) -- which emerged from Chapter 11 protection on March 31, 2003 -- should serve as stark reminders that the big carriers must continue to cut costs and boost traffic to avoid a similar fate. Analyst Corridore follows transportation stocks for Standard & Poor's