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Airlines Begin to Ride the Updraft

By Jim Corridore Given the recent slight improvement in passenger demand and efforts to cut capacity and costs, we at S&P upgraded our investment outlook for the airline industry to neutral. Over the past quarter, the stocks have started to move up in expectation, we think, of a revenue recovery. While we do not expect the industry to reach profitability until 2005, and although we think the mainline carriers will continue to lose money, many of them have stabilized their losses and shored up liquidity positions in an effort to ensure survival until demand strengthens.

Year to date through Sep. 19, the S&P Airline Index rose 26.5%, vs. a 17.8% gain in the S&P 500 index. In 2002, the Airline Index fell 39.8%, sharply worse than the 23.4% drop in the broader market.

SUBSIDING TURBULENCE. The severity of the current downturn and questions about when an upturn might occur has kept us cautious on the industry. However, improved travel demand this summer, coupled with cash grants from the government, has made us more optimistic about many of the carriers' ability to survive the current downturn. We are now expecting the top 10 carriers to lose $6 billion in 2003, the third year in a row of dramatic industry losses. For 2004, we project losses of another $1 billion. S&P tentatively expects the industry to return to profitability in 2005.

We at S&P expect a 5% rise in revenue passenger miles (RPMs) in 2003, to about 630 billion, following a 2.6% decline in 2002 -- but this would still be lower than 2000 levels. Most airlines are again moving to cut capacity that they restored in early 2002, following sharp reductions after September 11. Domestic capacity will likely be down about 6% in 2003, after a 5.2% drop in 2002.

Although we are cautious in our optimism, S&P expects that the worst days of the industry's slump may be behind us. While airfares and passenger demand remain well below previous trendline levels, most major airlines reported strong bookings for summer travel. Because capacity has been trimmed, these carriers have seen near record-high passenger load factors. Airlines also experienced strength in bookings during recent holiday periods, a trend we expect to continue.

FARES: UP AND AWAY. Despite the stimulus of low fares, though, travel demand continues to be soft. It remains to be seen whether recent seasonal strength can translate into a general increase in passenger demand. However, the pick-up in demand during the summer and efforts to cut capacity make us cautiously optimistic that carriers may be able to increase fares in the near future.

A return to profitability now depends heavily on traffic trends and pricing. The industry continues to struggle against the forces of a potential shakeout, following bankruptcy filings by industry giants UAL (UALAQ) and US Airways (USALA). Meanwhile, American Airlines parent AMR Corp. (AMR) has pulled back from the brink after reaching agreements with its unions for cost cuts. If UAL fails to emerge from bankruptcy and is forced to liquidate, S&P believes that enough capacity would likely come out of the market to allow the remaining carriers to raise airfares significantly and operate much more profitably. However, S&P thinks it's likely that UAL will emerge from bankruptcy, possibly much healthier and more competitive.

Legacy carriers need to reexamine their operational strategies. Some of the major airlines hope to compete more effectively by launching "low-cost" airline subsidiaries, including Delta's (DAL) new Song unit. S&P remains skeptical about the effectiveness of launching low-fare subsidiaries without attacking some of the core problems at the major airlines, such as high salaries, unprofitable routes, and large fixed costs of maintaining hubs.

HIGH FLIERS. Although the airlines have faced a brutal environment, the carriers that operate with low costs and low fares have been able to cope much better than their high-cost competitors. In our opinion, Southwest (LUV) is extremely well positioned vs. its peers, and we think it will remain profitable in 2003 and continue to outperform the industry over the next few years. In addition, both JetBlue (JBLU) and AirTran's (AAI) low unit costs enable them to thrive at the current low level of industry airfares.

Among the carriers, we at S&P have a 4 STARS (accumulate) ranking on shares of AMR, Southwest, and AirTran. We have a 3 STARS (hold) recommendation on shares of Delta, Alaska Air (ALK), America West (AWA), Continental (CAL), and Northwest (NWAC). On Friday, Sep. 26, we at S&P downgraded JetBlue shares to hold from accumulate based mostly on valuation. Analyst Corridore follows airline stocks for Standard & Poors

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