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Airline Stocks: Making the Connection

By Amy Tsao Few investments are more harrowing these days than the airline industry, where misfortune, missteps, and misreadings have been the order of the day. From September 11 and the ongoing terrorism alarm that it spawned to an economic slowdown, soaring fuel prices, and labor conflicts, carriers have been beset by gut-wrenching woes. Analysts and executives aren't exaggerating when they say the industry has hit the worst turbulence in its history.

Hard though it may be to accept, there remain a few airline stocks worth considering, however. What's key to remember is that there can be a handsome short-term payoff if you buy at or near the bottom of a downturn. Check the charts and you will find that sharp, sudden spikes have figured time and time again, even in the troubled years of late. After the horror of September 11, airline stocks actually recovered through most of 2003, investors figuring that a stronger economy would soon lift a handful of carriers' revenues and profits.

That rosy scenario has been battered by the impact of aviation-fuel prices. With oil topping $50 a barrel, gauges of economic health wavering, and yet another bankruptcy filing for US Airways (UAIRQ), the entire sector has taken a tumble. The Dow Jones airlines index is down 25% since the start of 2004. "Even Southwest (LUV) and Jet Blue (JBLU) are under enormous pressure in terms of competition and prices," says Darryl Jenkins, visiting professor at Embry Riddle Aeronautical University. "It's pretty scary."

LABOR PACT. So, is it time to buy? As with any sector, airline investing is largely based on the hope of better times. And even now, amid all the uncertainties, the notion that things can only improve remains strong. That's why analysts are still recommending a select few names, albeit with a litany of caveats. "Everything hinges on moderating oil prices," writes Robert Ashcroft, airlines analyst at UBS in his latest sector update.

Ashcroft put buy ratings on Northwest Airlines (NWAC) and AMR (AMR), parent of American Airlines. He reasons that Northwest boasts some interesting pluses. It isn't a combatant in the most ferocious fare wars (i.e. New York and Boston to Florida) and is a leader on routes to Asia, which is seen as a positive this year.

Indeed, one of Ashcroft's observations about Northwest has already proved correct: On Oct. 14, pilots and management agreed on a tentative labor agreement that will save the carrier some $300 million annually. The stock, which closed the previous day at $7.58, immediately soared to $8.55, before slipping to end the session at $8.25. Even though it is the highest-priced among its peers in the group, some of which are trading for around $1, Ashcroft sees it as attractive.

PENNIES FROM HEAVEN. With help from its exposure to Latin America, AMR, though it was at the brink of bankruptcy early last year, is seen as a "good middle-of-the-road proxy for general industry recovery," writes Ashcroft. AMR trades at $7, just above a 52-week low of $6.76, with some upside in its stock range, analysts believe.

None of the so-called legacy airlines is going to be a big profit generator anytime soon. Continental Airlines (CAL) could produce earnings per share of a penny in the third quarter, writes JP Morgan analyst Jamie Baker in an Oct. 8 report. The profit, he notes, "is largely symbolic, but a profit nonetheless." Yet, Baker rates Continental shares, which trade at $8.70, overweight.

What about low-cost carriers? Bizarrely, they still don't get much respect from analysts. For some time, industry experts have argued that these carriers' costs are rising relative to traditional carriers, arguing that the trend will put a lid on their share prices.

Baker figures that costs, excluding fuel, at traditional carriers have fallen to just above 1997 levels. "For low-cost carrier shareholders," says Baker, "we'd argue this phenomenon is highly relevant as diminishing long-term cost advantage suggests -- all else equal -- slower earnings growth." He rates Southwest and Frontier Airlines (FRNT) underweight.

THINK LOCAL. Another way to play airline stocks may be through regional carriers, which are becoming an increasingly important segment of the domestic market. Jim Corridore, an analyst at Standard & Poor's, has an accumulate rating on regional carrier SkyWest (SKYW). "I think United Air (UALAQ) will use SkyWest more," says Corridore. "Regional airlines in general can be attractive during periods of high oil prices."

Of course, there is a chance that this time the recovery will take far longer than expected -- and that airline stocks will go nowhere for the foreseeable future. "We took all of our buy ratings down on Oct. 7," says Corridore. The analyst had been positive on Airtran (AAI) and AMR, but those are now hold-rated stocks. Only SkyWest is positively rated among the 14 small and large airlines he covers

Although he's skeptical of a broad rebound, Corridore observes that airline stocks "move quickly when sentiment shifts." One glimmer of hope in the business: Recent fare increases seem to be sticking. It will take a lot more -- and lower fuel prices -- to see the industry's return to good health. But the stocks won't likely wait as long. Tsao is a reporter for BusinessWeek Online in New York.

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