Low Fliers May Be Poised To Take Off

Look for well-run airlines untouched by merger rumors

While most airlines have been raking in record profits during the economic boom--who among us hasn't been crammed into a middle seat lately?--you wouldn't know it from their stock prices. The one-two punch of rising interest rates and fuel costs, plus fear that an economic slowdown would send the highly leveraged airlines into a nosedive, have left the major carriers trading around six times earnings, their lowest in a decade.

But some Wall Street pros believe the gloom that has fogged in airline stocks may be overwrought, making airlines a nice defensive play. Truth is, the stocks may weather a downturn better than investors expect--thanks in part to airlines' aggressive cost-cutting: Carriers are retiring older, fuel-guzzling aircraft, while their Internet efforts should help them slash their ticketing and distribution costs. And with oil-producing nations expected to increase output before long, the carriers could even see some relief from those crippling fuel bills. "The pessimism surrounding the airlines has been overdone," says Goldman Sachs analyst Glenn Engel. "I'm willing to take my chances."

So are the airlines themselves. While investors may be shunning airline stocks, the carriers are in a buying mood: AirTran Holdings' proposed merger with Trans World Airlines and UAL's move to acquire US Airways for a fat 130% premium over its market price raise the prospect of a merger frenzy that could produce substantial profits for those holding the right stocks. Among the rumored targets: Northwest Airlines and Continental Airlines (of which Northwest controls 51%). Salomon Smith Barney analyst Brian Harris believes that based on the UAL offer for US Airways, Northwest would fetch at least $55 in a merger, roughly 75% above its recent price. Continental could go for $87, nearly double its current valuation.

Still, think twice before you invest solely on takeover speculation. Washington may well refuse to approve many prospective deals, including the UAL-US Airways plan. Indeed, industry watchers predict that the Justice Dept. will block the UAL-US Airways pact because it could start a stampede that could result in three megacarriers--United, American, and Delta--controlling more than 70% of all U.S. flights and increasing their monopoly over major hub cities. "The mating dance you're seeing is just blocking tactics on the part of American and Delta," says John Linehan, an analyst for the Baltimore fund manager T. Rowe Price. "They're forcing regulators reviewing the UAL-US Airways deal to consider the effects of three potential mergers." If regulators do bar that partnership, Continental and Northwest could slump. Continental, which hit as high as 50 following the UAL bid and is now at 44, could dip back into the 30s.

Instead of taking fliers on takeover candidates, experts advise looking at well-run carriers that would probably stay independent, as well as some would-be acquirers whose stocks have been battered on fears they might overspend on deals. For example, now may be a rare chance to snap up Southwest Airlines on the cheap. The no-frills carrier continues to extend its franchise, in the past 15 months opening hubs in Islip, N.Y., and Raleigh-Durham, N.C. Yet it trades at just 20 times estimated earnings, a relatively modest premium to its anticipated 15% to 20% growth in earnings per share for each of the next five years.

Southwest clearly has more upside than its rivals. The Texas-based carrier has raised fares only 2.5% this year, vs. 10% on average for others. And while others have slashed commissions paid to travel agents to an average 5%, Southwest still pays 10%. Salomon Smith Barney's Harris speculates that merely cutting commissions to 8% would boost Southwest's earnings 3 cents a share. The carrier also is expected to fatten earnings even further as it expands into more profitable, coast-to-coast routes.

Among regional carriers, analysts like Denver-based SkyWest, which flies feeder routes for United and Delta Air Lines. Analysts note that SkyWest plans to increase capacity by 10% this year, ramping up to 30% growth in 2003. But the real draw is SkyWest's tight alliances with United and Delta, which give it the most predictable revenues of any carrier. Yet SkyWest trades for 14 times estimated 2000 earnings, below its historical range of 15 to 20.

"UNDULY PUNISHED." If you prefer big U.S. carriers, the Wall Street favorite is Delta, whose stock has slid more than 10% on fears that it will be pressed to match UAL with a megamerger of its own, possibly with Continental or even American. But why tamper with success? Atlanta-based Delta boasts the industry's highest operating margins, lowest costs, and cleanest balance sheet. Even if oil prices spike higher, analysts note, Delta has hedged 70% of its fuel costs for 2000, and 50% for 2001. At around 50, Delta trades at 6.5 times estimated earnings for the next 12 months. "Potential buyers [of other carriers] have gotten unduly punished," says Goldman Sachs' Engel. Meanwhile, if you would rather invest in a fund, Fidelity Select Air Transportation Portfolio, which includes aircraft makers, boasts a load-adjusted return so far this year of 6.46% and a three-year average return of 23.54%.

There are good buys in airline stocks abroad, as well. An interesting play is Dublin-based Ryanair Holdings, a Southwest lookalike that operates 43 routes across 11 European countries. With a nonunion workforce and a streamlined route structure, Ryanair will generate operating margins of 23% this year, vs. the European industry average of 6%, Goldman Sachs figures. Ryanair's American depositary receipts trade at a pricey 37.5 times earnings, but analysts say that isn't out of line for a carrier increasing profits by 25% a year.

Airline watchers are also bullish on British Airways, which recently struck a deal to merge with Netherlands-based KLM Royal Dutch Airlines. Acquiring KLM would be a boon to BA, allowing it to route more lower-fare tourist traffic to KLM's Amsterdam hub while freeing gates at London's Heathrow for higher-paying business travelers. Even if European politicians veto the deal, some analysts believe the two airlines will still pursue a "virtual merger," with a common management running both airlines.

Andrew Lobbenberg, an analyst at Robert Fleming Securities in London, figures that by consolidating functions and streamlining their routes, a "virtual merger" could generate annual savings of up to $1.8 billion. Even investors worried about prospects for the industry would have to concede one thing: That's real money, and it will fall straight to the bottom line. Which suggests that while the expansion is showing signs of age, airlines may have a lot of range left.

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