The Hot Air under Airline Stocks

Even though share prices for ailing carriers are soaring, the group's fundamentals remain weak for the foreseeable future

By Amy Tsao

This spring, the embattled airline industry got some much welcomed news. The Iraq war ended in just six weeks (although the country has become a military and political quagmire). The deadly SARS virus, which threw much of Asia into a panic, was contained relatively quickly. These factors, plus some heralded labor union concessions, have spurred a relief rally in airline stocks since the war's end on May 1.

In the last three months, among the large traditional carriers, shares in Continental (CAL ) have risen 65%, and Northwest's (NWAC ) stock has jumped 25%. But AMR (AMR ), which operates American, has soared 120% as it managed to stave off bankruptcy.

Smaller carriers have benefited, too. America West (AWA ), which had been considered a sure loser after the September 11 terrorist attacks, has watched its stock rise 150%, to $8. Alaska Air (ALK ) and AirTran (AAI )are up 33% and 60%, respectively.


  Analysts caution, however, that the markets are suggesting a rosier future than the industry's fundamentals bear out. A gradual turnaround may be taking shape, but the intrinsic problems that led these airlines into financial distress remain: relatively high fixed costs, fierce competition from discounters, and a lack of pricing power, particularly among business travelers.

"The airlines aren't even halfway to recovery," says Michael Miller, president of consultants Miller Air Group in Washington, D.C. "Many -- though not all -- have reformed their cost structures. But with a sluggish economy, the revenue side won't rebound by itself." Profits will take at least another year to materialize -- and sounder business models could take considerably longer.

Ticket prices and demand for air travel remain depressed in the wake of the economic downturn, and while fears over terrorism have subsided, they haven't disappeared. The Homeland Security Dept.'s recent warning that al Qaeda is still planning airline attacks in the U.S. and Europe is another reminder of that possibility. SARS, too, is still on travelers' minds. Even though the industry has shrunk its supply of flights by 20% since 2000, passenger revenues are down 30% from levels hit at the peak of business-travel demand three years ago.


  Through June, 2003 domestic traffic is down 3.6%, according to the Air Transport Assn. And on average, domestic ticket prices are still declining. Average fares paid per mile are down 2.9% in the same period. These drops follow decreases in average fare paid per mile of 9.1% in 2002 and 8.6% in 2001.

Ticket sales should pick up as the economy improves, but analysts fear that a sizable portion of the airlines' revenue is lost for the foreseeable future. During the recession years of the early 1980s, the industry's revenues decline by about 1% from the start of the downturn to the trough, says Phil Baggaley, airline credit analyst at Standard & Poor's. In the early 1990s, the dropoff was about 2%. This time around, revenues are off 21%.

The dramatic difference is mainly due to a change in the buying habits of business passengers, many of whom are no longer willing or able to pay the exorbitant fares of just a few years ago.


  The industry's biggest problem going forward is revenue. "Even with capacity cuts, we're not generating enough travel," says Darryl Jenkins, director of George Washington University's Aviation Institute. In addition, as long as United (UALAQ ) remains in bankruptcy, it'll continue to sharply discount ticket prices and "depress the revenue picture even more than it is already," says Miller, adding that airfares are at 20-year lows. He points to a recent "buy one, get one free" business-class promotion from United, which competitors likely will match.

On the cost-cutting front, airlines that had the highest labor costs (and biggest problems) -- United, US Airways Group (USALA ), and American -- have wrangled significant concessions from their unions. However, those in relatively better shape, such as Delta (DAL ) and Northwest need to do the same -- a more difficult task since they aren't as desperate as their counterparts were during contract negotiations. In late July, Delta's pilots union withdrew from negotiations, refusing to have their pay lowered to the level reached at the more troubled carriers.

The challenges confronting the industry remain daunting, and some analysts point out that the percentage increases on many of the stocks doesn't give a true picture of how the companies are doing. "The stock rise isn't very significant for the airlines when you consider that only a few years ago airlines like United and Continental were trading over $100 per share," says Miller. United, now selling for under $1, will soon be delisted from over-the-counter trading on Nasdaq. Continental trades at $15.


  Of course, the broad stock rally of the 2003's first half helped airlines lower their pension liabilities, but overall balance sheets are still very weak. "This doesn't make the problem [of pension liabilities] go away, but it's less frightening," says S&P's Baggaley. The industry's pension liabilities total $22 billion, according to credit-rating agency Fitch. Even without any devastating events, the airlines "will still emerge from the downturn highly leveraged and financially weakened," Baggaley says.

Good news? Well, US Airways has come out bankruptcy as a far leaner company, and United is expected to emerge early next year in better shape. "The odds on liquidation have gotten much smaller. The big downside risks don't appear to be materializing," says Baggaley.

And some experiments in low-cost divisions at the large carriers with the aim of competing with discount carriers like Southwest (LUV ) and JetBlue (JBLU ) may prove skeptics wrong. Delta says its low-cost Song subsidiary is off to a promising start, though it's not currently providing performance details. United is in the early stages of planning such a division.


  Second-quarter income statements also show some improvement. A government rebate given to major airlines in the June quarter even helped some show a profit. Still, this was a one-time benefit, and none of the large carriers are back in the black operationally. In the second quarter, the largest airlines are expected to lose more than $1 billion, albeit an improvement on losses of $3.5 billion in the first quarter of 2003 and $11 billion in all of 2002.

Granted, the industry appears to be making gradual progress, but stock prices clearly have gotten ahead of what the fundamentals suggest, even assuming a stellar industry recovery. Investors can count on continued volatility in the sector as carriers face the challenging task of how to go beyond surviving and return to profitability.

Tsao covers financial markets for BusinessWeek Online in New York

Edited by Beth Belton

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