JP Morgan Throttles Back on Airlines

The firm downgraded its ratings on six industry players Friday, saying it doesn't see much upside for the shares

After initially seeing more hope for U.S. airlines, JP Morgan downgraded six of them in a report Apr. 27, explaining that the companies aren't likely to improve their businesses soon.

The firm moved its ratings on AMR Corp (AMR) and U.S. Airways Group (LCC) to neutral from overweight, Alaska Air Group (ALK) and UAL Corp. (UAUA) to underweight from overweight, and Continental Airlines (CAL) and JetBlue Airways (JBLU) to underweight from neutral.

"We erred in not taking a more substantive rating action earlier this month," JP Morgan analyst Jamie Baker said in a research note. "That said, we see few catalysts suggestive of upside potential from here." (The investment banking firm made disclosures such as its doing business with companies covered in its research reports.)

Baker explained that he and his team had first thought airline stocks would trade well during the first quarter earnings season on chatter about positive demand. Instead, evidence grew that domestic consolidated passenger revenue per available seat mile (RASM) is neither up to snuff nor likely to improve soon.

As a measurement of the sales generated for every mile flown, RASM suggests how many empty seats an airline had and how efficiently it performed. Many airlines have been flying fuller planes during recent years as they cut down on the industry's overall supply capacity. Meanwhile soaring fuel prices made airlines more reluctant to get into price wars, also contributing to stronger RASM.

But RASMs in the industry began to look less impressive in mid-2006 as the U.S. economy showed signs of weakness. To give a recent example, United Airlines' parent UAL had announced on Apr. 25 that its mainline RASM fell 2.7% year over year to $10.71 million during the three months ended March 31. The company also increased its capacity slightly during the quarter.

While management added too much capacity in January, it also plans to sharply reduce seat inventory in Los Angeles in the second quarter, Credit Suisse pointed out in a research note Apr. 26. Explaining that United may opt to return aircraft to those who leased it in the second half of 2007, Credit Suisse raised its estimate on the company's earnings in the second quarter of 2007 to $1.65 from $1.60 and in the third quarter to $2.40 from $2.10. (The investment bank does business with companies covered in its research reports.)

While acknowledging that United has indicated that it may trim capacity and U.S. Airways is also "willing to punt seven 737-300" airplanes, domestic supply will still grow 2.5%, J.P. Morgan says. "For all the talk of 'supply discipline,' the industry does a very poor job of policing itself," Baker wrote.

Meanwhile Baker and his team say they are unenthused about the odds of airlines getting help from other potential catalysts, such as fuel prices, demand for air travel spurred on by global economic growth, or consolidation activity.

"Basically this industry has recovered and has been much better than in prior years ... so overall capacity will increase," Morningstar analyst Brian Nelson agreed. He added the caveat that the first quarter is always seasonally weak. "I think it's still too early to throw the towel in, in terms of the domestic market. Demand still seems to be strong and we'll see how things pan out in the second and third quarter."

So far airline stocks in the S&P 1500 Index have shed 4.4% year to date as of Apr. 20, when the index was most recently calculated.

"We don't believe shares have yet reached a point where investors should wander back in," Baker said.

The stock's prices suffered in early afternoon trading on Apr. 27. On the New York Stock Exchange, AMR sank 3.3% to $26.78, U.S. Airways 3.3% to 38.02, Alaska Air Group 8.6% to $32.53, and Continental 1.4% to $37.09 per share. On the Nasdaq, UAL gave up 4.1% to $35.43 while JetBlue lost 2.8% to trade at $10.085 per share.

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