Clear Skies for Airline Stocks

A drop in oil prices, a bullish note on three regional carriers, and AMR's divestiture of American Eagle launched airline shares on Nov. 28

Airline stocks took off Nov. 28, sparked by a second day of steep drops for crude oil futures and a bullish note on the regional carrier sector from Calyon Securities analyst Ray Neidl, who upgraded three regional carriers based on valuation. Crude oil prices dropped $3.72, to $90.70 a barrel on the New York Mercantile Exchange, amid concerns about a U.S. economic slowdown, a bearish inventory report, and talk of a production hike by OPEC.

Atop all that, American Airlines parent AMR (AMR) announced plans to divest American Eagle, its wholly owned regional carrier. That move could mean a hefty cash infusion for the nation's largest airline and showed Wall Street that the industry is taking seriously calls to cull value from various parts of their operations.

Shedding American Eagle will offer the regional carrier more opportunities for new business, which could include flying for other airlines. AMR has not yet decided on the form of the divestiture, which may include a spin-off to AMR shareholders, a sale to a third party, or some other form. The company expects to complete the divestiture in 2008, but said it will depend on a number of factors, including general economic, industry, and financial market conditions.

AMR shareholders have been calling for the nation's No. 1 airline to sell its regional carrier and other assets. The news lifted AMR shares by nearly 7%, to $21.98, on Nov. 28. "This is a wise move in my opinion," Neidl wrote in an e-mail to BusinessWeek. Shares of rival Delta Air Lines (DAL) gained 6.9%, to $18.77; Northwest Airlines (NWA) was up 5%, to $18.01; Continental Airlines (CAL) rose 4.6%, to $27.98; and US Airways (LCC) surged 7.5%, to $20.97.

Regional Upgrades

Earlier on Nov. 28, Neidl upgraded the shares of three regional airlines: Republic Airways (RJET) and SkyWest Airlines (SKYW) were boosted to buy from add, while Pinnacle Airlines (PNCL) was raised to add from neutral.

"Recent declines in stock prices for the regional airlines on fears of network industry consolidation have made…SkyWest and Republic Air more attractive buying opportunities," wrote Neidl in a report. "We believe that the regional model is viable as long as they provide a real value to their partners."

Shares of Republic climbed 8.2%, to $20.27, while SkyWest moved up 4.9%, to $25.65, and Pinnacle rose 6.9%, to $15.72.

However, Neidl pointed out that his rating changes are based strictly on valuation given that he has not changed his sector outlook, estimates, and price targets. He warned: "The regional airline sector is facing major challenges including a lack of growth opportunities and continuing pressure to cut costs as their network partners bend under the pressure of high fuel prices."

He kept neutral recommendations on Mesa (MESA) and ExpressJet Holdings (XJT). And Neidl maintained price targets of $26 for Republic, $29 for SkyWest, $17 for Pinnacle, and $3 for ExpressJet. But he cut his price target for Mesa to $4, noting that he believes "there is significant uncertainty with multiple lawsuits taking place that makes it difficult to determine potential future cash liabilities despite its current low stock price and high cash reserves."

Stock Descent

Airline stocks have hit the skids this year, with the S&P Airline Index falling 19.3% year-to-date through Nov. 23, amid worries about skyrocketing oil prices and a weaker economy, which could hurt demand for air travel.

The most recent worry that's been driving down regional airline stocks is concern that consolidation among the major carriers would lead to the elimination of smaller hubs where regional airlines dominate, Neidl explained. This is a potentially serious issue, he said, but consolidation hasn't begun yet and it would take time to restructure hub operations if any merger gets done. He noted that although some of their contracts with major carriers will begin to expire over the next few years, most of them are long term, giving the regionals some additional protection.

"The regional airlines continue to generate strong cash flow through their fixed contracts and all have accumulated significant cash reserves," Neidl said. "Stock buyback programs using some of the surplus cash at most of the regionals should also add some strength to stock prices."

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