Renewed Terrorism Threat Rattles Airlines

After one of the worst years in their history, U.S. airlines were actually looking forward to 2010. At least until a Christmas Day attempt to blow up a jet. The incident raised concerns among some people that terrorism fears could derail the airlines' nascent recovery, as security procedures make international travel burdensome to the point that corporate fliers take a pass on some trips. Investors sold airline stocks, ending a recent upswing that had the industry outpacing the rest of the stock market. Since the Dec. 25 incident in Detroit, stocks for most of the majors have dropped: 5.7% for American's parent; 5.3% for Delta (DAL), whose jumbo jet was targeted; 4.7% for United (UAUA); and 2.3% for Southwest (LUV). But, despite legitimate security concerns, airline experts said worries about the incident's effect on the airline industry may be overhyped. Of course, anything that discourages air travel is bad news for North American airlines, which are expected to lose nearly $3 billion in 2009, according to the International Air Transport Assn. That's atop $55 billion in losses for U.S. carriers alone the previous seven years. Airline executives had been sounding enthusiastic about the new year. "While we still have a long ways to go, our revenue results are improving as overall demand strengthens and, importantly, business travelers return," United Airlines Chief Financial Officer Kathryn Mikells said Dec. 9 at an investor conference in New York. "We believe we will see improved conditions," Delta President Edward Bastian told investors Dec. 15. Potential Revenue HitThis optimism has prompted many analysts to predict U.S. airlines could return to profitability in 2010. In the past nine months, Delta shares had gained 90%, while stock in United parent UAL Corp. and American Airlines parent AMR Corp. (AMR) more than doubled. "We were actually getting to be more hopeful [that] we were going to see increases in business traffic," says Jesup & Lamont transportation analyst Helane Becker, who considers the terror incident a potential problem for revenues. Moreover, most airlines are burdened with heavy debt these days as they dealt with a sharp spike in fuel prices in 2008 and a severe recession. That debt load means that even a slight drop in 2010 air travel demand and revenue could wipe out a large chunk of airline profits. For example, Vaughn Cordle, chief analyst at research firm Airline Forecasts in Washington, D.C., estimates that the holiday terror attempt could dampen 2010 revenue by a mere 0.25% to 0.5% for the top 10 airlines. However, a sales decline even that small could translate into a 10% to 20% hit to those airlines' net earnings, he estimates. But airline experts and executives say it's important not to exaggerate the effects of terrorism fears. In the past, "these incidents have not had significant impacts on domestic travel," says David Cush, chief executive of Virgin America and a former executive at American Airlines, in an interview with Bloomberg BusinessWeek. The key, Cush said, is whether new security procedures make traveling so difficult that consumers prefer to stay home. "We need to have very measured responses to this, so that we don't make travel so arduous and burdensome that it [discourages] travel," Cush said. So far, he says, the Transportation Security Administration has displayed a "measured" response. (Virgin America has no international flights, which are currently subject to tighter security requirements than domestic flights.) Labor and Fuel ConcernsSince 2001, travelers have gotten used to terrorism warnings and annoying security procedures, says Craig Hodges, portfolio manager of the Hodges Fund (HDPMX), which owns airline stocks. "Everyone has grown to accept it," he says. After this last incident, "there may be a short-term blip," Hodges says. But, assuming no further incidents occur, "everything will be back to normal in a few weeks." Other issues could have a far more significant effect on airline bottom lines. According to Cordle's estimates, airlines squeezed about $19 billion in annual concessions from labor unions earlier this decade. Now many of those contracts are up for negotiation in 2010, including those at United, American Airlines, Continental Airlines (CAL), and US Airways (LCC). And many groups of workers are expected to demand large raises. Labor and fuel bills combined make up more than half of airlines' annual costs. That means airlines also watch energy markets carefully. Last year's spike in oil prices cost many airlines dearly. Airlines should also worry about higher taxes or more onerous government regulations, says Morningstar (MORN) analyst Basili Alukos. By itself, a spike in fuel prices, labor costs, or taxes could dash an airline's dreams of 2010 profitability. Luckily, there are a few positive trends for this industry. Airlines have slashed the number of flights, ending cutthroat price competition on many routes. "The airlines have done such a good job reducing capacity," Alukos says. "That's kept pricing higher." Airlines have also found new ways to wring revenue from customers, from baggage fees to charging for food, drinks, onboard movies, and in-flight Internet. "The airlines have added a tremendous amount of new revenue sources that weren't there a few years ago," Hodges says. Recovery HopesThe prospect of a better economic environment in 2010 and 2011 means airlines could reap significant financial benefits from higher ticket prices and new passenger fees. "When the economy [improves] I think the airlines are going to thrive," says Hodges, whose funds own shares of Continental, Delta, and Southwest. Yet others warn that the U.S. airline business remains highly unpredictable, historically a graveyard for capital. Serious long-term challenges mean that airline stocks are popular trading vehicles, but rarely buy-and-hold investments. "They're not fit for long-term investment," says Cordle. It's difficult, if not impossible, to predict the direction of energy markets, the economy's pace, future terror threats, or the outcome of labor negotiations. As a horrible year for the industry ends and hopes rise for 2010, airline executives must try to do all four at once.

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