Airlines Ready to Fly Again

Then get even. You can't change the airline system, but you can profit from it. Once again, it's time to buy some airline stocks.

Last year, I wrote about UAL. Since then the stock has appreciated about 100%, outperforming the entire sector. I am long since gone that profitable trade, but I do have a replacement idea that has similar upside potential. I think it's time to own US Airways in a big way.

First, the case for the airlines. All of the stocks, excluding United, are down and very cheap. Most recently, airlines dropped on recession fears. So now, they fit my buy formula. I only buy stocks that are down and cheap with solid near-term business prospects.

Despite being oversold and at low value levels, the airlines also have solid fundamentals. Strong business and leisure demand for air travel has planes full and ticket prices strong. Airlines are a major beneficiary of the declining U.S. dollar. Hordes of foreign tourists are flying to USAMart to take advantage of cheap American consumer goods. And, courtesy of the weak dollar, many a U.S. businessman is jetting off all around the globe to open new accounts, especially in Europe.

In a natural response to supply and demand, airlines are shifting capacity to their more expensive, more profitable, foreign routes and away from their less attractive domestic ones. Every airline with a healthy international business gets a boost. But even those with all or mostly domestic exposure benefit as well.

As seats leave the domestic system in bunches, fares on domestic flights rise. In some instances, domestic airlines are shifting so much capacity abroad that their domestic yields are rising 10% or more. The legacy airlines have so little new capacity on order that shifting capacity is the only way they can satisfy this burgeoning international demand.

Another positive for the airline sector should be declining oil and jet fuel costs. I expect oil to top out this autumn and fade as we progress through winter -- that is, assuming we have a winter.

Naturally, airlines benefit directly from a drop in jet fuel, their largest expense. But they also receive a less obvious benefit.

Last year, when oil corrected down to under $50, airline stocks soared. Significant incremental buying came from commodity funds that were using long airline positions as a natural hedge for long energy positions. This represents a large new buyer of airline stocks that didn't exist until very recently. Should oil correct this winter as I expect, expect similar long energy hedge buying from the massive commodity funds.

If the stock market continues to rally on the dissipation of recession fears, airlines could soar. Normally, the group is one of the best performing in the seasonally strong fourth quarter. US Airways clearly represents the cheapest stock in the group with the most significant catch-upside. In a way, US Airways reminds me of the United Airlines call from last August.

The stock is down, compellingly cheap, and yet has significant positive earnings estimate revisions. At $30, the stock trades for only five times my conservative 2007 estimate of $6. In fact, on Thursday, US Airways released operational data for the month of September that led investors in the know to meaningfully increase current profit forecasts. On Friday, a leading analyst in the airline industry from JP Morgan boosted his 2007 estimate to $6.86 from $6.10! A peer group price-to-earnings ratio of 8-9 would generate a stock in the $50 range.

Now, I know that airline trading requires a strong stomach. I cannot deny the industry possesses some "issues" such as capital intensity, questionable managements, irrational and arrogant labor (read: pilots) and stupid government regulators. But, like the steel industry, the airline business is clearly improving. Company officers and directors are finally getting the point that the airline companies need profits to survive, even if the pilot labor unions and politicians don't.

Airline managements have finally decided to favor profits over growth as capital spending discipline is the order of the day for the legacy airlines. With poor shareholder returns for the past decade, even the low-cost, high-growth airlines have tempered new capacity additions. Looking at the shareholder returns for the low-cost airlines, shareholders in JetBlew and Southwest have received little Luv. The knuckleheaded directors of the airline companies finally seem to get it. Now if only the lamebrained politicians who are preventing a natural industry consolidation would get a clue.

Assuming the economy avoids a full-blown recession and reaccelerates into 2008, the airline group has solid catch-upside to the major stock indices. The stocks are down and cheap, yet business fundamentals are still strong. Within the group, US Airways is by far the cheapest, with the most recovery upside. There might be episodes of turbulence, but airline stockholders could be amply rewarded if the strong international traffic demand and astute capacity and yield management trends persist.