Flying High With Airline Stocks

Lately, the skies have been unusually friendly for investors in the fickle airline industry. Over the past year (through November 5), the NYSE Arca Global Airline index surged 80.5%, beating Standard & Poor's 500-stock index by 66 percentage points. Can the sector keep it up? Don't bet on it.

One reason for the airlines' big move is that they are classic cyclical stocks. When the economy takes a dive, travel is one of the first expenses businesses and vacationers cut. As the economy picks up, airline profits rebound. Businesses reinstate travel budgets, so airlines get more passengers who pay full freight (as opposed to leisure travelers, who look for cheap seats).

Profit centers. One factor fueling a surge in earnings is the billions brought in by the fees airlines instituted for such things as luggage, food and pillows. Those fees fall right to the bottom line. By adding all of those nuisance charges and reducing the number of routes they fly, the "airlines have changed their business model," says Craig Hodges, co-manager of the Hodges Small Cap Fund.

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By cutting capacity, the airlines are better able to boost -- or at least maintain -- fare prices. They have done that by retiring aircraft and engaging in a frenzy of mergers. Delta Air Lines (symbol DAL) merged with Northwest in 2008. On October 1, United Airlines closed its merger with Continental Airlines to create the new United Continental Holdings (UAL). This came just days after Southwest Airlines (LUV), the largest U.S. discount carrier, agreed to buy AirTran Holdings (AAI), a low-cost rival, for $1.4 billion.

Still, not everyone is convinced that the airlines have transformed from money pits -- in which most of the big players have gone through bankruptcy at least once -- to solid, long-term investments. "I'm reluctant to say it's different this time," says Helane Becker, an analyst at Dahlman Rose & Co., a New York City-based investment bank. "Stuff always goes wrong."

The obstacles facing the industry include a high unemployment rate, which will keep consumer confidence low. And if taxes increase in 2011, disposable income will drop. Plus, as always, the industry is unable to control its largest cost: the price of jet fuel.

Given the industry's record and the recent run-up in share prices, it's hard to be enthusiastic about the stocks. Southwest is the best bet. The Dallas company should be able to dominate the U.S. market after it consummates its acquisition of AirTran. By cutting fares and refusing to charge for bags, Southwest will be a big hit in the high-fare markets it moves into, such as New York City, Atlanta and Washington, D.C. That will not only increase Southwest's market share but also take a toll on the revenues of competing airlines in these cities. Southwest's takeover of AirTran's Atlanta hub will hit Delta especially hard.

Southwest reflects the industry's improving profit picture. The company earned $143 million, or 19 cents a share, in 2009. Analysts expect 93 cents in 2011. The stock has recovered from about $5 in March 2009 to $14.19 in November 2010. "While Southwest is straying from its traditional business model with the proposed acquisition, we think the benefits are likely to outweigh the risks," says Standard & Poor's analyst Jim Corridore. His one-year price target: $17.