Cool Feelings About Hot Airline Stocks

Call it dumb luck or savvy investment insight.A reader named Jeannie writes that after taking a flight aboard a Continental Airlines ($25.30) plane two years ago, she was so impressed with the ease of the trip — the plane actually departed and arrived on time — that she bought 3,000 shares of the company’s stock (then at about $9.25) for about $28,000. With her shares now worth more than $75,000, she asks whether it’s time to sell.Actually, Continental is not alone in its sizzling showing. Many airline stocks have soared in recent years, rebounding from wicked declines caused by surging energy prices, fierce discounting, too much capacity, and a rash of bankruptcies. In fact, many analysts continue to tout the industry, theorizing that the rebound thesis is intact and that, fundamentally, the sector looks to be in high gear.One analyst, though, has lost his ardor for some of the major names, including Continental, and is suggesting to clients it may be time to head for the exits.The analyst is Merrill Lynch’s dogged airline tracker, Michael Linenberg, who was brainy enough to have alerted investors to a big run in the stocks, which includes a high-flying 29% gain this past season. In particular, he is warning clients about the parent of American Airlines, AMR Corp., Continental, and US Airways Group. These three stocks, which he recently downgraded, have exploded over the past nine months, ballooning 147%, 228%, and 166%, respectively, between October 1 and July 10.In the same period, the S&P 500 gained 3.1%, while the American Stock Exchange Airline Index rose 32.5%.Surprisingly, the analyst has pulled his buy rating on all three stocks even though he’s impressed with the industry’s fundamentals and expects strong June quarter results and an even stronger September quarter. For the recently ended June quarter, he’s projecting a net profit for the industry of $1.2 billion, its first profitable quarter since September 2000. An even bigger profit, $1.4 billion, is pegged for the current quarter.For the industry’s eight largest carriers (Alaska, AMR, Continental, Delta, Northwest, Southwest, United, and US Airways), Mr. Linenberg forecasts a 12% increase in the top line, to $28.6 billion, driven by a 12.3% hike in unit revenue on flat capacity. Significantly, the projected $3.2 billion revenue increase is seen as more than offsetting the $1.3 billion boost in fuel expenses.Not only that, he says he thinks the current upcycle could be extended at least another year as long as the industry continues to demonstrate restraint when it comes to adding capacity, particularly in domestic markets. Furthermore, modest capital expenditure plans combined with a profitable 2006 should result in meaningful free cash flow generation and record cash positions.So why is he downgrading the three stocks? For starters, while he thinks the industry’s return to profitability is good news, he says he believes this rebound, given the huge stock gains, is already reflected in some of the shares, notably the ones whose ratings he has cut.Likewise, airline stocks tend to underperform the market during the summer (or the third quarter), and in fact often actually go down in this period. For example, since 1992, the Amex’s airline index averaged declines of 1.4% in July, 3.3% in August, and 9.1% in September, for a totally quarterly loss of 13.8%.Although he takes a negative view of AMR, Continental, and US Airways, Mr. Linenberg does throw in a word of caution, pointing to a possible event that could drive airline shares considerably higher — a pause at the August 8 meeting of the Federal Reserve’s Federal Open Market Committee. Although the general expectation is that the Fed will raise the Fed funds rate to 5.5% from 5.25%, which would be its 18th consecutive hike since June 2004, a number of economists also believe a pause is a distinct possibility, given a slowing economy.What, you may wonder, do carriers have to do with interest rates? The answer: History shows that airline stocks go up, far outpacing the market, after the Fed’s final rate in a tightening cycle. That’s what Mr. Linenberg discovered when he looked at the last tightening cycles. He found that airline stocks, three and six months following those five cycles, averaged gains of 11.1% and 33.9%, respectively.Although down on a trio of airline biggies, the analyst says he thinks there’s a decent buck to be made on a number of out-of-favor airline names. Among them are Air Tran Holdings, UAL Corp., Alaska Air, SkyWest, and Republic Airway Holding.dandordan@aol.com

Cool Feelings About Hot Airline Stocks

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