For Airlines, Sunnier Skies Ahead
This article is from the archive of The New York Sun before the launch of its new website in 2022. The Sun has neither altered nor updated such articles but will seek to correct any errors, mis-categorizations or other problems introduced during transfer.
“Every dog has his day,” Jonathan Swift wrote.
The airline industry is one that investors a few years ago thought of as a dog. However, if you had bought the shares of any number of carriers around their 2004 lows – such as the parent of American Airlines, AMR; Continental Airlines; SkyWest, or Alaska Air – you could have made nearly 1,000% or more on your money.
If you didn’t board this gravy train, don’t fret: You can still do it, because there’s more mileage left in select airline issues, including a couple of the big winners, Morgan Stanley says. The company has just re-established coverage of four carriers on the theory they’ll outperform the market over the next 12 to 18 months.
Why? Because the industry is gaining altitude. Airlines are experiencing a strong cyclical upturn, analyst William Greene says. Business travel has rebounded, the near- to medium upturn capacity outlook is bullish, jet fuel prices have plateaued, and consensus estimates look too low, he says. Historically, the group has outperformed ahead of upward earnings revisions, and that is precisely what he expects.
Why upward earnings revisions? Because compared with the previous period during which he covered the airlines (2002-05), it would seem industry fundamentals have experienced a 180-degree turn, Mr. Greene says.
In particular, he notes, the major bankruptcies of the past few years (Delta, United and Northwest) have eliminated significant capacity from the system, which has helped create today’s strong unit revenue environment.
Further, Mr. Greene expects capacity growth in America to be constrained both this year and next by stretched airline balance sheets and the inability of aircraft manufacturers to sharply increase jet production. If airline capacity grows at less than 4% in 2006 and 2007, which is what the analyst expects, airline yields – a cost metric that measures what an airline generates transporting each paying passenger – should further improve if GDP growth stays positive, he says.
Pointing to flat capacity in 2006 and his estimate of 2% to 4% growth in 2007, Mr. Greene figures these modest capacity growth rates should support a solid pricing environment through the end of next year if domestic GDP grows as expected.
Mr. Greene also expects the summer travel season to be strong, load factors to be high, and pricing growth to remain in the high single or even low double digits.
What happens if fuel prices head higher? Mr. Greene says he never could have imagined the industry could turn a profit with oil trading at or near its current level of about $70 a barrel. Yet he’s forecasting that both AMR and Continental will be profitable this year and next. While he acknowledges that higher jet fuel costs would likely wipe out much of the profit he forecasts for major airlines, he hastens to point out that the higher costs also would likely force more uneconomic capacity to exit. In turn, he says, that would allow profitable, lower-cost capacity to take market share and benefit in any future upturn.
The analyst’s top pick is JetBlue Airways, which has massively underperformed the three other carriers Mr. Greene is also tracking – AMR, Continental, and Southwest.
Here’s a rundown of his 12-month price targets for the foursome: AMR ($25.32), $29; Continental ($27.56), $32; JetBlue ($12.60), $16, and Southwest ($16.28), $18. According to one Morgan Stanley strategist, add another 10% to 12% to the target prices if the economy doesn’t go into a tailspin.
However, it may not all be clear skies. Potential risks abound. Among them, aside from a maturing economic cycle, Mr. Greene notes airlines will likely push on price to recoup lost earnings and cash flow, which suggests intensifying price competition. Further, increased jet production by manufacturers could increase capacity growth to a worrisome 4% to 6%, and faster growth supply could erode confidence in the industry’s ability to raise prices. Oil, of course, is an unknown, but lower fuel bills could invite more capacity growth.
The risks notwithstanding, Mr. Greene’s bottom line is that there’s still plenty of green to be made in airline stocks.
