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The airline industry is in a solid recovery mode, having registered a 22% gain in the past three months, a 31% gain year-to-date and more than a 64% gain in the past one year (see industry performance below).

(click to enlarge)Airline Industry - one of the top performers in 2013

This rally is backed by solid fundamental factors that are contributing to growth in the industry.

In this article, we first discuss these key catalysts, and then pick three airline companies that have the potential to be the best airline stocks in the next year.

Key Catalysts For The Airline Industry

  1. The airline traffic statistics for the past couple of years indicate that the demand for airline travel is increasing and airline companies are seeing increased utilization rates.

    According to research by the IATA, airline companies are set to experience higher traffic volume, increased passenger demand, better profitability, and greater than expected cash flows.

  2. Airline companies have found new ways of increasing their revenues in the form of ancillary revenues. Ancillary revenues come through fees earned for hotel bookings, exchange or purchase of frequent flier miles, luggage fees, seat upgrades and in-flight services such as Internet. These revenues have increased by 12% in the past year and will continue to grow.
  3. Industry consolidation among major airline companies is not only helping the companies expand their network and capacity, but post-merger integration is providing better operational efficiency and revenue synergies to the companies.

Best Airline Stocks

To find the best airline stocks, we researched stocks that have attractive valuations and are projected to grow both earnings and revenues. In addition, these stocks have the most number of Buy (or better) analyst ratings, and the 12-month target price set by these analysts indicate a high profit potential. After applying those checks, we get the following results:

  1. Alaska Air Group (ALK)

    Alaska Air may seem like a small regional airline, but it happens to be the sixth largest in the U.S., operating a fleet of about 172 aircrafts that include a combination of Boeing 737 jets and other smaller aircrafts.

    Alaska Air has conveniently hedged jet fuel at the price of $97 for the year 2013, and it has a jet fuel hedging percentage of 50 percent, through which it intends to gain control over jet fuel price volatility.

    The company's revenues, operating margins and aircraft capacity are expected to increase in 2013. Its EPS is forecast to expand in the next couple of years as well (see below).

    (click to enlarge)Alaska Air

  2. US Airways Group (LCC)

    US Airways' deal with AMR Corp (OTCQB:AAMRQ) -- the parent company of American Airlines -- will be closed sometime in the third quarter of 2013. This deal will provide US Airways much-needed penetration into the international markets. This merger, if approved, will be a solid growth catalyst for the company and will help the company balance its debt and reduce costs.

    Both revenues as well as earnings are forecast to grow significantly in the next two years (see below).

    (click to enlarge)EPS and Revenue Forecasts

  3. Delta Air Lines Group (DAL)

    The combined entity formed after Delta Air Lines merged with Northwest Airlines in 2008 has now become one of the largest airline companies worldwide, serving more than 300 destinations across 59 countries.

    Delta Air Lines' 2012 initiative in the oil refinery business will provide jet fuel to the company's operations in the northeastern part of the U.S.

    This purchase cost the company around $150 million -- the cost of a new aircraft -- and yet it will reduce the company's expenses by $300 million annually in northeastern operations. The company's decision to try to take control of its biggest input costs is a bold, yet impressive strategic move.

    While this purchase would work towards improving its operating margins in the coming years, Delta's earnings and sales are both projected to increase -- a very positive sign for its stock.

(click to enlarge)EPS and Revenue Forecasts For Delta Airlines

Attractive Valuation And Statistics

The table below indicates that Alaska Air, US Airways and Delta Air Lines are still undervalued, and they have solid fundamentals to back their growth stories.

(click to enlarge)Valuation and Key Metrics

Analyst Ratings and Return Potential

Most of the analysts that follow these three companies have a Buy or better rating for their stocks, as shown below. In addition, the average target prices of these three stocks are considerably higher than the current trading prices (as of 4/29/2013).

(click to enlarge)Analysts Ratings and Profit Potential

Risks

Many investors prefer to stay away from investing in airline companies because these companies are burdened with very high fixed costs, they face heavy competition, and they are always dependent on external factors such as jet fuel prices and demand for travel.

Investors must consider the risks posed by higher jet fuel prices, increased costs due to strikes and other union or labor force related issues, government safety regulations that result in changes in flight operations and even fleet, and of course, the industry's dependency on economic growth, which directly impacts consumer and commercial travel spending.

Conclusion

Alaska Air, US Airways and Delta Air Lines are three of the six companies that earn more than 30% of the total global ancillary fees revenue, according to this report. These three companies have made some smart and strategic moves that have positioned them well to get revenue growth, earnings growth and improved operating margins in the next couple of years.

A recommended strategy for investors is to add these stocks to their summer shopping list and buy on market or stock pullbacks, instead of buying when the markets are rallying at record-high levels.

Source: 3 Of The Best Airline Stocks