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An economist interviewed on Bloomberg radio Wednesday was asked several questions about why legacy carriers are outperforming low cost carriers, and why the airline group as a whole has performed well. Listening to his answers, which I believe were completely wrong, encouraged me to take a fresh look at the group.

I turned bullish on airline stocks, and specifically legacy carriers Continental (CAL) and American, about one year ago while at my former employe, TheStreet.com. At the time, oil prices, crack spreads, and jet fuel prices, were all sky high and cutting into the profits of high cost legacy carriers. Even so, there was a large underlying transformation behind the scenes at Continental and others.

Specifically, legacy carriers were renegotiating terms with unions from flight attendants to pilots and securing better deals with travel companies such as Saber and Cendant. Most importantly though, carriers, with the exception of Continental, were cutting back on capacity and boosting prices right in sync with predictable economic recoveries with strong end market demand from consumer and business customers thus reducing the level of price elasticity. (The fact that CAL was adding capacity in an otherwise tightening market gave it financial leverage over other carriers).

So today, when I heard the economist on Bloomberg mention that a) the reason airline companies were raising prices was to offset higher fuel costs and b) even with price increases in place airlines will still struggle to eek out a 1% profit margin for 2006, I realized most investors still don't recognize the transformation the industry is undergoing. This will likely continue to push airline stocks higher.

I believe that oil prices, in general, have stabilized. Across the board in the industry load factors are holding steady with strong traffic thus producing encouraging yields. Also, capacity reductions remain in place despite strong demand.

On top of this, there is a massive round of unresolved consolidation occurring in the group; Delta (DALRQ.PK) is talking about some very positive market valuations as a standalone company once emerging from Chapter 11, and balance sheets have materially improved due to lower rates and turns in cash flow generation.

I think the rally will spread to low cost carrier JetBlue (NASDAQ:JBLU) in short order, as the company has slowed its "grow at any cost" approach, pushed back some jet orders, and remains a dominant JFK low cost carrier with new domestic routes recently announced.

Source: Why I'm Bullish On Airline Stocks