Most people know that over the long term the airline sector has been an absolutely horrible place to invest. In fact, the current value of the publicly traded airlines is far below the amount of capital that has been invested into them, so returns in the industry have been negative for decades.
Even though these stocks are not good investments, they can make for very profitable trades if you take a shorter term view that is easier to predict. Shares of low-cost leader Southwest Airlines (NYSE:LUV) have dropped 20% from their 52-week high for several reasons, and they appear poised to rebound if you believe its pending buyout of Airtran (AAI) is a positive and oil prices are peaking short term.
The deal to buy Airtran, which should close in the next couple of months, should be very accretive for Southwest. LUV trades for about 60% of sales, whereas the cash and stock deal for AAI is for about 30% of revenue. Expense synergies should make the deal a great long-term strategic transaction for Southwest.
Investors are also getting a discount on LUV stock thanks to skyrocketing oil prices and recent safety concerns with some of LUV's Boeing jets. The cracking found in a handful of its planes really should not be a big issue for investors. Fines from the FAA tend to be meager, and with inspections taking center stage now, Southwest should improve its safety profile dramatically after such an embarrassment. Traffic metrics show that passengers are not switching carriers after the hiccup, as Southwest continues to be near the top of the list for domestic passengers.
Oil prices are always a wild card, but there are reasons to think the recent spike is unsustainable. As tensions in the Mideast ease, it would not be surprising to see oil prices head back towards $100 per barrel, which will help airline stocks. As gas pump prices approach $4 per gallon nationally, we will undoubtedly see demand destruction which will serve as a self-correcting mechanism for high prices -- and jet fuel prices track crude oil fairly consistently.
Combine a possible near-term peak in oil prices, temporary negative headlines around safety, a very accretive deal to acquire a low-cost competitor, and a 20% discount in the stock price, and Southwest stock appears poised for a pop of 20% or more later in 2011, as near-term concerns subside and oil prices trend lower.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.