Airlines Ready to Soar Due to Falling Capacity and Fuel Prices

Includes: CPA, DAL, LFL, RJETQ
by: Ian Bezek

Normally airline stocks and the price of oil are inversely correlated to a significant degree. Airlines are so tied to the price of fuel that they are one of the few industries where another cost (fuel) exceeds employee compensation. Thus, one would expect with the sharp recent selling in crude that airlines would be rallying. Instead, airlines have continued their move lower. Since April 30, NYMEX crude has fallen from $114 to $94, and the benchmark XAL airline index has fallen 3%. Despite the improved profit environment offered by the sudden fall in oil prices, airlines remain stuck near 9-month lows.

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Certainly the increased economic headwinds in recent months play some roll in keeping the lid of airline stocks. But in general, the cost savings from lower oil prices exceed the demand destruction airlines face from a weaker economy. During the great financial crisis of 2008-09, airlines as a sector saw performance that did better than most others. While travel demand fell sharply, the cost savings from suddenly inexpensive jet fuel largely compensated for the lost passengers.

Now the airline industry finds itself in stronger shape than three years ago. Airlines have been aggressively cutting capacity with the expectation that high fuel prices are the new normal. Should this expectation be wrong, airlines are set to have an absolutely breathtaking string of profitable quarters before capacity can be effectively re-deployed. With mergers and acquisitions removing excess seats all over the industry, load factors for airlines are at high levels despite the rising ticket prices this year.

If the current trends toward lower fuel prices, higher passenger demand, and lower airline capacity continue, it will lead to a perfect combination for airlines to succeed. So far, the market has been slow to recognize the potential for a new secular bull market in airlines. While the thesis could of course fail to play out, airline shares are priced cheaply enough that they should still be able to perform at least equally to the market as whole even if conditions become less favorable for the industry. Here are some ways to play a potential rally in airline shares:

The Bellwether: Delta Airlines (NYSE:DAL) is America's second-largest airline. With its fortress hub at Atlanta, Delta controls the lion's share of traffic at the world's busiest airport, Hartsfield-Jackson Atlanta International Airport. The company's operations generated more than $2.5 billion in operating cash flow over the past year. While the company faces a large debtload, the company's highly profitable operations should be more than sufficient to service debt, especially if oil prices continue to fall. With a forward P/E of less than 5 according to Yahoo! Finance, Delta equity should have plenty of upside if the airline industry continues to enjoy favorable tailwinds.

The International Niche Player: Copa Airlines (NYSE:CPA) is perhaps the world's best-run airline at the moment. Though its stock is already trading near its all-time high, further appreciation can be expected. Its trailing P/E is a very reasonable 11, and profits are expected to rise again next year. The company has a monopoly in many of the Latin American markets it serves, and it has been able to pass fuel costs effectively on to consumers. Revenue grew 26% in the past year, and the company's debt/equity ratio is quite low compared with most of the airline industry. As long as Latin American economies continue to flourish, Copa should continue to outperform its peers within the airline industry.

The Merger Trade: Chile's LAN Airlines (NYSE:LFL) has been attempting to purchase Brazil's TAM Airlines (NYSE:TAM) since last summer. Though Chile's government is typically pro-markets and against excessive regulation, the country's courts have held up approval for the proposed merger thus far. It may be another six months before a final ruling is made. I still think the merger will end up being approved, creating a dynamic South American carrier with significant pricing power and growth opportunities. With forward P/Es of 17 and 14, LAN and TAM are not great values as standalone entities, however, assuming Chile approves the merger, the combined company is a steal at current values. I've written more about this merger here. As of last week, TAM is now trading nearly 20% below its value should the merger close, offering substantial upside -- particularly if the airline industry as a whole moves upward.

The Speculative Opportunity: Republic Airways (RJET) is being priced as if the company faces a high probability of business failure. Though the company's main operating subsidiary, Frontier Airlines, has fallen into unprofitability due to high fuel prices and fierce competition at its Denver hub, the company may be able to mount a turnaround as it aggressively cuts costs. At this point, Republic represents a cheap call option on the American airline industry; if fuel prices keep falling and demand remains strong, Republic shares should be able to quickly return to last year's $9 level, or higher. However, this one is definitely quite speculative. If my thesis is wrong and fuel prices return to $110/barrel or higher, Republic is probably heading for bankruptcy.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.