Airline stocks, and particularly the major network carriers, have significantly outperformed the broader market over the past two and a half months. The major catalyst for this turnaround was AMR's (AAMRQ.PK) bankruptcy filing in late November. This event fueled a new round of speculation regarding potential consolidation within the industry. Furthermore, with most analysts expecting American to cut back on some of its unprofitable routes, investors became more optimistic about the ability of the major airlines to keep fares high. This optimism was bolstered by robust revenue forecasts (and reports) for early 2012, most notably from Delta (DAL), which saw a nearly 15% January PRASM increase.
Since the November lows, Delta, United (UAL), and JetBlue (JBLU) have each risen more than 50%. Meanwhile, US Airways (LCC) has more than doubled from its lows near $4/share to its current price above $9. With such a rapid rise in share prices for these four airlines, is it time to start taking some money off the table?
I believe that most of the airline stocks still have ample room to grow over the next year or two, but I think it is prudent at this point to reduce exposure to airline stocks. The market as a whole is probably overbought at this point, with the Nasdaq at 11-year highs and the S&P 500 having risen more than 20% since the beginning of October. Any correction is likely to hit the airline stocks hard, since airlines are vulnerable both to commodity inflation (i.e. high oil prices) and macro-economic weakness.
Moreover, some of the hoped-for industry catalysts have not materialized, raising the potential for future earnings misses. Oil prices have risen substantially in recent days, in large part due to geopolitical concerns regarding Iran. While some have worried about Iran's threats to close the Strait of Hormuz at the entrance to the Persian Gulf, Iran probably does not have the capaibility to disrupt oil transport through the Strait for more than a few days. On the other hand, efforts by the EU and the US to impose sanctions on Iran (based on nuclear proliferation concerns) may decrease the supply of oil on the market. This is also not a long-term concern in all likelihood, but could still drive oil prices higher in the next few weeks.
Additionally, AMR unveiled the concept for a turnaround plan that does not involve capacity cuts. Instead, they are looking to cut $2 billion in costs and achieve a $1 billion revenue improvement through changes to the route network. The company intends to build on those changes by increasing departures by 20% in its five key markets. It seems likely that total capacity will increase by a smaller amount, but this is still a far cry from investor hopes for meaningful capacity reduction.
While many airline stocks still trade at very low forward P/E ratios, these headwinds may lead analysts to lower their EPS estimates in the coming weeks. US Airways is particularly susceptible to jet fuel price increases because of its unhedged position, and shares seem fairly valued at this point in time. Delta is still showing relative strength on the revenue front, but I think it has limited upside from current levels. JetBlue trades at a forward P/E of 9 (relatively high for the industry), and should probably be avoided until after a potential correction.
United Continental remains my top pick in the industry. If you want to maintain exposure, I think this is the best stock primarily because it has a low P/E, strong balance sheet, and is likely to see increased merger synergies over the next two years. After the integration of United and Continental is completed (hopefully by the end of the year), if things go smoothly, the company may be willing to start returning cash to shareholders.
I have exited my previous positions in DAL and LCC, and I also trimmed back my position in UAL last month. However, I still have a fairly large position in UAL that I intend to hold longer-term, as I think the stock is likely to hit $30 by year-end and $40 by the end of 2013.
Disclosure: I am long UAL.