Outlook for Airline Stocks

On January 14, The Wall Street Transcript interviewed Michael W. Derchin, Managing Director and Senior Transportation Analyst of FTN Midwest Securities Corp. Key excerpts, including his stock picks, follow:

TWST: Now that the stocks have taken a beating, are investors interested in this space at all?

Mr. Derchin: Truthfully there is very little interest. No one believes that consolidation will begin in early 2008 like I do. Most investors are worried about the high energy prices and the ability of the airlines to pass them on to consumers if the economy slows in 2008. I am in the minority thinking that managements will surprise by generating decent unit revenue growth in the first half of 2008 to offset much of the fuel price increases. The combination of capacity discipline domestically, fare increases in place, easy unit revenue comps in the first half of 2008, and management focus on generating adequate returns despite the fuel and economic environment are behind my thinking. Consequently, valuations are very attractive at these levels and we can see many of our favorite names doubling over the next two years.

TWST: Is it time for investors to look at them?

Mr. Derchin: Yes, absolutely. We tend to have a longer-term time horizon. When the stocks sell off, we recommend that you establish new positions or add to them if you have partial positions. There are three catalysts that could make these stocks be very big stocks next year.

First, you could have oil prices crack, no pun intended; there's nothing sacred about $90 a barrel. In fact, based on pure supply and demand, the price of oil should be a lot closer to $60 to $70. I don't think that anybody would question that there's a bubble in oil; you just don't know when it's going to burst.

Second, I think unit revenue growth next year should be solid and has a decent chance of being up double-digit levels in the first half of the year considering a) the amount of capacity that's coming out domestically in the first half of 2008, b) the number of domestic fare increases that have been put in place since Labor Day which are sticking and will extend through September 2008, c) the management philosophies on capacity discipline and running these companies like businesses, and d) the economy staying reasonably healthy. FTN Midwest economists and strategists don't believe that the US economy is going into a recession; it's more like a mid-cycle slowdown, with economic growth beginning to improve in the second half of next year.

Third, consolidation gets kicked off most likely by Delta and Northwest agreeing to merge. In order to get that deal reviewed by the current Bush administration DOJ, it has to be announced by February 2008. It takes six to nine months to get a deal of that magnitude reviewed and approved. If it makes financial sense to do and you have a slightly better chance of approval under a pro-consolidation, pro-business administration, why not try to get it in before they leave office? So my gut feel is it's going to get announced prior to March of next year. The Delta pilots union must think it's going to happen soon because they called a special meeting with their outside counsel, investment banker and consultants on consolidation in the first week of December — right before Christmas. The pilots want to be proactive in the process.

Then the interesting thing will be whether or not a Delta (DAL) acquisition of Northwest (NWA) leads to other transactions for defensive purposes. All the airlines have been talking about consolidation in a positive way to reduce the fragmentation in the industry, meaning there is too much competition domestically. Everybody is waiting for the first shoe to drop. After the first deal is announced, it wouldn't surprise me to see one or two others get announced fairly quickly, with Continental acquiring United as my guess for second most likely shoe to fall transaction. Northwest has a golden share which would block a transaction between Continental and another airline, but my understanding is that this blocking share would go away if Northwest were involved in a merger with another airline.

TWST: What names would you look at at this point?

Mr. Derchin: Our favorite stock in terms of upside potential is AirTran (AAI), which we see tripling over the next one to two years from its current $8 level. It's the lowest cost US low cost carrier; in 2008 AAI should even have lower unit costs excluding fuel than the "mother of all low cost airlines," Southwest Airlines. AirTran began operations as a low cost carrier called ValueJet, which, after a tragic crash in the late 1990s, merged with a small Orlando-based airline and kept the AirTran name. Despite fierce competition with Delta Air Lines, AirTran has been profitable every year since 1999. AAI's core operation is Atlanta, having taken over the terminal formerly occupied by Eastern Airlines after they went into liquidation. AAI has about 15% of the Atlanta market and Delta the other 85%. Prior to 2007, AAI and DAL did not co-exist well; Delta tried to put AAI out of business for years by adding uneconomic capacity against them and keeping fares too low for even a low cost airline to generate adequate returns. In the end, Delta's focus on battling AAI and taking market share from them was a contributing factor to Delta filing for Chapter 11. The "new" Delta is focused on shrinking its domestic operation and growing its international one. In 2008 we expect Delta to reduce domestic capacity 4%-5% and grow international 15%.

Meanwhile AAI has been successfully restructuring its route network and moving away from DAL — building a hub in Baltimore, adding a substantial amount of east-west flying from the Northeast, Midwest and Atlanta to western cities, and growing its Midwest presence, including adding flights in Milwaukee. AAI was rebuffed by Midwest Air (MEH) in 2007, which accepted a higher joint bid from The Texas Pacific Group and Northwest Airlines. AAI used to be exclusively a north/south carrier. Now 20% of its capacity flys east/west. AAI's strong profit performance in the third quarter (not historically a good one for AAI) was boosted by 90% load factors over its new east-west routes. AirTran has numerous opportunities to expand in the Northeast and Midwest and would be one of the airlines benefiting from consolidation between network airlines that are likely to eliminate marginal hub flying as part of the integration process. For example, a merger between Delta and Northwest would likely result in AAI picking up gates and beginning service in cities like Memphis and Cincinnati. AAI has an excellent product with business class and satellite radio on every flight, which appeals to both business and leisure travelers. The stock is trading at $8.06 a share right now. Our target price is $23, applying a 15 multiple on our 2009 estimate. Growth airlines like AirTran and Southwest (LUV) in the US and Ryanair (RYAAY) and easyJet in Europe typically sell at 15-30 times forward earnings, reflecting the fact that their low costs and unique business models have permitted them to be profitable in tough times like 2001-2005, and they have significant growth opportunities in the future.

Comments

[James Cullen:]

Buy airlines for the long term? Did I read that correctly?

2008 Jan 14 03:03 PM

[frumby:]

Yes, a little strange. Secondly, if Air Tran is so great, why are Air Tran pilots hoping for a buyout from Southwest?

2008 Jan 18 10:30 PM