Opportunity in Airlines, But Not For the Fainthearted

Includes: AAL, UAL, UAUA
by: Erik Dellith

Fundamentals in the airline sector appear to be improving, but the foiled plane bomb plot in Britain is a reminder that risks to the airline sector, many out of the scope of its control, remain. The recent sell-off in airline shares, including Thursday's early action, however, provides a buying opportunity for investors who are ready to tolerate the risks.

The recovery in the airline industry seemed to be gaining traction of late, despite high fuel costs. Although some carriers, such as Delta Air Lines Inc. [DALRQ] are still operating under bankruptcy, others, including UAL Corp.'s (UAUA) United Airlines, emerged earlier this year.

Solid economic growth has helped. Additional business and leisure travel has enabled members of the airline industry, on average, to grow revenue by more than 22 percent in the trailing 12-month [TTM] period, a significant improvement from the five-year average of only 11 percent revenue growth.

The increase in revenue growth has helped profit margins widen considerably and provided a nice boost to the pace of earnings-per-share [EPS] improvement.

(Click here to download an Excel file comparing the companies in the airline industry on the basis of key fundamental metrics.)

The improving fundamentals are also reflected in share prices. Over the last year, the average stock price in the airlines industry has climbed more than 22 percent. More recently, however, the re-pricing of risk that has led to volatility in the global equity markets has also impacted airline stocks. On average, airline shares have given back nearly 10 percent over the last three months. As such, before the bomb news broke, shares were trading below the midpoint of the range of the five-year high and low price-to-earnings (P/E) ratios. Not surprisingly, airline stocks took Thursday's bomb-plot news on the chin, and shares dropped, pushing valuations even lower.

The bomb plot reportedly involved three US carriers: AMR Corp.'s (NASDAQ:AMR) American Airlines, Continental Airlines Inc. (NYSE:CAL), and United Airlines, and shares of these airlines each fell more than 3 percent in early trading.

While the news reminds investors of the risks associated with such stocks, the recent sell-off provides more risk-tolerant types with a buying opportunity.

Consider Continental for a moment. As indicated below, its forward P/E ratios - the P/E based on the consensus of analyst EPS estimates for 2006 and 2007 - are a discount to the valuations of AMR and UAL, as well as the industry averages. While comparative valuations are good, a perhaps better way to use forward P/E ratios is as the numerator for the PEG ratio, which is calculated as the forward P/E divided by long-term EPS growth rate. Conservative value-oriented investors typically hunt for companies with readings below 1.0, but numbers even a bit higher are still well within value territory. Continental's PEG ratios are low enough to appeal to even the die-hard value types, but a caveat needs to be added that investors should also be aggressive enough to tolerate the additional risks like those associated with recent events.

At the time of publication, Erik Dellith did not directly own puts or calls or shares of any company mentioned in this article. He may be an owner, albeit indirectly, as an investor in a mutual fund or an Exchange Traded Fund.

Note: This is independent investment and analysis from the Reuters.com investment channel, and is not connected with Reuters News. The opinions and views expressed herein are those of the author and are not endorsed by Reuters.com.

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