You Don't Have to be Crazy to Buy Airlines

Includes: AAL, UAL
by: Dan Carty

One of Jim Cramer's mantras is "Never buy airlines." There is some merit to such a statement, given the rampant mismanagement in the industry and the large fixed costs that impact each of these companies' financial statements.

The industry is not known for its financial flexibility because, in short, airlines have very little of it. Energy costs account for roughly 27% of their expenses (on average) and pension costs take up a sizeable portion as well. The fashionable thing to do these days in this business is to go into bankruptcy, thereby dumping some of that cost structure, including the pension plan. Sure, there is legislation underway to prevent such things going forward, but this does not negate the fact that this is one treacherous industry for investment.

So when I say “I am buying airlines,” I am probably stepping off the deep end, right? Actually, I do have two sane reasons for investing in airlines, described in further detail below.

First, the collapse in crude prices, which have sunk back to April levels, is very encouraging and helpful to the bottom-line of the industry. For example, every $1 fall or rise equals roughly $0.13/share to Continental (NYSE:CAL) or $0.16 to US Airways (LCC) using the average of various house research reports.

Since the beginning of September, crude has fallen $2.70. Extrapolating, this equals roughly $0.35/share to continental bottom-line and $0.43/share to United's (UAUA) bottom-line. While this is only 3 days worth of trade, it does show the impact that crude can have on earnings and cash flow for these companies.

Last week, I released my forcast for crude oil prices. My ultimate target for crude is somewhere near $57/barrel. That is another $10 lower from current levels. Using the examples of CAL and LCC again, that equals $1.30/share for the former and $1.60 for the latter. It appears that the analyst community on crude is somewhere in the range of $65-70 range for this sector so if the price of crude is $67, we are perhaps now at the point where the airlines begin to make money.

The price of crude relative to its 6 month moving average is also turning over. There was a head fake last fall before a bounce higher. This time around, if crude holds around the current levels, the trend will be broken.

My second reason for buying airlines is that the current economic environment is airline-friendly. Airlines sink when the economy is weakening. In looking back at the XAL (Amex Airline Index) over the past 15 years, when the IRX (13 wk bill) trend is up and crude is moving lower, that is an ideal environment for an airline. Growth with falling expenses = rising profit margins.

Such developments existed from 1995 thru 1998. Super growth in the equity markets propelled the XAL higher from 1995 into 1996 and then a drop in crude prices provided a second lift higher. Meanwhile the 13 week bill moved sideways. Stable rates, flat to lower crude and rising equity markets = higher airline prices. So if I am projecting crude prices to $57 and stable growth with low inflation (how many times have I said this), we could be entering a time that supports my case in buying some airlines.

The markets think that the economy is turning over and the Eurodollar Markets are forecasting a cut sometime next year. But given my growth models' upward trajectory (and falling inflation trends), I think the market will soon realize the airlines are undervalued, thus supporting my position.

Now I am not talking 50 or 100% gains. Personally I think the run, if it does materialize, could be 33% in the XAL. That would take the current level to 63 (from the current 47 level). Speaking of the XAL, I would not have been a buyer of this index since the middle of 2004 (if buying the index were possible) but conversely, would not have been short either. The index is just stalled and waiting for a catalyst which is the scenario indicated.

At this point, among those airlines I have been researching of late, I have taken small positions in American Airlines (NASDAQ:AMR), LCC and CAL. I am not taking full positions due to the weak nature of the uptrend of each and the sideways trade in the XAL. Once some stability is formed, I will add to the positions.

So here is the bottom-line: As oil and jet fuel fall lower, airline stock buyers will take notice. If the economic situation holds, which I think it will (look to the UK for how I think the US economy will perform), then these planes should be flying come October. To what level? I will explore that further when things look better.

XAL 1-yr chart: