Airline stocks: Hot sector, room to run

According to analysts, there's still time to climb aboard. Assuming there's not another spike in jet fuel prices next year, the profit outlook should continue to improve, allowing the stocks to climb even if mergers don't materialize.

The Amex Airline Index jumped about 3 percent Wednesday on reports that United Airline parent UAL (Charts) is in talks with Continental Airlines (Charts), and on the news that Atlanta-based AirTran Holdings (Charts) is offering $11.25 a share in cash and stock, or about $200 million, for Midwest Express Holdings (Charts), a 24 percent premium from Tuesday's close.

Shares of both UAL and Continental rose about 5 percent in afternoon trading Wednesday on reports of their merger talks, while Midwest Express shares climbed nearly 20 percent.

Those merger talks followed last month's hostile $8 billion bid by US Airways (Charts) for Delta Air Lines, the offer that set off the current merger frenzy in the industry.

But even before that Nov. 15 offer, the Amex Airline Index had already gained nearly 30 percent in the previous three months, due mainly to the improved industry outlook. And while the index jumped about 7 percent in the aftermath of that offer, it actually has retreated a bit since, signaling that it's not just takeover speculation lifting the stocks.

"The PEs on these are very very low," said Jim Corridore, airline equity analyst with Standard & Poor's, referring to price-to-earnings ratios. "It's still not too late to get into these stocks. The two companies we have strong buys on, Continental and US Airways, do not need merger activity to see an upside."

The rally in airline stocks isn't a big surprise given the improved economic picture in the sector. After losing $42 billion between 2001 and 2005, most major carriers have returned to profitability this year. It's also a big turnaround from recent years when it's been very difficult to make money investing in airlines.

Strong demand for travel and sharp reductions in capacity after the 2005 bankruptcies at Delta and Northwest have lifted fares more than 11 percent through October from a year earlier. And while jet fuel prices are still up compared to last year, they were down nearly 5 percent in September from the record high in August.

But others warn that a round of mergers could work against the recovery in airline stocks, especially if managements have to cut expensive deals with unions to win support for mergers, or take their eyes off the ball on controlling expenses.

The failed attempt by UAL to buy US Airways in 2000 and 2001 led to an industry-leading labor deal with the pilots that unions at other carriers used a benchmark in their own contract negotiations. Only a round of post-9/11 bankruptcies and layoffs helped rescue the industry from those labor deals.

"We see a very strong 2007 coming in the airline industry," said consultant Michael Boyd. "But it will be less strong if these mergers take place."

Still, Boyd said that short-term there could be a number of airlines that see their shares lifted by takeover speculation, including trouble Frontier Airlines (Charts), which saw shares surge Wednesday, and Alaska Air Group (Charts), which was up nearly 4 percent.

"Alaska has been a merger target for at least 35 years," said Boyd. "Will it get bought? Who knows? But people will be talking about it."

Boyd said airlines are traditionally risky investments due to the threat to external shocks like fuel spikes, or just a downturn in the economy, which will quickly cut into business travel - and fares. He said the current environment is even more risky for investors.

"It's risky because the bubble in airline stocks is based on speculation, not fact," said Boyd.

Ray Neidl, airline analyst for Calyon Securities, has buy recommendations on most of the major carriers with the exception of UAL, on which he is neutral, due partly to its runup since August. It wasn't long ago that he wasn't recommending any of the major airlines other than low-cost leader Southwest Airlines due to ongoing losses and high cost structures.

Neidl said his current recommendations don't have anything to do with takeover speculation. But he's one of those who believes that deals would be good for the airlines, allowing them to cut capacity and costs, giving the industry as a whole more pricing power.

"I think based on fundamental it's time to be buying Continental shares," he said. "Continental has a fine operation. You add a complementary operation like Northwest or United, and they would be a powerhouse."

And Neidl and S&P's Corridore said it's too soon to be making investments that bet on any of these talked about deals actually going through, given the regulatory challenges and the opposition by some of the managements involved, although Neidl said he does believe AirTran will be successful in its bid for Midwest Express.

"The level of interest is so high, something is pretty likely to happen," said Corridore. "Which one of the deals sticks is more uncertain. There are a lot of moving pieces."

If airline mergers fly, fares could follow