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JANUARY 19, 1999

Airline Stocks: A Good Time to Get on Board?

They could gain altitude in '99 as carriers seem bound for another profit boost

The next time you feel the urge to gripe about how expensive the market is, look up. You may not find divine investment guidance, but you could catch a glimpse of one of the most overlooked sectors around: airlines.

Carriers such as American, Delta, and United have been stuck in a holding pattern since the broad market's sell-off in August. And despite a mini-rally two weeks ago, most stocks in the group continue to trade at price-to-earnings multiples that are below sea level. While the Standard & Poor's 500-stock index has jetted ahead to trade at 26 times projected 1999 profits, Delta and American hover at 8.5 and 10 times projected earnings, respectively. Continental, meanwhile, fetches a lowly forward p-e of 6. Mind you, airline stocks typically do trade at a 25% to 30% discount to the market given the fact that the carriers' bottom lines mirror the economy's cycles. Even by such standards, however, airline stocks are cheap.

As recently as six months ago, airlines were one of the hottest groups around -- a trend that carried over from 1997, when the S&P Airline index zoomed 66%, compared with a 31% gain for the broad market. Carriers were still running efficiently, filling over 70% of their seats, a percentage that ranks among the industry's highest capacity utilization numbers ever. Jet fuel, which accounts for about 15% of a carrier's costs, was cheap and getting cheaper, as oil prices softened. Little wonder, then, that Wall Street had no qualms about rewarding the group with a 24% gain by mid-1998, compared with 16.8% for the S&P.

By the end of August, though, the stock market's descent had driven the airlines into a nosedive -- bringing the group down 8.3% for the year. The market bounced back for a 1998 gain of more than 20%, yet the carriers never regained much altitude, closing the year down 3%.

MORE CAUTIOUS BUYING. Why the turbulence? For one thing, Wall Street gets fidgety about the airlines every time there's a hint of recession in the air, so predictions that the economy was headed for the hangars surely didn't help. That's because the conventional wisdom is that pinched consumers travel less, forcing airlines into pricing wars to keep seats filled. The Street also remembers the airlines' past tendency to binge on new aircraft -- and boost capacity -- immediately after a boom. Then, there was also the perpetually nagging question of how long fuel prices could remain dormant.

For now, the industry's fundamentals look about as strong as they did in 1998. With the economy looking healthy enough to post 2.6% or so growth in 1999, the airlines can look forward to a 2.5% boost in traffic during the year, according to Standard & Poor's analyst Stephen R. Klein. The industry is also being a lot more cautious about buying new planes, and by some estimates will only increase capacity by 5% this year -- more than traffic increases, but not enough to bring on a fare-cutting frenzy. Fuel prices, meanwhile, look like they may even fall a bit in 1999, says David Swierenga, chief economist for the Air Transport Assn., an industry group based in Washington.

In short, this year's earnings should match 1998's -- and the carriers are working on several fronts to boost profits to boot. Delta Air Lines has announced a $2 surcharge on round-trip ticket purchases that don't go through its Web site, and the rest of the industry is expected to follow suit. "Multiply that by millions of fliers, and you've got no mean sum," notes S&P's Klein. Carriers are also moving to cut commissions to travel agents. All told, moves to slash distribution expenses could save the industry more than $3 billion a year says CIBC Oppenheimer analyst Julius Maldutis. Finally, fare increases -- out of the question in late 1998, when Northwest Airlines had to offer specials to regain market share after a summer strike -- might well take hold this year, especially if most carriers adopt ticket surcharges across the board, says Klein.

OVERLOOKED. For investors, all these factors working in the airlines' favor could nudge p-e's up just a couple of ticks, making some stocks in the group quite attractive at current levels. As an example, raise Delta's multiple a notch and a half to 11, multiply that by Wall Street consensus earnings of $6.54 a share as compiled by Zacks Investment Research, and you get a price target of $72 a share, nearly 30% above the current price of $56.

Perhaps the biggest bargain in the group is Continental Airlines (NYSE: CAI.B). Through last November, the company had gained nearly 10 percentage points in market share for the year. S&P's Klein says the airline is on track to boost earnings 23% in 1999 from an estimated $5.10 a share in 1998, after a 96 cent-a-share charge to retire old aircraft. Klein says the company's traffic growth will slow to 6% from 8% or 9% in 1998. But that's still twice the anticipated average for the industry. Despite that, Continental trades at a 30% discount to both Delta and American.

One reason is Northwest Airlines' recent purchase of a majority stake in the company. Klein says that Wall Street worries about Northwest's management. What's overlooked, he adds, is that Northwest can't vote its stake for 10 years, effectively letting Continental run its own show. Morgan Stanley Dean Witter analyst Kevin C. Murphy, who thinks Continental can increase earnings 10% annually over the next five years, currently holds a $55-a-share price target on the stock, vs. its Jan. 15 close of $35.

GOTHAM GOLD MINE. Priced at nearly 21 times projected 1999 earnings, Southwest Airlines (NYSE: LUV) is an anomaly in the airline group. The carrier, which boosted its share of the domestic market 8% by November of last year, to 5.4% overall, is Wall Street's favorite in the group, if only because its earnings have grown an average of 24% annually over the past five years. Wall Street currently projects Southwest to keep rolling with an average of 13% in earnings growth yearly over the next five years, according to Zacks, compared with 7% projected for the S&P during the same period. One way management plans to live up to expectations is by initiating daily service out of the New York area in March. Greater Gotham could be a gold mine. It's a market that Morgan Stanley's Murphy says went bonkers for the last discounter to fly there, People Express, which reaped $1 billion annually from the region. Murphy currently holds a $35-a-share price target for Southwest, which closed on Jan. 15 at $26.38.

Long term, Delta Air Lines (NYSE: DAL) also looks like a good bet. After posting heavy losses in the early '90s, Delta logged record earnings in fiscal 1998 of $6.34 a share. Two things going for Delta, says Todd C. Ahlsten, director of Research for Parnassus Investments of San Francisco, are the carrier's domestic and international routes serving prime overseas locations across the Atlantic and in Latin America. Combine a rebound in the global economy with strong growth in the U.S. market, and Delta could well be rewarded handsomely. What's more, Delta has one of the lowest cost structures of the major airlines -- less than 9 cents per passenger mile, vs. an industry average of 10 to 11 cents. Meanwhile, Delta's foray into the low-fare segment of the market, dubbed Delta Express, is growing by more than 10% a year, according to Value Line analyst Ben Sharav. S&P's Klein currently holds a $65-a-share price target for Delta, vs. its Jan. 15 close of 56. Over the next five years, Wall Street projects the company to increase earnings an average of 9% annually, according to Zacks.

If you're looking for a pure fund play, you won't have much luck. A search of funds turns up one for the sector, Fidelity Select Air Transportation (FSAIX). Because of the weakness in airline stocks during the second half of 1998, the fund mustered a total return of just 6.42% according to Morningstar. Over the past three years, the fund has averaged 13.69% annually.

Even by the most optimistic scenarios, airline stocks won't be repeating this year the moonshot they made in 1997. Still, if you can stomach a little risk, they could reward you nicely over the next 12 months.

James Anderson, who teaches journalism for the City University of New York, writes Sector Scope every other week
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