The News

Airline stocks fired up their afterburners Wednesday after turnaround success story

US Airways Group

Arizona-based US Airways led the formation as it took wing, but it had plenty of highflying company. Investors stampeded the market to board fast-moving shares of Continental Airlines, JetBlue Airways and AirTran Holdings, which on Tuesday inked a partnership with Frontier Airlines Holdings that vastly expands its reach.

If the US Airways-Delta merger gets off the ground and that's a big if it would create the world's largest trans-Atlantic carrier. US Airways, whose chief executive, Douglas Parker, is a vocal proponent of consolidating the beleaguered airlines industry, is now the seventh-largest U.S. carrier. Delta, which entered Chapter 11 bankruptcy in September 2005, is the third-largest. US Airways' takeover bid is made up of $4 billion in cash and the rest in stock.

A successful union is about as uncertain as an on-time arrival. There are many regulatory and antitrust questions, and the industry itself is vulnerable to outside influences, from fuel prices to the potentially devastating effects of another terrorist attack. Most importantly, though, Delta's management isn't quite ready to play along with Parker.

"We received a letter from US Airways this morning and will of course review it," Delta CEO Gerald Grinstein said in a statement. "Delta's plan has always been to emerge from bankruptcy in the first half of 2007 as a strong, stand-alone carrier."

Roger King, an analyst at CreditSights, an independent capital structure research firm in New York, says Parker, who orchestrated last year's merger between then-bankrupt U.S. Airways and America West Airlines, is a forceful presence.

"I think the management at US Airways is much more entrepreneurial and can successfully complete mergers," he says. "If anybody could do it, it would be these guys."

The Analysis
The outbreak of pro-merger fever in the airline sector is no surprise. Market watchers have long touted the need to cull the number of legacy carriers, burdened by high labor costs and fuel prices, as an inevitable and necessary shift for the industry.

But the flurry around the US Airways overture won't necessarily translate into sustained gains for any airline stock, cautions Brian Nelson, an analyst at Morningstar who covers the legacy carriers. While a merger could allow the new airline to cut out flight routes, renegotiate labor contracts and bring capital expenditures down, those aren't necessarily good reasons to own the stock.

"Our opinion of legacy carriers is that these are lousy buy-and-hold investments," Nelson says. "We think these carriers are overvalued, and we think they are becoming even more so."

But if the market is overenthusiastic about the prospect of this deal, there are two factors to consider that make some move to consolidation more likely. The first is that a merger target in bankruptcy is much more attractive than one that's already emerged from Chapter 11. The second is that Delta and US airways aren't the only potential partners in the industry. Northwest Airlines filed for bankruptcy the same day as Delta, and United Airlines parent company UAL could enter the bidding at any time.

"US Airways is well along the learning curve in terms of effective merger management and proven value creation, but cannot offer sufficient West Coast capacity and any Pacific assets to turn the current Delta network into a world-class competitor," King wrote in a Wednesday research note. "UAUA is the perfect merger companion on paper, maximizing network synergies to create potentially the best airline in the world."

According to King, UAL CEO Glenn Tilton "has been on the merger bandwagon for quite a while" but has had to tend to internal issues and hasn't been as aggressive as US Airways. If United trumps US Airways, it could set a chain of industry dominoes in motion.

Airlines parent AMR] or Continental to look seriously at Northwest," King says.

If a Delta deal winds up being the consolidation kickoff, its industry-wide effects probably aren't going to last, cautions Marisa Thompson, a Morningstar analyst who covers regional carriers.

"Basically we all agree that if there's some way that this merger can go through, it can rein in capacity and help retain rational pricing," she says. "But there's a sort of irrational exuberance in airlines now, on the idea they can keep increasing fares, and that's where we differ [from the market.] We don't see prices going up 8% every year. It's not just sustainable."

The Bottom Line
It's better to take a flight on a domestic airline than take a flyer on its stock, and that's saying a lot in the era of shoeless security checks, delayed takeoffs and cost cutting that's stripped out even the dubious in-flight distraction of a hot meal.

The U.S. airline industry will make money this year for the first time since the terror attacks of Sept. 11, 2001, wrote Ray Neidl of Calyon Securities. In a research note published Tuesday, he said the outlook for 2007 is even more bullish, and predicted total profits of $5.6 billion next year based on lower nonfuel costs and some ticket price increases.

But that's predicated on $60-a-barrel oil, and that's hard to guarantee even for carriers that aggressively hedge fuel costs. "The industry is still subject to economic swings, but the legacy carriers should be in better shape to take on the next weakening of the economic cycle," he wrote.

While the new US Airways was able to capitalize on bankruptcy to cut out routes and run more efficiently, pushing its stock up 37% for the year to date, it's still part of an industry vulnerable to factors over which it has little or no control.

"I believe that the landscape is fraught with marauders, most of which are external to the industry," says King. "There are fuel costs, geopolitics, terrorism. Next summer will be the next real test of how the industry can push its yields, assuming the demand is still there. The cart's a little ahead of the horse right now, and these equities are overbought."