Air Supremacy

Just look at the headlines. On Wednesday, AMR (AMR), the parent of TWA and American Airlines that lost two jets on Sept. 11, reported its biggest quarterly loss ever: $414 million, or $2.68 a share, compared with a profit of $1.91 last year. And early last week, James Goodwin, the chief executive of United Airlines parent UAL (UAL) (which also lost two jets in the attacks), revealed in a letter to employees that the company's costs were outpacing revenues at four times the rate before Sept. 11.

Trade groups, meanwhile, have become bearers of some of the worst industry news on record. The Air Transport Association of America reported last week that the industrywide load factor, or the percentage of filled seats on flights, fell to 59.0% in September from 69.9% a year ago. The back-to-school season typically sees load factors in the 70% range. To make matters worse, to hit break-even, airlines have to bring that number up even more when they run at a fraction of full capacity (idle planes are also costly). And the International Air Transport Association warned that the steep drop-off in air travel would produce sectorwide losses of $10 billion to $12 billion this year. It's no wonder Congress passed its $15 billion industry-bailout package so soon after the tragedy.

Airline stocks, predictably, have reflected the industry's woes. The Standard & Poor's Airlines Index plunged 32% during the week following the attacks. While it's rebounded a bit since then, it's still down 18% since Sept. 10.

Yet opportunity knocks in this struggling sector — that is, if you think small. Much more nimble and specialized than their long-haul peers, Southwest Airlines (LUV) and Alaska Air (ALK) have shown quite a bit of grace under pressure these past two months. And while their shares are down 5% and 25%, respectively, since Sept. 10, the gauges point to a strong rebound.

For starters, with big losses the order of the day in the airline group, it's notable that Southwest and Alaska Air are still profitable — even without government bailout dollars, the majority of which went to the major long-haul carriers. Even more impressive, Southwest and Alaska haven't resorted to the huge payroll and route reductions that have been so prevalent among the top five.

No. 7 carrier Southwest, which swears by short routes and lesser-used airports, managed to earn a dime per share in the third quarter, despite September operating losses of more than $100 million resulting from a brief, but sharp, drop-off in traffic that has since mostly reversed course. Credit a lower cost structure for Southwest's earnings power. According to Deutsche Banc, Southwest's cost per available seat mile, or CASM, is roughly 30% below the industry average. And unlike United and American, which often suffer from labor issues, the no-frills Southwest has a largely happy work force that rallies around Chairman and business-magazine favorite Herb Kelleher. Southwest also doesn't bother with luxuries like in-flight meals, which can hurt profits in lean times.

For its part, Alaska Air, the parent of Alaska Airlines and Horizon Air, blew away the Street's third-quarter estimate of a 56 cent a share loss by registering a 27 cent profit. While Alaska isn't as fortunate as Southwest in the expense department — pilots recently won an 11% raise, and total operating expenses nudged higher than analysts expected last quarter — it's tops in the industry in terms of filling its planes. The No. 9 carrier — and the only major one serving Alaska — draws a third of its revenue from its home state, where short-distance air travel is a way of life. Alaska's third-quarter passenger traffic increased 3.2% and produced a load factor of 71% — short of the 72% it posted last year, but 13 percentage points higher than the industry average. The airline's insulated niche of leisure travelers, and its dominant West Coast presence, turned out not to be particularly sensitive to the East Coast shockwaves of Sept. 11.

Both carriers will also benefit from lower fuel costs — a rising tide that lifts all industry boats, but helps the leaders the most. With plummeting demand pushing jet-fuel supply significantly higher during the past six weeks, carriers find themselves paying 15% to 25% less than they paid last year. Further weakness in jet-fuel pricing would be more icing on the cake.

So we've established that Southwest and Alaska have survived, and even prospered, while others have floundered. What does the future hold for investors in the companies? A lot, we think.

Alaska has $667 million in cash, while Southwest holds $1.5 billion. That's important. With the major carriers cutting back on shorter, lesser-served routes to preserve precious cash, Southwest and Alaska can consolidate their dominant positions in smaller markets. Southwest, for example, operates out of a network of airports in the shadow of major hubs — places like Chicago's Midway, New York's Islip and South Florida's Fort Lauderdale International. That will help them service nearby markets abandoned by the likes of Delta Air Lines (DAL) and US Airways (U).

"Southwest will likely gain market share as some carriers have shut down their low-cost subsidiaries," says Kevin Murphy of Morgan Stanley. For example, US Airways has shut down its MetroJet line, Delta has scaled back its Express operation, and United has shuttered its Shuttle division. "Thus far," says Murphy, "Southwest has been the only carrier to resume its flight operations to the same level they were before Sept. 11's attacks" — and it has gained market share as a result.

Alaska could benefit from this trend as well. "We believe Alaska Air will be in a position to capitalize on additional market opportunities as other airlines retrench to conserve cash," says Wells Fargo Van Kasper's Peter Jacobs. There's America West's (AWA) abandoned Spokane-Phoenix route, for instance, or the Pacific Northwest and Alaska routes being vacated by United Express. Alaska Air is already in the process of increasing service between Seattle and Washington, D.C. "Alaska is going to be challenged just like all the other airlines," adds Jacobs, "but the odds say that it'll be one of the few that emerges stronger from all this."

Given such prospects, the stock prices of Southwest and Alaska seem woefully out of step. We think that'll change.