2 Airline Stocks to Buy, 2 to Watch
By Ted Reed 08/25/10 - 08:00 AM EDT

(TheStreet) -- Although airlines are getting close to the slack post-Labor Day travel period, their outlook continues to be bolstered by fuel price trends and a continuing commitment to reduced capacity.

In a negative scenario, the economy slows and travel falls off a cliff after Labor Day, leading to yields that decline beyond anticipated reduced levels. Even this scenario has a silver lining, however, because capacity would remain tight and fuel prices could decline further.

In a report issued Tuesday, Stifel Nicolaus analyst Hunter Keay said he remains bullish despite projected tepid growth in passenger revenue per available seat mile during 2011, a result of difficult year-over-year comparisons and "a higher likelihood of a slow and at times painful return to economic normalcy." He assumes just 2.2% PRASM growth for the full year, based on GDP growth of negative 2%.

Nevertheless, Keay wrote, "we remain bullish on the space and still see meaningful upside over the next 12 months as the cycle recovery story gains momentum, though [the next three months] could be relatively stagnant due to a likely data vacuum and fewer trading catalysts."
So far this year, airline shares are up about 15%, while the S&P 500 Index is down about 5%. The sector has been helped by run-ups in the shares of Continental(CAL) and United(UAUA), partners in a pending merger.

But analysts like Helane Becker of Dahlman Rose say that now United, the surviving company, faces a year of integration spending.

Becker prefers Delta(DAL) (see stock chart above), which is now getting the most of the synergies from its 2008 merger with Northwest.

The sector's leader this year, US Airways(LCC), is up about 90%. Analysts including Becker, Keay and Avondale Partners' Bob McAdoo continue to include both US Airways and Delta among their favorites.

In late July, before it pulled back due to the recent surge in concerns about the economy, US Airways stock was up 115%. That's when four insiders sold about 185,000 shares at prices ranging between $10 and $11 a share. But the carrier's high margins, the highest in the industry, still holds an appeal.

Recently, Alaska(ALK) has led the sector down. The carrier reported a disappointing gain in July passenger revenue per available seat miles on Thursday, Aug. 19, and has watched its shares fall by about 15% since then.

In a report on Alaska on Monday, CRT Capital Group analyst Mike Derchin said he revised his estimates downward after the PRASM filing. "We are now assuming that 3Q PRASM for Alaska increases 6% compared with our previous projection of 7%," Derchin wrote. Nevertheless, Derchin maintains his $58 price target, noting "valuations are already at the low end of the range for network airlines."

Of course, recent trends make everybody wary. An Aug. 19 report by the Air Transport Association, pegged July revenue gains for U.S. carriers at about 20%. "Demand for air travel remains well above last year's depressed levels," said ATA CEO Jim May, in a prepared statement. "But the industry is mindful of cautionary notes about the health of the overall economy."

Meanwhile, American remains the industry's biggest question mark. Is it on the cusp of a breakthrough, after finally gaining access to enhanced revenue from trans-Atlantic immunity with its partners, or is it in a downward spiral in relationship to competitors with broader networks and higher efficiencies of scale?

Keay, in an interview, said "American has a great network, a lot of strong alliance partners, and a very extensive Latin network." Going forward, the airline is expected to benefit substantially from the new revenue.

McAdoo, however, said the airline is simply not making enough progress. In terms of second quarter results, most carriers slipped between 2007 and 2010, reflecting the impact of an economic reversal during the interlude. But the changes were not dramatic and some carriers improved.

American, however, lost $10.7 million in the second quarter of 2010 after earning $317 million in the second quarter of 2007. It reported a 2010 loss of three cents a share compared with a 2007 gain of $1.08. "These other carriers didn't get worse since 2007, but American did," McAdoo said, in an interview. "I don't know why that is, but some organizations are just not oriented towards change."