Bottom Fishing Among The Clouds

By Mark Whistler | April 13, 2008 AAA

In the second week in March, I took a hard look at airlines. Many stocks had received downgrades, and the industry was plagued with uncertainty over the direction of the U.S. economy and the price of oil. I predicted there would be mergers, but in the end the underlying motto was: When in doubt, stay out. (To read the original article see, Airlines Flying Underweight.)

And staying out was probably the right thing to do, especially considering the sector has been plagued with volatility since. However, we could be nearing the time investors may want to consider nibbling on airline stocks, especially with the recently released news of the Delta (NYSE:DAL) and Northwest Airlines (NYSE:NWA) merger.

Evaluating the Present State of Affairs
Looking at the broader sector, the AMEX Airline Index (XAL) is down 62% since its 2007 high. Delta and Northwest Airlines shares have both fallen about 50%, while AMR (NYSE:AMR), parent of American Airlines, plummeted almost 77%. In addition, AirTran (NYSE:AAI) witnessed a massive landslide on Friday, April 11, with the shares prices cut virtually in half on fear the company could be close to folding, on the heels of Frontier Airlines bankruptcy filing the day before. The shares recovered some of the losses on Monday (partially due to an upgrade by Raymond James), but are still down more than 70%, since the 2006 high.

One of the main causes behind airline declines is the usual suspect: oil. Sky-high oil prices are crimping income at many air carriers. Some airlines have hedged fuel costs in futures markets, but no one really knows how high oil might go and when crude might retreat, if at all. At the end of the day, even savvy oil traders don't know for sure when oil will retreat, thus airlines are having trouble effectively hedging fuel costs without killing bottom-line potential. (To learn how to protect yourself from the rising cost of oil, see How can I hedge against rising diesel prices?)

Consequently, airlines have experienced a hard year, with many struggling just to stay above water. Frontier Airlines (Nasdaq:FRNT), which just filed for Chapter 11 on April 10, is a good example. The airline filed for bankruptcy protection after Colorado-based First Data Corp., changed policies regarding the company's holdback receipts. At the end of the day, First Data's policy change was an aggressive and unfriendly move, which Frontier immediately recognized and thus, took appropriate action to abate, at least in the short-term.

In my earlier March article, I cited JPMorgan (NYSE:JPM) analyst Jamie Baker's five reasons for why airlines might file for chapter 11: Fix pensions, mark aircraft to market, reset labor wages, flush unsecured debt, and preserve liquidity. The move by First Data that triggered Frontier's bankruptcy filing falls under reason No.5 - preserve liquidity. The policy change was an unseen event that took many by surprise. (To learn what this risk means to you, check out An Overview Of Corporate Bankruptcy.)

Aged Airways and Ticket Increases
The coupe de grâce for air carriers was an increased FAA scrutiny, which grounded several air fleets for inspection. According to an Associated Press article, Northwest Airlines' fleet of roughly 350 planes has the oldest average age at nearly 18 years old, followed by American Airlines at 15 years, and United Airlines, parent UAL Corp. (Nasdaq:UAUA) at 13. Overall, around 3,500 flights have been canceled in the past weeks, due to inspections.

What's taken place is the "perfect storm" to stimulate mergers and also allow airlines to slip higher prices by consumers. On Friday, United Airlines announced it would raise ticket prices by $30 (round trip) to help the company pad itself from increasing fuel charges. Do you really think they will lower prices, if the price of crude falls?

Shortly after the news, Delta, Northwest Airlines, Continental Airlines (NYSE:CAL) and US Airways (NYSE:LCC) all jumped on the bandwagon stating they would also increase round trip fares $4 to $30 per round trip. BestFares.com data shows airlines have successfully increased fares 7 out 12 attempts since December 20, "adding as much as $170 in airfare increases for many routes," Christopher Hinton points out on Marketwatch.

Now, there's plenty of buzz within the sector now that Delta and Northwest are have officially announced their merger. At present, the biggest hurdle remaining is consent of unions, who supposedly already entered talks over the weekend, according to the Wall Street Journal. (To learn how to invest in companies before, during, and after they join together, read The Merger - What To Do When Companies Converge.)

Two Peas in a Pod
Evaluating all of the above, the merger between Delta and Northwest is virtually a sure thing, assuming the remaining hurdles, such as union consent and pilot consent, are cleared. The simple reality is that the airlines simply can't afford not to merge, especially with the price of oil. Moreover, a merger is one of most viable solutions for both companies to solve future liquidity issues.

Assuming Delta and Northwest do go ahead and complete their union, the industry could see a wave of other mergers, as airlines scramble to consolidate to hold position within the sector. We're on the eve of potential "merger-mania" in airlines, something that will most likely bode well for investors, especially since most of the stocks have been pounded down over the past year.

For more information, check out Is That Airline Ready For Lift-Off?

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