Why Airlines Are Soaring in 2012

Some of the biggest winners in the stock market this year have been airline stocks. The oft-maligned industry, equally disparaged by customers and investors, has trounced the S&P 500. Take a look at the chart below.

LCC Chart
LCC Chart

LCC data by YCharts

With the broad market returning less than 6%, all four of these airlines have more than doubled the S&P, and US Airways (NYS: LCC) has left the rest of the industry in the dust (more on that later). As a measure of the industry, the Guggenheim Airline ETF is up more than 18% so far this year. Let's take a look at why this industry is soaring.

Oil prices
The simple answer for this boom appears to be the low oil prices we've seen over the past few months. The industry is expected to spend $200 billion on fuel this year and, without hedges, the major airlines are estimated to save about $400 million for every dollar the price of crude oil drops. Fuel generally makes up 25% to 40% of operating costs.

Airlines have also been taking novel steps to deal with fuel costs, including increased hedging since the 2008 oil spike and updating equipment such as replacing radar with GPS-navigation to shorten takeoff and landing times, saving a bit of fuel on each end. Airlines such as United Continental (NYS: UAL) have added more fuel-efficient planes to its fleet and are putting winglets on its planes to cut down on drag. DeltaAir Lines (NYS: DAL) has even made the unusual move of buying an oil refinery. The Atlanta-based airline will spend a total of $250 million on the refinery including purchasing and upgrading costs, and expects the move to save it $300 million a year in fuel costs. Some energy analysts are skeptical that the decision will be profitable, however.

The industry pattern of consolidation through mergers and acquisitions has increased in recent years. In 2010, United and Continental merged in a $3 billion deal, following the combination of Delta and Northwest in 2009, and there's been similar activity among smaller airlines around the world including Southwest (NYS: LUV) absorbing Air Tran. A deal between US Airways and the bankrupt American Airlines also began to take shape in April as observers await details.

Consolidation has led to less competition and greater pricing power for the airlines, and heavily discounted fares and half-empty flights are fast becoming a thing of the past. In the past five years, the average domestic airfare has risen 30%. The airlines have also added a new revenue stream through bag fees. In 2007, total bag revenue was just $500 million, but by 2011 it had jumped to $4 billion. All of these factors should help airlines boost profit margins in the years to come.

The US Air juggernaut
Let's take a look back and see how US Airways had been leading the pack of outperformers by nearly tripling its share price this year.

The company got the year started off right with a January earnings report that blew estimates out of the water. On expectations of just $0.02 a share the company delivered an adjusted EPS of $0.13, and shares jumped 17% in one day. They continued to rise in the following week as other airlines beat estimates, and speculation swirled that US Airways could be a buyout target of Delta. US Airways management also indicated that it would be interested in acquiring American.

On April 19, word came out that unions representing workers at AMR, the parent of American Airlines, would support a merger with US Airways, sending shares up another 16%. Fitch ratings followed with an upgrade the next day, and the company again beat earnings expectations in its first-quarter report the following week. Despite an adjusted loss of $0.13 per share, the results were still well ahead of $0.25 EPS loss consensus.

Shares again soared at the end of May to more than $13 on a host of analyst upgrades for the industry, with US Airways receiving the most optimistic outlook as it does not hedge its fuel expenses.

Looking ahead, the stock trades at a rock-bottom forward P/E, like many of its peers, at just 3.8. There's no guarantee that oil prices will stay this low of course, and airlines are notoriously risky. Still, a struggling economy could depress demand for oil, which could in turn translate into stable profits for US Airways in the near future.

Foolish takeaway
Considering the tide seems to be rising for the industry as a whole, I've decided to make a bullish CAPScall on the industrywide fund, Guggenheim Airlines ETF. It trades at a P/E of just eight and offers exposure to many high-performing foreign airlines like Chile-based LATAM Airlines and Panama-based COPA Holdings. Earnings at the fund's holdings grew 22% annually over the last three years and are expected to continue that pace with the help of foreign companies. Like many of the domestic airlines, this fund looks tremendously undervalued.

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At the time thisarticle was published Fool contributor Jeremy Bowman holds no positions in the companies in this article. Motley Fool newsletter services have recommended buying shares of Southwest Airlines. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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