Airline stocks in a holding pattern

The longer-term outlook is bright despite turbulent times ahead

Turbulent times lie ahead for airline companies, despite the long-term trend of rising passenger numbers. Although the share prices of many airline carriers throughout the world have enjoyed a sharp bounce since March last year, rising oil prices, overcapacity and the threat of further terrorism are headwinds that are preventing the sector from making further significant progress.

Chris White, head of UK Income funds at Threadneedle, said over the year to March 2004, airline stocks delivered stunning performance. The share price of British Airways, for example, trebled over that 12-month period.

"There was a strong appetite for risk in the stock market and airline stocks therefore benefited," Mr White said.

A recovery in passenger numbers since early last year has also proved favourable for airline stocks. The Association of European Airlines announced last week that traffic (the number of passengers multiplied by the distance flown) rose significantly when compared with the same week, ended 20 June, a year earlier. Traffic increased by 41 per cent on Asian and Australian routes, 5.5 per cent on North Atlantic flights and 9 per cent within Europe.

It should be remembered, however, that this improvement marked a recovery from an extremely low base. People avoided flying in the first half of 2003 because of the Iraq War and Sars outbreak. Passenger numbers were already depressed amid the economic slump and in the aftermath of the 11 September 2001 terrorist attacks. In the past 16 months, economic confidence has improved, the Sars epidemic has subsided and people are starting to live with the threat of terrorism.

However, that brighter picture for airlines once again turned bleak from around March. The recovering stock market began to stutter and investors became more selective with higher risk airline stocks being heavily sold.

At the same time, the surging oil price started to put the squeeze on already slim margins, and overcapacity and heavy competition across the European market started to take its toll on prices, resulting in a bloodbath, particularly among lower-cost airlines.

Joe O'Donnell, a fund manager at Rensburg, based in Liverpool, said several low-cost providers have forecast fares to fall by up to 20 per cent over the coming months. As such, both Ryanair and Easyjet have issued profits warnings and their share prices have plummeted in recent months.

British Airways has fared better. Despite having fallen some way in recent months, the share price has still gained around 15 per cent since the start of 2004.

"Unlike Ryanair and Easyjet, British Airways is not solely reliant on the struggling European market. BA has benefited from an improvement in business travel and in long-haul flights," Mr O'Donnell said.

Mr White points out that while passenger numbers have improved, capacity has also increased, which has dampened price rises. Planes that had been previously parked in the Mojave Desert in North America have been brought back into action by big European carriers such as Lufthansa and Air France, he said.

And there is always the threat of a further significant terrorist attack, which would cause shares to nosedive.

"We are only ever one attack away from a further significant knock to passenger numbers. Furthermore, it is difficult to see any eventuality at all which will remove the fear of terror from passengers' minds completely. More likely, both passengers and airlines must simply learn to live with this fear on a day-to-day basis and that is likely to continue depressing passenger numbers," Mr O'Donnell said.

Given these headwinds, investment professionals find it difficult to argue a positive case for airline companies, particularly the low-cost carriers.

Mr White said: "I would not recommend purchasing any airline stocks right now, due to uncertainty over the economy, the lack of pricing power amid high capacity, and high oil prices," he said.

"However, British Airways is probably my favoured airline of the majors in Europe. This is simply because it is the best-managed airline in Europe. Unlike its peers, BA is not putting on too much capacity, and it is operationally geared to an improvement in premium traffic over the Atlantic."

The situation for airlines is equally as unexciting at a global level. Christian Holland, a manager on the Cavendish Worldwide fund, is taking a neutral approach to global airline stocks. He holds Malaysian Airlines and Southwest Airlines, the low-cost short-haul carrier in the US.

Mr Holland however is less concerned about the rising fuel costs than others.

"The impact of fuel costs is largely a red herring. The issue of empty seats is a far bigger problem for airline companies. One of the features of the airline industry over the past 10 years is the fact that while labour costs have been rising in line with inflation, the cost of fuel, when inflation adjusted, has actually been falling. Therefore, the effect that high oil prices have on airlines is only about a half or third of what it was in the 1980s or early 1990s. Another factor is that airlines have become much more efficient in terms of fuel consumption," he said.

Meanwhile, for some carriers such as Southwest Airlines, the bulk of fuel cost have been hedged, so these companies are less affected.

Despite current woes amid airlines, the longer term picture is brighter. The expansion in the rate of air travel has exceeded the annual rate of UK economic growth since the first commercial jets flew, so companies involved in providing air transport should benefit.

Stephen Ford, an analyst at Brewin Dolphin Securities, said a good way to benefit from this growth is through investing in airports with the best infrastructure and transport links.

An obvious beneficiary therefore is BAA, which owns the Heathrow, Gatwick, Stansted, Glasgow, Edinburgh, Aberdeen and Southampton airports.

Heathrow is operating close to capacity, but this will ease when Terminal five opens in 2008. Meanwhile, growth in BAA's other airports continues apace with the popularity of the short-haul European no-frills airlines.

Mr White said airports are beneficiaries of an increasing number of passengers going through their terminals, but are not affected by the associated problems of rising fuel costs.

"Airports are much less risky to play than airlines at the moment," he said.

Mr Ford said meanwhile, BAA has been able to secure a positive regulatory change, in higher airport charges for airlines landing and taking off. Set every five years by the Civil Aviation Authority, uncertainty about the regulatory formula has been lifted and charges will rise significantly from this year. The higher airport charges will be used to fund an estimated £8.4bn of investment over the next 10 years, of which about half will be spent on the new terminal five.

Another way to gain exposure to the long-term growth in passenger numbers is through investing in companies that manufacture airlines and airline components. Rolls-Royce, for example, provides engines for aircraft, ranging from Tornado, Harrier and Eurofighter to Boeing and Airbus civil aircraft. Despite the dip in airline passenger numbers, Rolls-Royce is thriving and making progress on all areas of its business, Mr Ford said. The share price has risen sharply as a result.

Another area worth consideration is online travel companies such as ebookers.com and lastminute.com. These are small and internet-based and therefore classified as high-risk companies.

Alistair Currie, manager of the Premier Smaller Companies fund said such companies have good long-term prospects given the rising volumes of travel booked via the internet. Although these companies are affected by short-term dips in travel numbers, they tend to recovery quite rapidly, he added.

WHICH OF THESE SHARES WILL TAKE OFF?

BRITISH AIRWAYS

One-year share price: +81.85%

Three-year share price: -19.91%

Anthony Bor, an analyst at Merrill Lynch, classes British Airways as a buy, and has hailed it as the "best value play in the sector". He said the stock is now trading on near its lowest value since privatisation in 1987. He added: "Management's commercial and cost reduction initiatives have consistently delivered structural improvements over the last nine quarters."

Stephen Ford, an analyst at Brewin Dolphin, classifies the stock as a "hold". "BA'sproblem is its large fixed cost base makes it extremely vulnerable to changes in demand. However, management have acknowledged the threat from the low-cost carriers and have acted to reduce these costs, while some of their European competitors still seem to have their heads in the sand."

EASYJET

One-year share price: -30.65

Three-year share price: -58.44

Brewin Dolphin rates EasyJet as a sell. Mr Ford said: "No one really believed that the no-frills airline concept could expand indefinitely. In view of the problems of overcapacity we recommend that the shares are sold."

SOUTHWEST AIRLINES

One-year share price: -11.18 (GBP%)

Three-year share price: -29.43%

Christian Holland, a fund manager on the Cavendish Worldwide Fund, holds Southwest Airlines, a low-cost carrier in the US. He said that around March this year the stock was trading at the same depressed levels as in the aftermath of the 11 September 2001 attacks. The weak share price resulted from concerns about the economic environment and Mr Holland viewed this as a buying opportunity.

Although the share price has regained some ground since, he still classes this company as a longer-term buy. The company has hedged much of its fuel costs, so is not affected by the high oil price. However if the oil price does fall back, Southwest Airlines will benefit less than many of its competitors from cheaper fuel costs, he said.

BAA

One-year share price: +12.84

Three-year share price: -16.14

Brewin Dolphin, rates BAA as a quality buy over the longer term. Mr Ford said: "Given the aggressive expansion plans of the low-cost no-frills airlines and the gradual recovery in the long-haul routes, it appears that BAA has not suffered too badly following the 11 September effect."

Mike Felton, manager of the Isis UK Prime Fund, is also a buyer. "BAA consistently earns a return above its cost of capital while redeploying its free cash into attractive capital projects. At current levels, the shares are not factoring in any of the upside benefits of opening terminal five," he said.

Joe O'Donnell, a fund manager at Rensburg, also rates BAA as a buy. "This is a defensive company which, whilst indirectly impacted by the problems faced by the airlines, is to a large extent, insulated from it."

BAA currently offers a 4 per cent yield going forward and the valuation looks supportive, he added.

FRAPORT

One-year share price: -12.65% (GBP)

Three-year share price: -22.13%

Fraport, which owns and operates Frankfurt-based airports, is a beneficiary of increasing passenger numbers, while not being affected by rising fuel costs. Head of UK Income funds at Threadneedle, Chris White, classifies this stock as more of an "add" than "buy".

"It is much less risky to invest in airports rather than airlines at the moment. A key advantage of Fraport is that its retail capacity is underdeveloped. This company plans to increase its retail pace by 30 per cent between now and 2008," Mr White added.

ROLLS-ROYCE

One-year share price: + 96.30

Three-year share price: +7.36%

Cazenove rates Rolls-Royce as a "buy". Simon Pilkington, an analyst, said following a heavy period of investment in new engines and production capacity in the second half of the 1990s, the company is likely to start reaping the benefits. A moderate rise in production over the next few years is likely, and it is encouraging that the directors are now incentivised. He expects that interim results, to be announced on 29 July, will be encouraging.

Mr White said: "Rolls Royce is a stock we like. It is taking increasing market share in aviation."

LASTMINUTE.COM

One-year share price: +3.44%

Three-year share price: +446.97%

Morgan Stanley lists the company as an "overweight", given the industry and company has delivered better than expected top line performance over the past couple of quarters. Anuj Mutreja, an analyst, said Lastminute is on target to be profitable in 2004 and the recent purchase of the German independent travel agency Lastminute.de made sense.

Dresdner Kleinwort Wasserstein has maintained Lastminute as a "hold". James Ainley, an analyst, said although the purchase of Lastminute.de is a logical strategic move and he likes the online travel market, he is cautious about forecasts for travel figures over the summer.