Air Transport Industry participants are experiencing a revitalization of their bottom lines. Indeed, in the third quarter, each of the major carriers recorded solid profits, as compared with losses in the prior-year period. These airlines consist of Delta Air Lines (DAL), United Continental Holdings (UAL, formerly UAL Corp. and Continental), AMR Corp. (AMR, owner of American Airlines), US Airways Group (LCC), and Southwest Airlines (LUV). The improvement stemmed from a pickup in the domestic economy, and, to a greater extent, an enhanced ability of carriers to boost airfares. At the same time, the industry is consolidating, a development that will likely be a positive long-term earnings factor. Two sizable mergers have closed within the past two years or so and a third, albeit smaller, combination was recently inked.  Given these factors, the investment appeal of the Air Transport Industry is on the rise.  

Air traffic and bookings are largely ascending, thanks to improving economic conditions. Furthermore, carriers are generating substantially increased yields. The favorable top-line trends are helping to alleviate cost pressures. Accordingly, year-over-year profitability metrics ought to advance nicely. Looking to 2011, major airlines intend to keep capacity tight, as they target ongoing productivity gains.

The Air Transport Industry is further consolidating amidst a competitive domestic operating environment. In October, the merger of majors UAL Corp. and Continental Airlines was completed, creating United Continental Holdings. Moreover, in late September, Southwest Airlines and AirTran Holdings (AAI) agreed to combine in a transaction that would bring together two low-cost carriers. Both combinations have occurred subsequent to Delta Air Lines' October, 2008 purchase of Northwest Airlines. As these carriers integrate, we look for heightened fleet efficiency, allowing the airlines to better cover their costs.

United Continental Holdings, likely now the largest U.S. airline in terms of revenue, has been created from the combination of UAL Corp. and Continental. The carrier should be able to better compete on the increasingly competitive domestic stage than its predecessors. The majority of gains realized from this deal will likely be revenue related, as the two airlines' fleets are integrated and new routes added. More efficient aircraft utilization is also apt to help widen margins. We believe synergistic benefits will increase over the next several years. The forerunner for the UAL/Continental marriage was Delta's 2008 buyout of Northwest. Delta has considerably reduced the combined fleet size of those two carriers, resulting in a leaner, more efficient airline.

Southwest's proposed acquisition of AirTran, likely to close during the first half of 2011, would assist it in increasing its own network. Like UAL/Continental, the two currently share few routes. Given a smooth integration, $400 million in annual cost synergies may well be realized, thus boosting the prospects for Southwest, a carrier that has remained profitable to a large extent.

Major airlines are experiencing increasing passenger traffic compared with the 2009 level, coinciding with a better economic environment. Climbing Thanksgiving and December holiday bookings are indicative of this rebound. The bulk of service expansion is on international flights. Corporate flying is also on the upswing, supporting increases in the average airfare. In fact, yield expansion has been the primary revenue driver, facilitated also by the aforementioned efficiency enhancements, as load factors (occupancy) improve.

Unit costs, meantime, may well now be declining in many cases. AMR, for one, is reducing its costs-per-available-seat-mile, though it is still encumbered with an elevated cost structure. Fuel prices have been on the upswing of late, though strategic hedging should alleviate some of this affect. In all, operating margins are widening, with fare hikes far exceeding unit cost increases.

Many of the companies in the Air Transport Industry offer above-average year-ahead appreciation potential. Cost-cutting measures over the past several years have left carriers well situated to reap benefits from an economic upturn. That said, we remind potential investors that this sector’s risks are formidable, because profit outlooks are tied closely to fuel prices and the vagaries of the economy. Thus, these stocks tend to be volatile.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.