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Airline stocks deserve a second look: analysts

Airline stocks have been mainly relegated to the most risk-tolerant investors as they can move violently in reaction to macro-economic factors and company-specific issues.

But slowly improving conditions in Canada and the United States should support improving airline profits and higher share prices as the key summer flying season approaches, industry observers said.

"As long as the economy is doing reasonably well…they should be positioned to be able to continue to grow moderately and potentially improve profitability until those conditions change,'' said David Tyerman of Canaccord Genuity.

Fuel remains the big wild card. Rising prices should continue to be a headwind for profits when results are posted in the next month and even into the second quarter.

But disciplined capacity controls and higher fares should increasingly position airlines to offset energy costs and improve operating margins later in the year, he said in an interview.

Investing in airlines has not been for the faint of heart. The industry has earned a terrible reputation over the years. Many carriers have gone bankrupt or disappeared entirely, making them notorious for destroying capital.

It's the motivation for Buffett's assertion that the capital-intensive industry has not made any money in the U.S. since the dawn of aviation.

"If a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favour by shooting Orville down,'' he famously wrote in a 2008 annual letter to Berkshire Hathaway shareholders.

But consolidation among U.S. airlines, often through bankruptcy protection, has allowed the industry to be the most disciplined in more than 30 years, since deregulation opened the floodgates of competition and super cheap fares.

Capacity has shrunk as legacy carriers such as Delta and United have removed planes from service and let go staff. Shares in the American operators are up 24 and 16 per cent respectively this year.

Canada's duopoly of Air Canada and WestJet Airlines are also keeping a lid on domestic capacity and increasing fares.

"It appears that it's starting to unfold that the airlines are acting in a much more rational manner as investments and they're more focused on the types of things that can make investors money,'' Tyerman added.

Instead of chasing market share through price wars, carriers are increasingly focused on things like generating returns on invested capital which can boost share value, the financial analyst said from Toronto.

Despite its history of rapid growth, WestJet has also moved in this direction. It is one of the few airlines to pay a dividend and has one of the best balance sheets in the industry.

"It has a lot of the attributes of a company that you can buy and own for the long haul.''

It has boosted its dividend by 20 per cent and its share price has increased by 14 per cent so far this year to $13.25.

Air Canada's shares have lagged its chief Calgary-based domestic rival. Weighed down by labour uncertainty and a higher cost structure, the country's largest carrier is worth about $1, well below its 52-week peak of $2.53.

But with such a low trading price, the entry cost is low and large gains are possible.

Industry observers believe that at some point the Montreal-based airline's $10 billion of assets should generate decent income.

"The leverage in Air Canada is absolutely tremendous,'' said Chris Murray of PI Financial Corp.

"You would expect that they would outperform someone like a WestJet but at the same time you're also going to see more volatility.''

He said Air Canada's current trading price doesn't reflect fair value.

But Murray said the carrier's reputation was severely hurt by the bankruptcy filing of maintenance firm Aveos and a wildcat strike last week by ramp personnel that resulted in flight cancellations.

The events could impact consumer perceptions about the airline's reliability, reducing demand that could force down fares and impact profitability.

Murray said investing in airlines is not appropriate for everyone. Unlike some more stable sectors like railways and banks, investors have to closely follow macro-economic and company specific information that can cause airline shares to swing.

"I'm very leery about recommending airline stock just for general investors because they can be volatile,'' he said.

Murray said there are times to own such shares and times to run. Improving economic conditions suggest it's not the worst time to invest.

Investing in Air Canada also merits caution because of its high debt and pension liabilities. Tyerman said a good proxy is Chorus Aviation which operates most of the regional service for Air Canada.

Investors can earn a healthy dividend until the Halifax-based operator's share price rises in step with that of its largest customer, he said.

"It's sort of a way of playing Air Canada by getting a big dividend yield along the way.''

An alternative is investing in the airlines index XAL that follows the U.S. industry. It too moves violently in reaction to the economy. The index is up 17 per cent so far this year.

Other potential investments are Transat A.T., the tour operator that operates Air Transat and individual U.S.
carriers.

An expected initial public offering by Porter Airlines could also present a buying opportunity, although analysts won't assess its attractiveness until they see financial metric for the regional airline operating out of Toronto City Centre Airport.