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Taking Off

Investors see fare increases that stick and better fundamentals as reasons to take a flier on airlines. Some warn of a rough landing.

With spiraling fuel bills, falling bond ratings and backbreaking pension obligations, the airline industry's oldest carriers are notoriously troubled. But some global equity investors who are not afraid of flying have been finding good value lately.

The American Stock Exchange airline index, comprising ten so-called legacy airlines (U.S. carriers that have been around for 20 to 30 years, such as American Airlines, US Airways and United Airlines), soared more than 43 percent from its September 2005 low through April 5, 2006, though it has eased some since. In contrast, the index lost two thirds of its value from the beginning of 2001 through last September as airlines struggled with deregulation and diminished travel in the wake of 9/11.

What has sparked the takeoff?

Several forces have been at play. Long-established carriers that filed for bankruptcy were able to radically restructure their operations to slash costs without drastically reducing capacity. For instance, when United sought court protection at the end of 2002, its available seat miles for that year were 148.8 million; in 2005 the airline's ASMs were down, but not drastically, to 140.3 million; even a bankrupt airline may have the extra seating capacity to benefit from a robust economy.

Without resorting to Chapter 11, struggling operators like AMR Corp., the parent of American, have forced unions to accept deep pay and benefit cuts, providing a bit more ground clearance. Since 2000, AMR has racked up more than $7 billion in aftertax losses, before extraordinary charges and credits. Yet the company's shares have doubled over the past six months, closing at $24.32 on April 25, owing to rising load factors, higher fares and lower costs.

Airline industry consolidation worldwide is one factor boosting profitability. The latest international merger wave began in 2003, when Air France paid $900 million to acquire Dutch flagship carrier KLM Royal Dutch Airlines. In February 2006, Air France­KLM reported that net profit for its fiscal third quarter (ended December 31) more than tripled from the comparable quarter in 2004, to $92 million. The chief factor: rising passenger volumes.

Germany's Lufthansa, which reported a 51 percent rise in profits for 2005 because of increased capacity and load factors, agreed last May to acquire deeply troubled Swiss International Air Lines (the old Swissair) for $375 million. And America West Airlines' May 2005 buyout of bankrupt US Airways was one of the largest U.S. airline takeovers on record, involving $1.5 billion in new financing.

Perhaps most encouraging, a number of foreign legacy airlines are executing impressive turnarounds. British Airways was slammed as hard as any carrier after 9/11 and during the protracted airline recession that followed. By early 2003 it was trading at $13.80, down 90 percent from its $118 all-time high. Three years later, on the heels of surging business-class revenues and aggressive cost-cutting, BA's shares have more than quadrupled, closing above $60 in late April.

John Escario, manager of the $67 million Rydex Transportation fund, which has 15 percent of its assets in airlines, sees last fall as a turning point for the sector. First, the series of major bankruptcies hit a peak as Delta Air Lines and Northwest Airlines filed for Chapter 11. Investors also feared that Hurricane Katrina would severely affect oil supplies, pushing sky-high fuel prices even higher.

Around the same time, though, airlines managed to impose -- and sustain -- fare increases. "Airlines finally got them to stick without inducing a price war," Escario observes. As he sees it, that was a significant shift.

With three- and five-year annual average returns of 23.71 and 8.79 percent, respectively, through April 6, Escario's Rockville, Maryland­based fund has outperformed the market, supported by positions in venerably profitable Southwest Airlines and the revitalized AMR.

His colleague Adrian Bachman, who manages the $393 million Rydex Sector Rotation fund, has a different approach but is likewise high on airlines. Bachman tracks 64 industries and invests in the top-performing six to 12, based on their shares' results over the most recent three months; he sells sectors when they drop out of the top 20 percent. In November he added ten airline stocks, including Southwest, Ryanair and AMR, to the Sector Rotation portfolio. Through February 16, Bachman's $25 million airline investment was up 9.45 percent.The fund's three-year return: an annualized 23.74 percent through April 5.

The travails of the big carriers in the U.S. and Europe, which started in 1978 with sweeping airline deregulation in the U.S., have spelled opportunity for their low-cost rivals -- like Ireland's Ryanair. Not only is the Dublin-based carrier one of the few consistently profitable airlines, but it also has been a great growth play, one owned by a wide swath of fund managers. The Morningstar-five-star-rated Fidelity Contrafund, for example, held $247 million, or 3 percent, of Ryanair at the end of 2005's third quarter. Through March 2006 the airline's shares had appreciated at an average annual rate of 15 percent over the past five years.

Fidelity Investments' Andrew Hatem keeps nearly one third of his $117 million Select Air Transportation fund in airline shares (the remainder is in air parcel delivery services, airplane manufacturers and other related stocks). Although the airline stocks weren't what drove the fund's impressive three- and five-year annualized returns through April 5 (32.51 and 8.68 percent, respectively), they have started to boost performance.

Taking over the fund at the start of 2005, Hatem added to positions in Southwest, AirTran Airways and Ryanair through November 2005; they collectively represent more than 11 percent of Select Air's assets, up from 7 percent at the beginning of 2005. For the 12 months ended February 8, 2006, the three stocks collectively rose 55.18 percent.

Hatem, who sees improving fundamentals for airlines, is sanguine about the industry's near-term outlook. He points out that for U.S. airlines, excluding regional carriers, the rate of increase in revenue per seat mile rose from 6.2 percent to 11.7 percent between June and December 2005, as the cost per seat mile -- not counting fuel -- declined 5.7 percent. "These significant improvements have driven up free cash flow across the industry and could mean further upside" Hatem says.

Some top-performing equity funds have been soaring on airline stocks. Last June, Columbus, Ohio­based Diamond Hill Capital Management's Small Cap fund, which has generated five-year annualized returns of 19.31 percent through April 5, invested 6 percent of its $459 million portfolio in airline stocks. Co-managers Roderick (Ric) Dillon and Thomas Schindler purchased three low-cost regional carriers, and in less than a year, the value of the fund's airline investment has risen nearly 50 percent. Bullish on AirTran's efficient operations and route expansion, the fund managers invested 1 percent of the fund's assets in the stock at an average cost of $11.12 a share. It closed at $15.61 on April 25.

Dillon and Schindler are especially enthusiastic about the prospects for America West, the new owner of once-bankrupt US Airways. "Not only did America West buy the East Coast regional at a depressed price," explains Schindler, "but bankruptcy also led to substantial restructuring that brought costs under control and has enabled the combined entity to establish a low-cost transcontinental reach." With an average cost of $21.78 per share, the fund's 3.5 percent position in America West has nearly doubled since the managers bought it in June.

Diamond Hill steered into headwinds with one stock: Denver-based Frontier Airlines. "Here is a highly disciplined, well-run airline whose seat cost per mile, excluding fuel, is actually lower than Southwest Airlines'," Schindler notes. But Frontier failed to hedge against rising fuel costs and, beginning this year, faced competition from Southwest for the first time in the Denver market. With Frontier's shares trading at $7.09 in mid-April, the fund's 1.5 percent holding is off by about 25 percent since it acquired it in mid-2005. Schindler expects the stock to rebound, though not necessarily to his average purchase price.

Many investors remain wary of the airlines. Whitney Tilson, who manages $120 million across several hedge and open-end funds, owns none whatsoever. "Valuing airlines is very difficult," he says. He thinks future free cash flow is the most meaningful gauge of a stock's potential, but he believes the industry is "too mercurial" for investors to make any reasonable projection.

Tilson argues that the only way to profit in airline stocks is to buy at a point of maximum distress and sell when other investors appear to be complacent -- the state they may be reaching now, he contends. He says this reinforces a maxim that an airline CEO once shared with him: "You can't own airline stocks; you can only rent them." That doesn't necessarily mean, however, that you can't find bargains.