A bad year for airlines – but don’t ditch your stocks

It’s been a summer that most airline executives would no doubt rather forget. But it seems it is the passengers rather than the airlines themselves who will suffer.

It's been a summer that most airline executives would no doubt rather forget. First there was the World Cup, which kept air travellers glued to their television sets for the course of the tournament; then there was the foiled terrorist plot, which caused havoc in Britain's airports. Now a series of headline-grabbing crashes overseas have focused negative attention on the sector again.

Russia's abysmal air-safety record took another blow last week when a Tupolev 154 crashed and burst into flames in eastern Ukraine during a storm, killing all 170 people on board, in the country's third major air disaster since May. The crash made 2006 the worst year on record for air travel in Russia and re-ignited all the old worries about its maintenance and training procedures.

Then came the incident with Atlanta-bound Comair Flight 5191, which caused it to crash and burst into flames. Forty-nine people were killed in the worst American plane crash for five years. Terrorism was ruled out in both cases, but the loss of life did nothing to calm nerves in what was already a jittery environment.

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For an industry trying to recover after the London terrorist plot, this was further bad news. Some struggling airlines could be severely hit, particularly Comair, the airline involved in the US crash. Comair is a Delta Air Lines subsidiary that filed for Chapter 11 bankruptcy in September 2005 and has since been restructuring. Both Delta and Comair were planning to leave bankruptcy behind them next summer. Quite apart from the tragic human cost, this accident does nothing to improve the outlook for them.

Meanwhile, the airlines also seem set to be losers in the debacle involving UK airports operator BAA and its management of the terrorist crisis. British Airways stands to lose £50m from the 1,100 cancelled flights and compensation claims. Ryanair and Easyjet are likely to lose £10m each, a proportionally bigger hit to their businesses as the low-cost carriers rely on very tight cost structures.

Ryanair says it will sue the British government for £3m in lost earnings although the fact that it plans to donate the money to charity if it wins suggests that the group sees this more as a good publicity stunt than a business decision.

So should investors be looking at airline stocks at the moment? The answer is a cautious yes you don't need to look far to find value. While airline share prices fell in the immediate aftermath of the terrorist palaver, they actually rose over the next few days. This suggests that the risks in the sector appear to be priced in already. (The reaction after September 11th was much more drastic BA's share price almost halved.)

Irish carrier Aer Lingus seems to be unconcerned about any impact that raised security concerns will have on investor sentiment it has just announced plans to become the first airline to float on the London Stock Exchange in the six years since Easyjet's initial public offering.

It seems that the real losers from the problems are likely to be the airline passengers themselves. Whether it's the price of upgrading security at airports or the losses suffered by the airlines, the costs are likely to be passed on to the consumer one way or another. So airlines may not suffer as badly as investors think. Below we look at three that could beat expectations.

Three airlines whose shares could take off

The upcoming Aer Lingus float is certainly one to watch. The airline nearly went bankrupt in the wake of September 11th and suffered with competition from its compatriot Ryanair, among others, but it has moved into the middle ground, adopting a business model that combines competitive fares with a superior service to the low-cost carriers. Next it wants to add more long-haul routes to the mix. Any IPO is likely to be priced realistically in these difficult times and may well be worth considering, depending on the offer price.

British Airways (BAY, 410p) is something of an overlooked entity in the airlines sector. While Ryanair and Easyjet are the glamorous sector picks, with valuations to match, BA trades on a price/earnings ratio of only seven times UBS's forecasts for the year ending in March 2008. There will be a loss of revenue this year because of cancellations, but the strikes it suffered last summer will make the year-on-year comparison less bad. The firm has been reducing its debt load and in the future will benefit from Heathrow's new Terminal 5.

Low-cost US airline JetBlue (NSDQ:JBLU, $10.42) is a riskier recovery play. Summer revenues are on track, but the key question is whether the firm's cost-saving plan, which runs to the end of 2007, will bring it back to profitability. The shares trade on a p/e ratio of 13 times Morgan Stanley's 2008 adjusted-earnings estimates.