While many airline stocks performed well in 2012, their performance over the past three months has been nothing short of extraordinary. Since early December, the five largest U.S. airlines (excluding American, which is currently in bankruptcy) have seen their share prices appreciate by more than 30% on average.
The biggest carriers, Delta Air Lines (NYSE: DAL ) and United Continental (NYSE: UAL ) , have shown the strongest performance, gaining 60% and 45%, respectively, over that time period. Low-cost carriers Southwest Airlines (NYSE: LUV ) and JetBlue Airways (NASDAQ: JBLU ) have each gained more than 20%, while US Airways (UNKNOWN: LCC.DL ) stock price has taken a bit of a breather after tripling in the previous year.
Airline stocks may be flying high now, but this performance is not necessarily supported by the fundamentals. While some companies like Delta and US Airways have posted consistently strong results recently, others have lagged. United Continental and Southwest have both been hampered by merger integration problems and have not yet generated any meaningful "revenue synergies." Meanwhile, JetBlue is starting to regain its momentum after seeing Hurricane Sandy eat into revenue and earnings.
Owning the strongest airline stocks is probably the best decision now, as is often the case. At some point, there will likely be an industry correction, but Delta and (to a lesser extent) US Airways may be more insulated from such volatility than peers. Both companies still trade at attractive valuations (five to six times expected 2013 earnings) and have been increasing their profit margins recently. By contrast, the share prices for Southwest and United Continental seem to be running ahead of the fundamentals: Continued disappointments could lead to a quick reversal in either case.
The merger catalyst
One major cause of the recent airline stock run was growing speculation that US Airways would merge with American Airlines. US Airways had been publicly pursuing American since early 2012, but it was only recently that American's management team warmed to the idea. The merger was ultimately announced on Feb. 14, but the decision was widely expected by then. In the week before the announcement, I wrote that US Airways and American Airlines shareholders were unlikely to profit from the merger (at least in the short term). Sure enough, US Airways shares have dropped by roughly 10% since the merger was announced, as investors have come to grips with the obstacles that lie ahead.
By contrast, other airlines held their ground or moved higher after the merger announcement, despite having already rallied on speculation that US Airways and American would indeed merge. Some airlines may indeed see benefits: for example, JetBlue CEO Dave Barger recently stated that he believes JetBlue will be able to expand its partnership with American Airlines later this year. By allowing more passengers to connect seamlessly between the two airlines at JFK, both companies should benefit.
On the other hand, United Continental could be a big loser, as it competes with American in several markets. On balance, a stronger American with a broader network will be a more formidable competitor and could gain market share at United's expense. While executives at United and Delta have publicly supported the US Airways-American merger, their arguments that the move will improve pricing ring hollow. Pricing on international routes is already strong, while Southwest has been the "gatekeeper" for domestic fare hikes. In other words, US Airways and American Airlines have not been impediments for fare hikes, so their merger does not change anything. United stock's 45% gain over the past three months cannot really be explained by a corresponding improvement in the company's prospects.
Oil prices pull back
Merger speculation drove gains for airline stocks in late 2012 and early 2013, despite a concurrent rise in oil prices. However, oil prices have since receded, due in part to worries about the global economy. Oil's slide over the past several weeks has helped many airline stocks rise even further during that period of time.
Over the next year or two, Brent prices may continue to retreat, as implied by the futures curve. From a fundamental perspective, sluggish growth and efficiency gains in developed economies are offsetting much of the demand growth from emerging economies, while the shale oil boom in North America has led to rapidly increasing production. However, oil prices have fallen only to spike again on several occasions in recent years. It is therefore very risky to buy airlines indiscriminately in the hope that falling oil prices will boost profits: A sudden oil price spike could quickly send airline stocks lower. All airlines will benefit from falling oil, but it is worthwhile to be "choosy."
What should you do?
Delta and US Airways have been the most consistent performers in the sector and have modest valuations. There is a bigger cushion for those two stocks if airline industry fundamentals or investor sentiments deteriorate. However, I prefer Delta because of its stability and profitability. Even if oil prices spike higher and American gains corporate market share after merging with US Airways, Delta has enough margin growth drivers of its own to justify holding the stock. US Airways is riskier because it is entering a merger integration process that, based on recent airline merger history, is likely to cause some hiccups.
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