Budget airline an option

Mar 12 2008 by Andrew Miller, The Journal

WHO’D run an airline? It has been a tough decade for the global aviation industry.

After the terrorist attacks of September 2001, many passengers stopped flying and the Asian Sars outbreak in 2003 hardly helped matters.

Meanwhile, the market has been rocked by low-cost carriers which have undercut established airlines.

Now, there is a whole new raft of concerns. As the US prepares for potential recession, the airline industry fears leisure and business travel will fall.

The high oil price is adding to fuel costs, which cannot be hedged forever. And looking ahead, airlines may well face higher tax charges to cover environmental costs.

Against this backdrop, it’s hardly surprising that airline stocks have been in the doldrums of late. British Airways’ share price has halved in the past 12 months. Nevertheless, BA recently advised that it expected its revenues to grow 4-4.5% in 2008/09, with margins falling from 10% to about 7% for the year.

Estimates and ratings are still on the move in this sector (mainly downwards), as the outlook is changing rapidly. Fair value estimates will have a shelf life compatible with earnings and ratings, and will move with oil prices and shifting economic data.

Longer term, aside from external shocks, a steady 4-5% growth in air travel is expected, driven mainly by emerging markets. BA should benefit from its focus on costs, a stronger balance sheet, and its move to Heathrow’s new Terminal 5. So there should be longer-term value in the stock, but risks remain from oil prices and the economic outlook. We expect BA’s share price to stay weak and volatile in the near term.

Elsewhere in the airlines sector, budget carriers may well fare better than premium brands as travellers trade down to cheaper flights. And holiday flights (which make up the majority of its business) generally withstand an economic downturn better than business travel.

We see EasyJet shares as a good long-term growth prospect, though this is still a very risky stock. EasyJet trades at a premium to most network airlines, but in line with its European peer, Ryanair. It released good February data last week showing that passenger numbers were up 14.8% to 3.03 million over the month. There was also a welcome increase in load factor (the percentage of seats filled on an average flight), up 1.4% to 84.3%.

The news supported EasyJet’s own upbeat outlook, but has done little to help the share price, which has languished at just over 400p since stock markets tanked in early January.

Our fair value for EasyJet is 512p, cut recently to reflect the general fall in share prices, and the specific risks a downturn would pose to the airline industry.

As an established low-cost carrier, EasyJet has excellent long-term potential. Nevertheless, to hold the shares investors have to be able to withstand short-term falls and look beyond the current economic uncertainty and oil price moves. Those factors lie behind our neutral rating on the company.

For most investors, we think the airline sector is probably best avoided for now. However, if you are looking to invest with a longer-term horizon, can absorb some short-term risk and expect the oil price to fall, the low-cost airlines are worth a second look.

Just be grateful you don’t have to manage one.

Andrew Miller is regional head of Barclays Wealth