Time to Fly the Friendly Skies Again?

12/15/2006 12:00 am EST

Focus:

Jocelynn Drake

Financial Analyst, Schaeffer's Investment Research

Schaeffer team member Jocelynn Drake recently turned her keen eye to the airline sector where she noted a recent boost. On the heels of her review, more interesting news emerged, confirming her opinion, and providing added 'fuel' to the industry.

"After hitting a peak of $81.14 on July 14, near-term crude oil futures have retreated approximately 24%, continuing to hover around 60. The AMEX Airline Index (XAL) has taken this opportunity to stage an impressive rally, soaring more than 34% along the support of its 10-day and 20-day moving averages from its August low, and taking the index through former resistance in the 56 area, which capped XAL in December 2005, March, July, and November.

"Yet, the number of Continental Airlines (CAL NYSE) shares sold short increased 10% in November and this accumulation of bearish bets now accounts for more than 23% of the stock's total float. Short interest for AMR Corp. (AMR NYSE) jumped almost 13% last month and 10.5% of its float has been shorted. Meanwhile UAL Corp. (UAUA NASDAQ GS) saw its short interest increase by almost 22% and 6.4% of its float is sold short.

"All three are in the process of bouncing off support at their 20-day moving averages. This combination of technical strength and lingering pessimism leaves these securities poised to continue their stellar uptrend. As the bears finally shed their short positions, it will add fresh buying power to the shares, pushing them higher.

"The sector could see some heavy trading on news that #2 UAL and #5 Continental are holding talks on a potential merger, possibly creating the largest U.S. domestic carrier, with a market valuation of approximately $9 billion.

"The Wall Street Journal reported that the two airlines have been in exploratory talks for a business combination for several months. However, the talks have taken on new urgency since US Airways Group (LCC NYSE) made a hostile bid for Delta Air Lines (DALRQ OTC) several weeks ago.

"However, the talks between UAUA and CAL could hit a snag due to the special voting shares that Northwest Airlines (NWACQ OTC) holds in CAL which it could use to block a merger of CAL with another major airline--if the combination required a vote by CAL shareholders. Yet, CAL could still acquire another airline without interference from NWACQ if that transaction didn't require shareholder approval.

"The Journal also reported that AirTran Holdings (AAI NYSE) is poised to launch an offer for Midwest Air Group (MEH AMEX), signaling that consolidation pressure has extended beyond the industry's behemoths. The proposed deal would award MEH's shares a 24-percent premium to where the company's shares traded recently."

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