A New Day for the Airline Industry

12/07/2011 9:45 am EST

Focus: ETFs

Benjamin Shepherd

Analyst, Breakthrough Tech Profits, Global Income Edge and Personal Finance

Aside from mining companies and energy companies, airlines are the pinnacle of boom and bust industries and that trend continues with recent news of a major carrier’s challenges, which spell opportunity for others, writes Ben Shepherd of Global ETF Profits.

“I’m an airline manager. I don’t invest in airlines.”—Robert Lloyd Crandall, President and Chairman, American Airlines

There have been nearly 200 airline bankruptcy filings since 1979, according to an informal listing compiled by the Air Transport Association. Several carriers have even filed for bankruptcy protection more than once.

But AMR Corp (AMR), the parent company of American Airlines, has long been an exception, having made herculean efforts over the years to avoid a reorganization via bankruptcy court.

That dogged determination left AMR Corp at a significant disadvantage to its competitors, who were able to pare labor costs by using the bankruptcy process to break contracts and unload pension plans. While those bankruptcies saved the broader industry billions of dollars in costs, AMR Corp suffered, as its own labor costs ran about $800 million higher than its competitors.

Additionally, the carrier’s aging fleet of aircraft caused it to struggle with higher maintenance expenses. And energy commodity inflation further impacted its bottom line, with jet fuel costs averaging $3 per gallon this year, a record high.

In fact, AMR Corp actually lost money over the past two years—its earnings have been negative in 14 of the last 16 quarters—even as the overall airline industry was profitable.

With such overwhelming headwinds, AMR Corp filed for Chapter 11 protection last week, becoming the first major airline to do so since 2005.

AMR Corp’s bankruptcy wasn’t entirely unexpected, however, as shares of the carrier’s stock had already lost more than three-quarters of their value this year prior to the trading session following its bankruptcy filing. When that trading day is included in the tally, the airline’s shares are off by 96% for 2011.

The bankruptcy will have a major impact on AMR Corp’s employees and shareholders, and some bondholders even face a potential haircut. But in a bit of an ironic twist, the airline’s bankruptcy may actually be positive for the broader industry.

Last year, the US airline industry reported its highest profits in more than a decade, with only AMR Corp reporting a loss for the year. Although rising fuel costs meant that 2011 wasn’t expected to be another record year for airline profits, AMR Corp was again the only airline expected to post a net loss for the year.

During its bankruptcy reorganization, AMR Corp should be able to reduce its costs significantly, which could boost the profits of the airline industry as a whole, particularly if fuel costs moderate.

Given that ironically bullish development, Guggenheim Airline (FAA) has enjoyed a bit of a run to the upside after a year of fairly steady losses.

The exchange traded fund tracks a basket of 22 foreign and domestic airlines. Even though AMR Corp has a 2.6% weighting in its portfolio, the ETF still managed to gain about 5% last week.

Much of that return was driven by jumps in share prices among two of AMR Corp’s major competitors. Shares of Delta Airlines (DAL), which has an almost 16% weighting in the ETF’s portfolio, returned nearly 8%. And shares of United Continental Holdings (UAL), which has a 14.2% weighting in the ETF’s portfolio, returned roughly 10%.

The ETF is experiencing higher-than-average trading volume because of the renewed interest in the airline industry. But it’s also benefited from the fact that its only ETF competitor was discontinued early last month. Direxion Shares closed its Airlines Shares ETF because a lack of investor interest kept its assets from ever reaching a profitable threshold.

Even in the absence of competition, Guggenheim Airline’s average trading volume is still only about 18,000 shares a day, while its assets currently stand at just $16.5 million. With an annual expense ratio of 0.65%, the ETF is only earning its sponsor about $100,000 in annual revenue.

Unless Guggenheim Airline somehow attracts more assets, the ETF could face closure itself.

In fact, we would probably take Robert Crandall’s advice and steer clear of the airlines, since they’re better known for generating volatility than positive investment returns. Still, if you’d like to invest in the sector, Guggenheim Airline is your best—if only—option available among ETFs.

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