The World's Biggest Airline...

News that Delta and Northwest are getting hitched is likely to set off a chain reaction in the domestic airline industry. The merger would create the largest airline by traffic in the world, although the same can’t be said for profitability. The US airlines have been bleeding red ink thanks to higher fuel prices and steady competition from low cost competitors. Since my writing on this subject three weeks again, there has been a spate of bankruptcies. Almost everyone is blaming the high cost of jet fuel for the industry’s woes, and the airline industry is a poster child for underwhelming performance.

But the airline stocks might not be so bad for a number of reasons, in fact, there might be good reasons to start bottom fishing for some of the beaten down companies. Here are a few I can think of:

1. The airlines are all trimming back on capacity, meaning lower operations costs, and from the market standpoint, improved revenue and profits.

2. Fuel prices are at unnaturally high, and with the economy in recession, the price of oil is likely to fall and thus relieve of some of the operating costs from the airline industry

3. The increased number of international routes that are both profitable and generally under served. This is especially true for the Pacific routes.

4. Increased travel demands internationally means that competition is generally still small and there is significant room for expansion.

5. Airlines are raising prices to combat fuel costs, and might not be so willing to cut back costs if there are less competition due to mergers.

I think these factors will allow the domestic airlines to improve their profitability. Especially if there is more focus on the international travel and paring back domestic routes which are under pressure from low cost carriers. Mergers will force airlines to cut staff and reduce number of flights in order to reduce operational costs and improve efficiencies. The merger between Northwest and Delta will likely to enable further consolidation within the industry, barring the unlikely event of regulatory concerns on market share.

Based on the assumptions that we will see further consolidation, I think the best stock in the airline group with upside is Continental Airlines (CAL). They are likely to be targeted United, and the consolidation there would make sense. The international routing of a combined company would benefit significantly, for the Pacific routes, each would bring in unique capabilities: Continental with India, and Israel, and United with several Southeast Asia routes including Thailand, Singapore, Vietnam, as well as Taiwan, Australia, and Kuwait. Then both also serve China which would allow increased frequency on very profitable China US routing. For Europe, Continental would add significant number routes for a combined entity, bolstering United’s lackluster offering. The comparable reduction in domestic routes would also make a merger between to two companies extremely attractive. Based on this, and the current Continental pricing, I think it is probably more attractive domestic airline stock out there for short term gains.